ITEM 1. BUSINESS.
We bottle, market and distribute natural spring water under the Vermont Pure(R) and Hidden Spring(R) brands, and purified water with minerals added under the Crystal Rock(R) brand, to the retail consumer and Home & Office markets. We sell our products primarily in New England, New York and New Jersey, as well as the mid-Atlantic and the mid-western United States.
INDUSTRY BACKGROUND
Bottled water has been and continues to be one of the fastest growing segments of the beverage industry. According to studies prepared by Beverage Marketing Corporation, on a calendar year basis, total bottled water consumption on a per capita basis in the United States more than doubled from 1990 to 2002. Annual consumption increased from 8.8 gallons per capita in 1990 to 21.2 gallons per capita in 2002. Bottled water volume in the United States has grown significantly, increasing from approximately 2.2 billion gallons in 1990 to approximately 6.0 billion gallons in 2002, a 173% increase. The wholesale sales value of bottled water increased more, from approximately $2.6 billion in 1990 to approximately $7.8 billion in 2002. Over the period from 1993 to 2002, bottled water was the fastest growing beverage category in the United States.
The bottled water market is divided into two distinct categories: non-sparkling (defined as still or non-carbonated water), which accounts for approximately 91% of bottled water sales, and sparkling (carbonated), which accounts for the balance. Non-sparkling water was responsible for 99% of the incremental volume increase from 1990 to 2001. Both our natural spring water and our distilled water with minerals added are in the non-sparkling category.
We believe that consumers perceive bottled water to be a healthy and refreshing beverage alternative to beer, liquor, wine, soft drinks, coffee and tea. We anticipate that sales of bottled water will continue to grow as consumers focus on health and fitness, alcohol moderation and the avoidance of both caffeine and sodium. Bottled water has become a mainstream beverage as the centerpiece of consumers' healthy living lifestyles. In addition, we believe that the development and continued growth of the bottled water industry since the early 1980's reflects growing public awareness of the potential contamination and unreliability of municipal water supplies.
In recent years, the bottled water industry has experienced periods of significant consolidation. Large multi-national companies such as Perrier (owned by Nestle), Groupe Danone and Suntory Water Group have been active acquirers of small and medium sized regional bottled water companies. In 2003, Danone and Suntory pooled their respective United States assets in the industry into a joint venture to create the largest Home & Office water delivery company in the country. In general, the primary drivers of this consolidation are the incremental growth realized by acquiring the target company's customer base, and synergies resulting from integrating existing operations.
The entrance of major soft drink bottlers into the bottling and distribution segment of the industry has had a major impact on the bottled water industry. Both Coca-Cola and Pepsi Cola have started producing and marketing their own brands of reverse osmosis drinking water within the past
four years and, based on dollar sales, are among the top ten bottled water companies in the United States.
COMPANY BACKGROUND
Vermont Pure Holdings, Ltd. has two main operating subsidiaries, Crystal Rock Spring Water Company, Inc. and Vermont Pure Springs, Inc.
Established in 1990, we originally developed Vermont Pure(R) Natural Spring Water as our flagship brand in the still, non-carbonated retail consumer category. Over the next decade, we grew aggressively both internally and through acquisitions, primarily in the Home & Office market. In addition to marketing the Vermont Pure(R) brand, in 1995 we renewed marketing efforts with respect to our original trademark, Hidden Spring(R). We expanded our product lines to include more sizes and features, such as sports caps on selected bottle sizes for convenient single serve, and multi-packs for the grocery and convenience store channels.
By 1996, we began to pursue a strategy of diversifying our product offerings. Most notably, we began to utilize an acquisition strategy in 1996 to minimize our reliance on the retail consumer side of the business and to increase growth in other categories. Prior to 1996, our retail business represented 90% of our total sales revenues. In 2003, by way of contrast, our Home & Office delivery category represented 65% of our total sales. Based on historical data, this sales volume would place us fourth in the United States and second in the northeast region for this type of distribution. Additional benefits of increasing the Home & Office channel have included higher gross margins and reduced seasonality of our sales.
In October 2000, we merged with the Crystal Rock Spring Water Company, Inc. of Watertown, Connecticut. Crystal Rock had historically focused its manufacturing resources on the still, non-carbonated segment of the bottled water industry. Although its primary business had been the marketing and distribution of Crystal Rock(R) brand of purified and mineralized drinking water to the Home & Office delivery markets, it also distributed coffee, other refreshment type products, and vending services in Connecticut, New York and Massachusetts. We continue to provide these products and services.
We continued our acquisition strategy in fiscal year 2002 with smaller acquisitions in our established Home & Office markets. Noteworthy among these was our acquisition of Iceberg Springs, a Home & Office distributor servicing Fairfield and New Haven counties in Connecticut and the suburban New York communities in Westchester and Putnam counties. Iceberg's annual revenue was approximately $3 million while servicing 4,500 customers. In 2003, we acquired seven small water and coffee companies in our core market areas. The historical annualized sales of these businesses totaled a combined $4.2 million.
To date, we have not experienced significant problems in integrating our acquired businesses with our existing operations. However, the acquisition of new businesses, particularly ones of significant size and complexity, may require management to devote substantial time and energy to the successful, efficient and timely integration of operations, labor forces, administrative systems (including accounting practices and procedures and management information systems), and varying corporate cultures. A failure to realize expected synergies could have an adverse effect on our business.
Management believes that, despite such risks, our acquisition strategy has been and continues to be a success. The combination with Crystal Rock enabled us to nearly double our sales revenues, significantly accelerated our Home & Office growth strategy and added to management depth.
The growth in our Home & Office delivery category has been predominantly fueled by market expansion through our acquisition strategy, which we have pursued mainly in New England and northern New York. We have also experienced subsequent internal growth in those acquired markets following these acquisitions.
We have also leveraged our distribution system to expand our product lines. In particular, coffee, a product that is counter seasonal to water, became the second leading product in the distribution channel, now accounting for almost 10% of our total sales. We buy coffee under contracts that set prices for a period of six to eighteen months, in order to maintain price and supply stability. Because coffee is a commodity, we cannot ensure that future supplies and pricing will not be subject to volatility in the world commodity markets. Any interruption in supply or dramatic increase in pricing may have an adverse effect on our business.
In the consumer retail market, we have taken advantage of our customer relationships, quality water sources and bottling operations by co-packing private label brands. Private labels are a growing portion of this category and have become increasingly competitive with branded products in terms of price and market share. In addition to providing increased bottling volume and contributing margin, we believe this business enhances relationships with the retailers we serve. Current customers include large northeast retail grocers such as A&P, Giant Carlisle, Finast, Hannaford, Shop Rite, Stop & Shop, CVS, and Tops, among others. In 2003, private label sales grew to account for 72% of our consumer retail sales, representing 27% of our total sales.
To accommodate the growing demand for our bottled spring water products, we have regularly increased our investment in plant and equipment. When we were founded, our assets included one spring on 1.7 acres of land, a 9,000 square foot office facility and a bottling plant in Randolph, Vermont. Since that time, we have acquired additional springs on approximately 65 acres of land in Randolph. We have also built a second office, bottling and warehouse facility of 32,000 square feet in Randolph, which we recently expanded to approximately 72,000 square feet. In 2002, we added a second bottling line for our retail consumer products, more than doubling the production capacity for this category. We also lease a 67,000 square foot facility located on ten acres in Watertown, Connecticut. This facility houses the bottling operations, our largest Home & Office distribution center, and centralized customer service and administrative offices for our Crystal Rock subsidiary. We also have a five-gallon bottling facility near Albany, New York, and distribution centers throughout New England and northern New York.
WATER SOURCES AND BOTTLING OPERATIONS
The primary sources of our natural spring water are springs located at our property in Randolph, Vermont, and a spring owned by a third party in Stockbridge, Vermont, that is subject to a water supply contract.
Percolation through the earth's surface is nature's best filter of water. We believe that the exceptionally long percolation period of natural spring water in the north central Vermont area and, in particular, in the area of our springs, assures a high level of purity. Moreover, the long percolation period permits the water to become mineralized and pH balanced.
We believe that the age and extended percolation period of our natural spring water provides the natural spring water with certain distinct attributes: a purer water, noteworthy mineral characteristics (including the fact that the water is sodium free and has a naturally balanced pH), and a light, refreshing taste.
In addition to drawing water from our own springs, we buy bulk quantities of water from natural springs owned or operated by non-affiliated entities. All of these springs are approved by the State of Vermont as sources for natural spring water. During fiscal year 2003, purchases of spring water from a source in Vermont that is not owned by or affiliated with us amounted to approximately 60% of our usage of spring water. We are actively exploring the acquisition of additional spring sources that would enable us to reduce our reliance on third-party springs.
We have for several years bought spring water from a source in Stockbridge, Vermont. Until late 1999, we had no contract with respect to this source. Commencing in November 1999, we obtained a 50-year water supply contract to purchase, on a first priority basis, up to 5,000,000 gallons per month from the spring owner. Because this amount is well in excess of our current needs and within the apparent capacity of the spring, we believe that we can readily meet our bulk water supply needs for the foreseeable future.
In 2002, we signed a 20-year agreement with the Town of Bennington, Vermont to purchase water from a spring owned by the town. Under that agreement, we can use up to 100,000 gallons a day from this site. We plan to use this water primarily in our Halfmoon, New York bottling facility. Presently, we have yet to use water from this site.
An interruption or contamination of any of our spring sites would materially affect our business. We believe that we could find adequate supplies of bulk spring water from other sources, but that we might suffer inventory shortages or inefficiencies, such as increased purchase or transport costs, in obtaining such supplies.
Water from the local municipality is the primary raw source for the Crystal Rock(R) brand. The raw water is purified through a number of processes beginning with filtration. Utilizing carbon and ion exchange filtration systems, we remove chlorine and other volatile compounds and dissolved solids. After the filtration process, impurities are removed by reverse osmosis and/or distillation. We ozonate our purified water (the process of injecting ozone into the water as an agent to prohibit the formation of bacteria) prior to storage in four 30,000-gallon storage tanks. Prior to bottling, we add pharmaceutical grade minerals to the water, including calcium and potassium, for taste. The water is again ozonated and bottled in a fully enclosed clean room with a high efficiency particulate air, or HEPA, filtering system designed to prevent any airborne contaminants from entering the bottling area, in order to create a sanitary filling environment.
If for any reason this municipal source for Crystal Rock(R) water were curtailed or eliminated, we could, though probably at greater expense, purchase water from other sources and have it shipped to the Watertown manufacturing facility.
We are highly dependent on the integrity of the sources and processes by which we derive our products. Natural occurrences beyond our control, such as drought, earthquake or other geological changes, a change in the chemical or mineral content or purity of the water, or environmental pollution may affect the amount and quality of the water emanating from the springs we use. There
is a possibility that characteristics of the product could be changed either inadvertently or by tampering before consumption. Even if such an event were not attributable to us, the product's reputation could be irreparably harmed. Consequently, we would experience economic hardship. Occurrence of any of these events could have an adverse impact on our business. We are also dependent on the availability of water and the continued functioning of our bottling processes. An interruption may result in an inability to meet market demand and/or negatively impact the cost to bottle the products. Additionally, the distribution of the product is dependent on other businesses.
Finally, the terrorist attacks of September 11, 2001 and any further attacks could impact our operations negatively if such attacks result in a prolonged or severe economic downturn. Further, because our products are packaged for human consumption and could be considered a substitute for public water infrastructure, there is a possibility that we or our products could be a direct target of future terrorist attacks. Although management believes this risk to be remote, any such act of terrorism or attempted act could be catastrophic to our business or operations.
PRODUCTS
We sell our natural spring water in the retail consumer market under the Vermont Pure(R) and Hidden Spring(R) brands, packaging the product in various bottle sizes ranging from 8 ounces to 1.5 liters, and selling it in single units and plastic shrinkfilm of six, eight, and twelve bottles. We sell our products in 12-pack and 24-pack cases. In recent years, sales indicate that the preferred container sizes are "single serve" sizes - 750 ml and 500 ml. We use a sports cap on various product sizes to create convenience and add extra value. We bottle consumer sizes in clear PET (polyethylene terephthalate) recyclable bottles that are perceived in the marketplace as a high quality package. Although the Crystal Rock(R) brand is bottled in this type of bottle for retail sale, and in similar sizes, this outlet does not comprise a significant amount of our sales.
We sell our three major brands in three and five gallon bottles to homes and offices throughout New England and New York. In general, Crystal Rock(R) is distributed in southern New England, while Vermont Pure(R) and Hidden Spring(R) are distributed in northern New England and upstate and western New York. We rent water coolers to customers to dispense bottled water. Our coolers are available in various consumer preferences such as cold, or hot and cold, dispensing units. In conjunction with our Home & Office accounts, we also distribute a variety of coffee, tea and other hot beverage products and related supplies, as well as other consumable products used around the office. We offer vending services in some locations. We rent or supply multi-burner coffee machines to customers. In addition, we supply whole beans and coffee grinders for fresh ground coffee and cappuccino machines to restaurants. We are the exclusive office coffee distributor of Baronet Coffee in New England, New York and New Jersey. In addition to Baronet Coffee, we sell other national brands, most notably, Green Mountain Coffee Roasters.
MARKETING AND SALES OF BRANDED PRODUCTS
Marketing
We generally market our products as "premium" domestic bottled water products in two categories.
Home & Office Delivery
We distribute and market our water in five and three-gallon bottles as "premium" bottled
water products. We seek brand differentiation by offering quality service. Home & Office sales are generated and serviced using our own facilities, employees and vehicles.
We also use telemarketers and outside/cold-call sales personnel to market our Home & Office delivery. We support this sales effort through promotional giveaways and Yellow Page advertising, as well as radio, television and billboard advertising campaigns. We also sponsor local area professional sports and professional sporting events, participate in trade shows, and endeavor to be highly visible in community and charitable events.
We market our Home & Office delivery service throughout most of New England and New York.
Retail Consumer (PET)
In the retail consumer category, consumers distinguish a premium bottled water product from other available bottled water products by packaging consisting of small portable containers, typically clear plastic PET recyclable bottles. We believe that this is the "ultimate" consumer bottle package because it is clean, clear, light and recyclable, and generally perceived by consumers to be higher quality. We also believe that the high quality packaging of our products enhances their image as premium domestic bottled water products.
We endeavor to price our Vermont Pure(R) brand at a level that is competitive with other domestic premium brands, but lower than imported premium water products. Hidden Spring(R) brand products are similarly packaged and sold to retail grocery and convenience markets. Both of these brands, as well as Crystal Rock(R), are marketed from our own delivery routes.
We market the Crystal Rock(R) brand by providing the same consistent, refreshing taste in a small package that customers have relied on from their coolers in their homes and offices. We also distribute Crystal Rock(R) products for sponsorship of organizations and events.
We market our spring water products such as the Vermont Pure(R) brand by highlighting the unique characteristics of our water, namely a natural spring source, purity, mineral composition and desirable taste. We also strive to use the image of the State of Vermont in our marketing and brand identification. We believe that consumers feel that products originating from Vermont have a general reputation for being pure, wholesome, trustworthy and natural.
We have focused our consumer product marketing and sales activities in the eastern and mid-western United States. We currently distribute our products in the New England, New York, New Jersey, mid-Atlantic and northern mid-western states and the northern Virginia - Washington, D.C. - Baltimore metropolitan area.
Slotting Fees
To achieve placement of our retail consumer products in certain supermarket chains and individual supermarket stores, we must sometimes purchase shelf space by paying slotting fees. Typically, supermarket chains and prominent local supermarkets impose these charges as a one time payment before the products are permitted in the store or chain. Other types of retail outlets, such as individual convenience stores and delicatessens, impose slotting fees less frequently. These fees are negotiated on an individual basis. As we have become better established and as our brands have achieved greater recognition, we have become less dependent on slotting fees to gain space.
Nevertheless, like many producers of food products, we still pay slotting fees in some cases, and expect to continue to do so.
Advertising and Promotion
We advertise our products primarily through print, television and radio media. In connection with this advertising, we use point of sale, in-store displays, price promotions, store coupons, free-standing inserts and cooperative and trade advertising. We have also actively promoted our products through sponsorship of various organizations and sporting events. In recent years, we have sponsored professional golf and tennis events, as well as major ski areas and sports arenas, and various charitable and cultural organizations, such as Special Olympics, the National Association of Breast Cancer Organizations, the Multiple Sclerosis Society, and the Vermont Symphony Orchestra.
Sales and Distribution
Home & Office Delivery
We sell and deliver products directly to our customers using our own employees and route delivery trucks. We make deliveries to customers on a regularly scheduled basis. We bottle our water at our facilities in Watertown, Connecticut, Randolph, Vermont, and Halfmoon, New York. We maintain numerous distribution locations throughout our market area. From these locations we also distribute dispensing equipment, a variety of coffee, tea and other refreshment products, and related supplies. We ship between our production and distribution sites using both our own and contracted carriers.
We use outside distributors in areas where we currently do not distribute our products. Distributor sales represented less than 2% of total revenue in 2003.
We continue to pursue an acquisition strategy to purchase independent Home & Office bottlers and distributors in New England and New York State. Management's decision to expand in this market has been driven by, among other things, attractive margins and good cash flows from equipment rentals, as well as by the advantages of product diversification. Moreover, the Vermont Pure(R) and Crystal Rock(R) brands in the multi-gallon or Home & Office setting affords consumers an opportunity to sample the product, which we believe augments retail sales and contributes to brand awareness.
Retail Consumer (PET)
We use major beverage distributors to distribute most of our retail consumer products, while we distribute our Home & Office products directly. Using distributors is typical in the beverage industry as an efficient use of capital for maximum market penetration. Beverage distributors purchase the products of many companies and then wholesale them to retail chains or make bulk retail sales. Distributors generally have established relationships with local retail outlets for beverage products and facilitate obtaining shelf space. Occasionally, we sell our products directly to grocery store chains.
We distribute our Vermont Pure(R) brand using a number of distributors. We are obligated to supply the distributors with their requirements of the Vermont Pure(R) brand at established prices. Arrangements with the distributors of the Hidden Spring(R) brand are, in general, less restrictive.
We ship our consumer products from our bottling facilities in Randolph, Vermont by common carrier either directly to beverage distributors and retail outlets or to authorized warehouses for later distribution to beverage distributors and retail outlets. Storage is charged on a per pallet basis. Transportation costs vary according to the distance of the shipment.
We employ a sales force of four people for retail and distributor coverage on a product line basis. Our sales personnel act as a liaison among distributors, customers and ourselves for ordering product, facilitating distribution, servicing retail outlets, and coordinating warehouse distribution. Sales personnel actively seek to expand the number of retail outlets and distributors, and they participate in overall market development.
CONTRACT PACKAGING
In recent years, our fastest growing products in the retail consumer category have been private label products. We bottle private label products in essentially the same sizes and configurations as for our branded products for grocery, drug, and convenience store chains, using their label. As the retailers have entered the market, they have preferred natural spring water for the product that they market.
Contract packaging is a growing part of the retail consumer marketplace and is very price competitive. We seek opportunities for contract packaging for a variety of reasons, including the fact that it develops favorable relationships with retail chains and provides volume to fill bottling capacity. For the past three fiscal years, contract packing represented the most significant growth portion of our retail consumer product sales revenue - more than doubling in 2002 and increasing 26% in 2003. Private label revenue was 27% of our total sales in 2003 compared to 20% in 2002 and 9% in 2001.
We also package five gallon Home & Office containers, on a limited basis, for third parties. These sales represented less than 2% of sales in the most recent fiscal year.
SUPPLIES
We currently source all of our raw materials from outside vendors. In the retail PET business, we source PET bottles, caps and corrugated packaging under supply agreements ranging from one to three years. Pricing is fixed in the agreement with pass through formulas for price increases or decreases based on total market prices for these commodities. Due to increases in demand or shortage of key raw materials, we have, at times, had difficulty procuring raw materials. Supply shortages or subsequent increases in pricing of these materials have historically had an adverse effect on our expense structure.
We entered into a new supply agreement for bottles effective January 1, 2003 that enables us to further reduce the weight and cost of our bottles. In recent years, we have effectively reduced our cost per case for bottles due to the reduction in gram weight of resin. In addition, this reduction has had a favorable impact on the environment, reducing the amount of plastic in our containers and the amount of plastic entering the waste stream by over 1,000,000 pounds per year. Management is constantly undertaking further raw material cost saving initiatives for caps, plastic, and corrugated packaging. Notwithstanding these expectations, we may experience shortages or unscheduled price increases that would adversely effect our cost of goods.
The merger of Crystal Rock and Vermont Pure has nearly doubled the size of our operations in the Home & Office category and, as a result, afforded us the opportunity to increase our combined buying power for such things as bottles, dispensing equipment, supplies, and administrative services. We have experienced some success in this area and, as one of the largest Home & Office distributors in the country, we expect to capitalize on volume to continue to reduce costs. We are a member of the Quality Bottlers Cooperative, or QBC, a purchasing cooperative comprised of some of the largest independent Home & Office water companies in the United States. QBC acts as a purchasing and negotiating agent to acquire national pricing for the cooperative on common materials such as bottles, water coolers, cups, and other supplies. QBC believes that due to its size it can effectively purchase equipment and supplies at levels competitive to larger national entities. We also believe that our relationship with other QBC members can provide access to potential acquisition targets.
In all aspects of our business, we rely on trucking and fuel to receive raw materials and transport and deliver finished product. Consequently, the price of fuel significantly impacts the cost of our products. We purchase our own fuel for our Home & Office delivery and use third parties for transportation of raw materials and retail consumer product. While volume purchases and hedging can help control erratic fuel pricing, market conditions ultimately determine the price. We have entered into some agreements with haulers and fuel vendors in an effort to control costs, but substantial changes in fuel prices, including, for example, increases due to hostilities in the Middle East, would likely affect our profitability.
No assurance can be given that we will be able to obtain the supplies we require on a timely basis or that we will be able to obtain them at prices that allow us to maintain the profit margins we have had in the past. Any raw material disruption or price increase may result in an adverse impact on our financial condition and prospects.
SEASONALITY
Our business is seasonal, with the retail consumer portion of the business being more seasonal than the Home & Office market. Coffee sales are counter seasonal to water. The period from June to September represents the peak period for sales and revenues due to increased consumption of beverages during the summer months in our core Northeastern United States market. As the larger share of total sales has trended toward the Home & Office category, our business, as a whole, has become less seasonal.
COMPETITION
Management believes that bottled water historically has been a regional business in the United States. As a result, there are numerous bottling operations within the United States producing a large number of branded products that are offered in local supermarkets and other retail outlets in the smaller consumer sizes and sold to the Home & Office markets in one gallon and multiple gallon containers.
The bottled water market in this country is dominated by large multi-national companies such as Nestle (Perrier Group), and Danone/Suntory Water Group. Perrier markets such regional brands as Poland Spring, Deer Park, Ice Mountain, Great Bear, Arrowhead, Calistoga, Ozarka, Zephyrhills, and Aberfoyle Springs, and the Aqua-Cool division of Ionics. Groupe Danone distributes Evian, Dannon, and Naya nationally. Danone/Suntory markets primarily through the Home & Office channel regional brands such as Sparkletts, Belmont Springs, Kentwood, Crystal Springs, Sierra
Springs, and Hinckley Springs. The entry of Pepsi Cola (Aquafina) and Coca-Cola (Dasani) into the PET retail segment, leveraging their production and distribution infrastructure, has significantly altered the bottled water industry. All of these global competitors have greater resources and their brands are often better established than our brands.
We also face increased competition from Canadian suppliers at low prices due to the exchange rate differential and governmental subsidies in the retail PET business. Additionally, there are well-established regional water companies with operations that could adversely affect our business. We also face competition from the fast growing "private label" and contract-packaged brands of natural spring water. These brands compete on a low-price basis and often occupy premium shelf space because they are retailer brands.
The Home & Office market has several national or large competitors such as Perrier Group (Poland Spring, Deer Park, and Great Bear), and Danone/Suntory (Belmont Springs). Additionally, we compete with smaller regional bottlers such as Monadnock in the Boston area, Leisure Time in the Hudson Valley of New York, and Mayer Brothers in Buffalo.
With our Vermont Pure(R) brand, we compete on the basis of pricing, customer service, and quality of our products, the image of the State of Vermont, attractive packaging, and brand recognition. With the Crystal Rock(R) brand, we compete on the basis of the purity of the distilled product with minerals added back for taste. We consider our trademarks, trade names and brand identities to be very important to our competitive position and defend our brands vigorously.
We feel that installation of filtration units in the home or commercial setting poses a competitive threat to the business. To address this, we make available plumbed-in filtration units and servicing contracts on a limited basis.
As the retail industry consolidates, we are increasingly subject to competition from large multinational companies with more resources and product lines which could give them an advantage in selling, promoting, bottling, and delivering products. We have one plant devoted to bottling retail size packages, which to some extent hinders our ability to react to competitive changes in a larger marketplace. In addition, a substantial event that incapacitated the facility could result in an inability to satisfy customer needs.
Consolidation of the retail and distribution trade has limited the number of potential customers in the marketplace and increased competition to obtain their business. If this trend were to continue, it could hamper our ability to sell our retail products for an adequate profit margin.
In the Home & Office segment, competition from non-traditional sources is changing the marketplace. The two most notable examples are water filtration as a substitute for purchasing water and cheaper coolers from offshore sources, making customer purchasing a more viable alternative to leasing. We are reacting to these changes by integrating these options into our business. If we are not able to successfully integrate them into our business, our sales and profits could decrease.
TRADEMARKS
We sell our bottled water products under the trade names Vermont Pure Natural Spring Water(R), Crystal Rock(R), Hidden Spring(R), and Stoneridge(R). We have rights to other trade names, including Pequot Natural Spring Water(R), Excelsior Spring Water(R), Happy Spring Water(R),
Manitock Spring Water(R), and Vermont Naturals(R). Our trademarks as well as label design are registered with the United States Patent and Trademark Office.
GOVERNMENT REGULATION
The Federal Food and Drug Administration, or FDA, regulates bottled water as a "food." Accordingly, our bottled water must meet FDA requirements of safety for human consumption, of processing and distribution under sanitary conditions and of production in accordance with the FDA "good manufacturing practices." To assure the safety of bottled water, the FDA has established quality standards that address the substances that may be present in water which may be harmful to human health as well as substances that affect the smell, color and taste of water. These quality standards also require public notification whenever the microbiological, physical, chemical or radiological quality of bottled water falls below standard. The labels affixed to bottles and other packaging of the water are subject to FDA restrictions on health and nutritional claims for foods under the Fair Packaging and Labeling Act. In addition, all drinking water must meet Environmental Protection Agency standards established under the Safe Drinking Water Act for mineral and chemical concentration and drinking water quality and treatment which are enforced by the FDA.
We are subject to the food labeling regulations required by the Nutritional Labeling and Education Act of 1990. We believe we are in substantial compliance with these regulations.
We are subject to periodic, unannounced inspections by the FDA. Upon inspection, we must be in compliance with all aspects of the quality standards and good manufacturing practices for bottled water, the Fair Packaging and Labeling Act, and all other applicable regulations that are incorporated in the FDA quality standards.
In May 1996, new FDA regulations became effective that redefined the standards for the identification and quality of bottled water. We believe that we meet the current regulations of the FDA, including the classification as spring water.
We also must meet state regulations in a variety of areas. The Department of Health of the State of Vermont regulates water products for purity, safety and labeling claims. Bottled water sold in Vermont must originate from an "approved source." The water source must be inspected and the water sampled, analyzed and found to be of safe and wholesome quality. The water and the source of the water are subject to an annual "compliance monitoring test" by the State of Vermont. In addition, our bottling facilities are inspected by the Department of Health of the State of Vermont.
Our product labels are subject to state regulation (in addition to the federal requirements) in each state where the water products are sold. These regulations set standards for the information that must be provided and the basis on which any therapeutic claims for water may be made. We have received approval from every state for which we have sought approval and can distribute our brands in 49 states.
The bottled water industry has a comprehensive program of self-regulation. We are a member of the International Bottled Water Association, or IBWA. As a member, our facilities are inspected annually by an independent laboratory, the National Sanitation Foundation, or NSF. By means of unannounced NSF inspections, IBWA members are evaluated on their compliance with the FDA regulations and the association's performance requirements, which in certain respects are more stringent than those of the federal and various state regulations.
EMPLOYEES
As of January 22, 2004, we had 367 full-time employees and 29 part-time employees. None of the employees belongs to a labor union. We believe that our relations with our employees are good.
Our continued success will depend in large part upon the expertise of senior management. On October 5, 2000, Timothy G. Fallon, Chairman and Chief Executive Officer; Peter K. Baker, President; John B. Baker, Executive Vice President; and Bruce MacDonald, Chief Financial Officer, Treasurer and Secretary entered into five-year employment contracts with the Company. These agreements do not prevent these employees from resigning. John Baker's contract has a "reduced employment" option that became available to him in April 2002 that allows for part-time employment at Mr. Baker's option. To date, Mr. Baker has not exercised this option.
The departure or loss of Mr. Fallon or Mr. Peter Baker in particular could have a negative effect on our business and operations.
ADDITIONAL AVAILABLE INFORMATION
Our principal Internet address is www.vermontpure.com. We make our annual, quarterly and current reports, and amendments to those reports, available free of charge on www.vermontpure.com, as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC. Reports of beneficial ownership of our common stock, and changes in that ownership, by directors and officers on Forms 3, 4 and 5 are likewise available free of charge on our website.
ITEM 2.
ITEM 2. PROPERTIES.
We own office, bottling and warehouse properties and natural springs in Randolph, Vermont. We also rent, on a monthly basis, an office in White Plains, New York.
We rent public warehouse space in different locations from time to time for the purpose of the trans-shipment of our bottled water products to our distributors and retailers. This space is rented on a per pallet basis.
As part of our Home & Office delivery operations, we have entered into or assumed various lease agreements for properties used as distribution points and office space. The following table summarizes these arrangements:
In conjunction with the Crystal Rock merger, we entered into ten-year lease agreements to lease the buildings that are utilized for operations in Watertown and Stamford, Connecticut. The landlord for the buildings is a trust with which Henry, John, and Peter Baker, and Ross Rapaport are affiliated.
We expect that these facilities will meet our needs for the next several years.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS.
In August 2003 we filed a lawsuit in federal court in Massachusetts against Nestle Waters North America, Inc. and its parent company, Nestle S.A. Our lawsuit alleges that Nestle has engaged, and continues to engage, in false and misleading advertising of its Poland Spring(R) brand of bottled water, and that Nestle has marketed and sold, and continues to market and sell, Poland Spring(R) as "spring water" with the knowledge that it is not spring water and does not meet the scientific, regulatory or plain English definitions of the term. We believe that these practices have helped Nestle, one of our major competitors, to capture a very significant market share of the bottled water market.
We have made claims under the federal Lanham Act, which creates civil liability for any person who, in commercial advertising or promotion, misrepresents the nature, characteristics, qualities or geographic origin of goods, services or commercial activities. We have also made claims under corresponding provisions of unfair trade practice laws in approximately 25 states that provide a private right of action for such violations. We are seeking an injunction that would require Nestle not to engage in false advertising and to publish corrective advertising that would retract its false and misleading statements. We are also seeking monetary damages. Nestle has filed a motion to dismiss the case on the grounds that we have failed to state a proper claim. The court has not yet ruled on Nestle's motion to dismiss.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
No matter was submitted to a vote of security holders during the quarter ended October 31, 2003.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
Our Common Stock is traded on the American Stock Exchange, or AMEX, under the symbol VPS. The table below indicates the range of the high and low daily closing prices per share of Common Stock as reported by AMEX.
The last reported sale price of our Common Stock on AMEX on January 14, 2004 was $3.13 per share.
We had 390 record owners of our Common Stock as of January 14, 2004. As of that date, we believe that there were approximately 3,200 beneficial holders of our Common Stock.
No dividends have been declared or paid to date on our Common Stock, and we do not anticipate paying dividends in the foreseeable future. We follow a policy of cash preservation for future use in the business.
SECURITIES AUTHORIZED FOR ISSUANCE UNDER EQUITY COMPENSATION PLANS.
The following table sets forth additional information as of October 31, 2003, about shares of our Common Stock that may be issued upon the exercise of options and other rights under our existing equity compensation plans and arrangements, divided between plans approved by our stockholders and plans or arrangements that were not required to be and were not submitted to our stockholders for approval.
(1) On July 24, 1996, we granted non-qualified stock options to each of Robert Getchell, Beat Schlagenhauf, Norman Rickard, and David Preston to acquire 30,000 shares of our Common Stock for a per share price of $2.50. The options expire in July 2006. Each grantee was a director at the time of grant and received the option as a performance incentive. The material features of these plans are substantially similar to those of the stockholder-approved plans.
(2) On September 12, 1997, we granted non-qualified stock options to David Preston to acquire 26,000 shares of our Common Stock, and to each of Robert Getchell, Beat Schlagenhauf, and Norman Rickard to acquire, in each case, 22,000 shares of our Common Stock for a per share price of $2.50. The options expire at various times between September 2004 and December 2005. Each grantee was a director at the time of grant and received the option as a performance incentive. The material features of these plans are substantially similar to those of the stockholder-approved plans.
(3) In an agreement dated November 4, 1994, and modified on September 12, 1997, we granted non-qualified stock options to Tim Fallon to acquire 293,335 shares of our Common Stock for a per share price of $2.50. The options expire on December 1, 2004. In February 2002, Mr. Fallon exercised 25,000 of these options. On July 24, 1996 we granted an additional 10,000 shares of our Common Stock of non-qualified stock options at an exercise price of $2.50 per share. The material features of these plans are substantially similar to those of the stockholder-approved plans.
SECURITIES SOLD AND EXEMPTION FROM REGISTRATION CLAIMED.
On January 2, 2003, the Corporation issued shares of the Company's Common Stock, at a per share price of $4.33, to the following Directors of the Company in lieu of the board fees owed them for calendar year 2002:
Effective as of June 30, 2003, the following directors purchased shares of the Company's Common Stock at a per share price of $3.49, pursuant to their right to accept a portion of their compensation as directors in stock. Certificates representing these shares were issued in January 2004.
Each such transaction was exempt from registration under the Securities Act of 1933 as a private placement under Section 4(2) thereof.
PURCHASES OF EQUITY SECURITIES BY THE ISSUER AND AFFILIATED PURCHASERS DURING THE FOURTH QUARTER.
None.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA.
The selected consolidated financial data set forth below should be read in conjunction with our financial statements and footnotes and "Management's Discussion and Analysis of Financial Condition and Results of Operations" appearing elsewhere in this report. The historical results are not necessarily indicative of the operating results to be expected in the future.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
FORWARD-LOOKING STATEMENTS
When used in the Form 10-K and in our future filings with the Securities and Exchange Commission, the words or phrases "will likely result," "we expect," "will continue," "is anticipated," "estimated," "project," or "outlook" or similar expressions are intended to identify "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. We wish to caution readers not to place undue reliance on any such forward-looking statements, each of which speak only as of the date made. Such statements are subject to various risks and uncertainties that could cause actual results to differ materially from historical earnings and those presently anticipated
or projected. We have no obligation to publicly release the result of any revisions which may be made to any forward-looking statements to reflect anticipated or unanticipated events or circumstances occurring after the date of such statements.
RESULTS OF OPERATIONS
Performance Overview - Recent Trends
Our net income declined from fiscal year 2002 to fiscal year 2003. In addition, our operating results for fiscal year 2003 have been affected by significant decreases in gross margin. In general, these decreases are attributable to lower sales and higher costs for raw materials, direct labor and operating overhead.
The sluggish economic environment in our core markets has had a negative effect on sales in the Home & Office segment. Net of acquisitions, these conditions have resulted in lower volume through loss of customers, reduced business with continuing customers, and increased competition causing lower average selling prices. In addition, those products that reflect increased sales are lower margin products. The retail segment has been transformed by competition. Price cuts by large competitors in the branded market have significantly reduced sales of our branded products. An increase in sales of private label products has more than made up for this revenue. However, the competitive environment has continued to decrease pricing for all products in this segment. Although increased volume and bottling efficiencies have more than offset commodity (PET plastic) price increases, it has not offset the reduction in selling prices. The result was a lower gross margin percentage in the retail segment compared to previous years.
Fuel costs have increased both transportation and plastic costs. Higher insurance costs have affected both employee benefits and property and casualty expenses.
Despite these adverse trends, current profitability levels and continued positive cash flow have allowed us to continue to service our debt, fund capital expansion, and continue our acquisition strategy.
Results of this fiscal year have not altered our strategic direction, even though growth and profitability trends have changed in the current fiscal year compared to the past several years. We believe that variable external factors such as economic conditions and commodity pricing will not change current trends in the near term. While no assurance can be given that these factors will change or moderate in the foreseeable future, we continue to position our business so that cyclical improvements that have characterized these and similar factors in the past are more likely to produce growth and improve our profitability.
Fiscal Year Ended October 31, 2003 Compared to Fiscal Year Ended October 31,
Sales
Sales for 2003 were $76,195,000 compared to $71,720,000 for 2002, an increase of $4,475,000 or 6%.
Sales through our Home & Office distribution channel increased to $49,854,000 in 2003 from $49,068,000 in 2002, an increase of $786,000 or 2%. The increase was a result of several small
acquisitions. Net of the acquisitions, sales were down 5%, primarily due to lower sales prices and lower demand for products in this segment.
The comparative breakdown of sales of the product lines within the segment is as follows:
Water - Sales were favorably affected by $260,000 of sales attributable to acquisitions made during the year. A 1% decrease in delivered bottles, net of acquisitions, accounted for $523,000 of the decrease in sales. The decreased volume was a result of lower market demand due to the economic environment and competition from the filtration market. The average selling price per delivered bottle decreased 2% as a result of competitive pressures in our core market. In aggregate, the change in price amounted to $445,000 of the decrease in sales for this line.
Coffee and Other Products - The acquisition of a large office coffee distributor during the year increased sales $653,000. In addition, revenue increased $707,000 from administrative fees to recapture increased fuel costs in the third quarter and the recovery of bottle deposits not returned.
Equipment Rental - Water cooler rental was down as a result of the lower market demand referred to above and competition from retail outlets selling units. Placements were down less than 1% and average price was down 2%, resulting in an aggregate decrease in rentals of $202,000. Brewer rentals increased slightly as a result in demand for single serve units.
Sales of our consumer retail products increased to $22,382,000 in 2003 from $21,197,000 in 2002, an increase of $1,185,000, or 6%. Total case volume increased 25% from fiscal year 2002. However, all of our lines face stiff competition from national and regional brands. The result is that average selling price decreased 15%.
The comparative breakdown of sales by product line for this segment is as follows:
Private Label - The increase in sales of private label products is attributable to the acquisition of new customers and continued growth of market demand. Sales volume increased 26% while average selling price fell 8% from 2002 to 2003.
Vermont Pure(R) & Hidden Spring(R) - Sales of branded products declined as a result of a decrease in volume due to limited distribution options and price due to the competitive environment.
Sales of water in the one-gallon size more than doubled in fiscal year 2003 to $3,959,000 from $1,455,000 in fiscal year 2002. The increase is attributable to two major customers that started purchasing product in fiscal year 2002.
Gross Profit/Cost of Goods Sold
Gross profit decreased to $34,952,000, or 46% of sales, in 2003 from $36,137,000, or 50% of sales, in 2002. The decrease in gross profit was attributable to lower average selling prices and higher costs. Gross profit for the Home & Office segment decreased to $29,054,000, or 58% of sales, in 2002 from $30,009,000, or 61% of sales, in 2001. The decrease in gross profit was due to lower sales volume and average selling prices, particularly for our higher margin water-related products. In addition, increased cost of sales lowered margins. The increase in cost of sales is attributable to higher insurance and employee benefit costs, higher costs of production as a result of higher costs of materials for bottles and labor, and higher service costs as a result of lower sales volume per customer.
Gross profit for the consumer retail segment decreased to $5,229,000, or 23% of sales, in 2003 from $5,732,000, or 27% of sales, in 2002. The decrease in gross profit was attributable to the effect of lower average selling prices despite higher sales volume. Lower average selling prices are attributable to a change in competitive pressures affecting all products as well as a change in product mix from branded to private label. Production costs were stable from 2002 to 2003 with savings from efficiency and volume being mitigated by increases in energy-related raw materials.
Gross profit for the retail gallon segment increased to $669,000 in 2003 from $396,000 in 2002. The higher gross margin is attributable to higher sales. However, a decrease in average selling prices due to competitive pressures caused gross margin as a percentage of sales to decrease to 17% from 27% for the respective years.
Income from Operations/Operating Expenses
Total operating expenses increased to $28,294,000 in 2003 from $27,024,000 in 2002, an increase of $1,270,000, or 5%. Operating expenses in the Home & Office and gallon segments increased 6% and 52%, respectively, while operating expenses decreased 3% in the retail segment. Higher operating costs, combined with lower selling prices and higher production costs, resulted in a decrease in income from operations of $2,454,000, to $6,659,000 in 2003 compared to $9,113,000 in 2002.
Selling, general and administrative (SG&A) expenses were $26,802,000 and $25,084,000 for 2003 and 2002, respectively, an increase of $1,718,000, or 7%. For the Home & Office segment, SG&A expenses increased to $21,030,000 in 2003 from $19,515,000 in 2002, an increase of $1,515,000, or 8%. This increase was primarily driven by an increase in the sales force to maintain and improve sales volume. SG&A expenses in the retail segments increased 4% to $5,772,000 in 2003 from $5,569,000 the prior year. The increase of $203,000 was primarily attributable to higher transportation, storage, and administrative costs associated with higher sales volume.
Advertising expenses decreased 24% to $1,266,000 in 2003 from $1,656,000 in 2002. Advertising for the retail segment totaled $465,000 in 2003 compared to $683,000 in 2002, a decrease of 32%. In the Home & Office segment, advertising decreased 18% to $801,000 in 2003 from $973,000 in 2002. The decrease is reflective of a sales strategy that focused more on direct sales than advertising. Advertising for the retail segment totaled $462,000 in 2003 compared to
$683,000 in 2002, a decrease of 32%. As private label products make up a larger part of our sales mix, less promotional support is required.
Amortization decreased to $186,000 in 2002 to $232,000 in 2003 because certain acquisition agreements that we amortize have been fully amortized during the year. We performed a test for impairment of goodwill in the second quarter and determined that there is no impairment to the goodwill presently on the balance sheet. An assessment of the value of goodwill will be completed annually by an outside, independent firm. All amortization is accounted for in the Home & Office segment.
Other compensation in fiscal year 2003 totaled $39,000 compared to $52,000 in fiscal year 2002. This expense relates to compensation paid in company stock.
Interest, Taxes, and Other Expenses
Net interest expense decreased to $4,413,000 in 2003 from $4,553,000 in 2002, a decrease of $140,000. This was reflective of lower market interest rates on the variable portion of our senior debt and operating line of credit. Further savings were mitigated by higher-than-market interest rate swaps that fixed a portion of our senior debt, as discussed further in the next section. While we expect to experience savings of as much as $600,000 in fiscal year 2004 from the termination of current swap agreements, these savings could erode if market rates increase considerably.
We had a loss of $42,000 on the sale of equipment in the normal course of business compared to a loss of $228,000 last year.
Income before income tax expense was $2,204,000 for 2003 compared to $4,260,000 in 2002. Lower taxable income resulted in a $900,000 decrease in income tax expense from 2002 to 2003. The effective tax rate that we used to compute our expense reduced slightly from 41% to 39%. For a reconciliation of the effective and statutory expense, see Note 18 to our Notes to the Consolidated Financial Statements. Our total effective tax rate is a combination of federal and state rates for the states in which we operate. Historically, our rate has been approximately 40% of income before taxes and we expect that to continue.
Net Income
Lower interest and taxes did not offset lower prices and higher costs mentioned earlier. As a result, net income decreased to $1,352,000 in 2003 from $2,509,000 in 2002, a decrease of $1,157,000, or 46%.
Based on the weighted average number of shares of common stock outstanding of 21,282,294 (basic) and 21,764,698 (diluted) during 2003, net income was $.06 per share - basic and diluted. This compares to $.12 per share, basic, and $.11 per share, diluted, in 2002.
We entered into a new swap agreement during the year ended October 31, 2003 as (described under Liquidity and Capital Resources). Cumulatively, the fair value of our four outstanding swaps increased $785,000 during the year, resulting in an unrealized loss of $36,000, net of taxes, over the life of the instruments. This amount has been recognized as an adjustment to net income to arrive at comprehensive income as defined by the applicable accounting standards. Further, it has been recorded as a current liability and a decrease in stockholders' equity on our balance sheet.
Fiscal Year Ended October 31, 2002 Compared to Fiscal Year Ended October 31,
Sales for 2002 were $71,720,000 compared to $64,858,000 for 2001, an increase of $6,872,000 or 12%.
Sales through our Home & Office distribution channel increased to $49,068,000 in 2002 from $47,551,000 in 2001, an increase of $1,517,000 or 3%. The increase was a result of an acquisition in our core southern New England market. Sales were down 2%, exclusive of the acquisition, primarily due to a decrease in sales of our non-water related products.
Home & Office sales were 68% of total sales in 2002, compared to 73% in the previous year. Water sales totaled $24,738,000 in 2002 compared to $23,027,000 in 2001, an increase of $1,711,000, or 7%. Coffee and other product sales in this area were $15,581,000 in 2002 compared to $16,501,000 in 2001, a decrease of $920,000 or 6%. Equipment rentals totaled $8,749,000 in 2002 compared to $8,023,000 in 2001, an increase of $726,000, or 9%. The increase in water sales and equipment rentals was largely attributable to the acquisition and growth in our northern New England and New York markets. Sales for the category, in general, were negatively affected by poor economic growth conditions, particularly in the southern New England market.
Sales of our consumer retail products increased to $22,652,000 in 2002 from $17,307,000 in 2001, an increase of $5,345,000, or 31%. The increase is attributable to the private label brands which more than doubled from $6,893,000 in 2001 to $14,530,000 in 2002. This reflected growing market demand and the addition of a major grocery chain and a national drug chain as customers during the year. Vermont Pure(R) brand sales decreased 25% from $6,346,000 in 2001 to $4,763,000 in 2002. Hidden Spring(R) brand sales decreased 17% from $4,068,000 in 2001 to $3,359,000 in 2002. We believe that the decrease in the branded products for the year was due to the increasingly competitive nature of the branded marketplace. Competition has affected both price and distribution channels. As a consequence, there is no assurance that we can regain sales that have been lost in the branded markets. Average selling price for the segment was down 9% for 2002. We believe the reduction in average selling price was due to competitive pressure for both branded and private label products. Furthermore, in conjunction with new private label agreements, we added a one-gallon size bottle during 2002, which is a lower priced product by volume compared to other products.
Cost of goods sold for 2002 was $35,583,000, or 50% of sales, compared to $29,803,000 or 46% of sales, for 2001. The increase in cost of goods sold, as a percentage of sales, compared to the prior year was attributable to the increase in consumer retail product costs and higher costs in the Home & Office segment. Cost of goods sold was $19,059,000 in 2002 for the Home & Office segment compared to $18,059,000 for the previous year. For the consumer retail segment cost of goods sold was $16,524,000 in 2002 compared to $11,744,000 for 2001. Cost per unit of retail product remained stable from 2001 to 2002.
Gross profit increased to $36,137,000, or 50% of sales, in 2002 from $35,055,000, or 54% of sales, in 2001. Gross profit as a percentage of sales decreased by 4% as a result of lower average selling prices and higher costs. The aggregate dollar increase was attributable to higher sales volume. Gross profit for the Home & Office segment increased to $30,009,000, or 61% of sales, in 2002 from $29,492,000, or 62% of sales, in 2001. The dollar increase in gross profit was attributable to higher sales volume. The decrease in gross profit as a percentage of sales was due to higher service costs in the segment. Gross profit for the consumer retail segment increased to $6,128,000, or 27% of sales, in 2002 from $5,563,000, or 32% of sales, in 2001. The dollar increase in gross
profit was attributable to higher sales volume. The decrease in gross profit as a percentage of sales was due to lower average selling prices. Lower average selling prices are attributable to a change in competitive pressures affecting all products as well as a change in product mix from branded to private label.
Total operating expenses decreased to $27,024,000 in 2002 from $28,178,000 in 2001, a decrease of $1,154,000, or 4%. Operating expenses for the retail segment of the business increased to $6,304,000 in 2002 from $5,510,000 the previous year, an increase of $794,000, or 14%. Home & Office delivery operating expenses decreased to $20,720,000 in 2002 from $22,668,000 the previous year, a decrease of $1,948,000, or 9%.
Selling, general and administrative, or SG&A, expenses were $25,084,000 and $24,302,000 for 2002 and 2001, respectively, an increase of $782,000, or 3%. SG&A expenses in the retail segment increased 16% to $5,569,000 in 2002 from $4,824,000 the prior year. The increase was attributable to higher distribution and storage costs associated with higher sales volume. For the Home & Office segment, SG&A expenses increased to $19,515,000 in 2002 from $19,478,000 the prior year.
Advertising expenses increased 26% to $1,656,000 in 2002 from $1,317,000 in 2001. Advertising for the consumer retail segment totaled $683,000 in 2002 compared to $670,000 in 2001. In the Home & Office segment, advertising increased 51% to $973,000 in 2002 from $646,000 in 2001. The substantial increase was due to an effort to offset poor economic conditions with increased visibility.
Amortization decreased from $2,544,000 in 2001 to $232,000 in 2002 because at the beginning of 2002 we implemented Statement of Financial Accounting Standards No. 142, which stipulates that goodwill will not be amortized. The pronouncement also stipulates that goodwill will be assessed periodically for impairment. We completed a valuation of goodwill in the second quarter and determined that there is no impairment to the goodwill presently on the balance sheet. An assessment of the value of goodwill will be completed annually. Other intangible assets continue to be amortized. All amortization is accounted for in the Home & Office segment.
Other compensation in fiscal year 2002 totaled $52,000 compared to $16,000 in fiscal year 2001. This expense is attributed to the exercise of stock options.
Income from operations was $9,113,000 in 2002 compared to $6,877,000 in 2001, an increase of $2,236,000. The increase was a result of higher sales and lower operating costs. Net interest expense decreased to $4,553,000 in 2002 from $5,034,000 in 2001, a decrease of $481,000. This was reflective of lower market interest rates on the variable portion of our senior debt and operating line of credit. In 2002, we had a loss of $228,000 on sale of land and buildings in New York and Vermont. As a result of the sale, we no longer own property in New York. Also in 2002, we had miscellaneous expenses of $71,000 representing the net of worker's compensation and tax settlements combined with income from the sale of a trademark.
Income before taxes was $4,260,000 in 2002 compared to $1,849,000 in 2001, an improvement of $2,411,000. The increase is a result of higher sales and lower amortization and interest.
We recorded net tax expense of $1,751,000 in 2002, reflecting an effective tax rate of 41%, compared to $680,000 in 2001, an effective tax rate of 37%. We had no deferred tax benefits available in 2002 since loss carryforwards, for book purposes, have been fully utilized. Tax expense in 2001 was offset by a deferred tax benefit of $973,000. Our effective tax rate in 2001 was 37% compared to our assumed statutory rate of 40%. The rate was lowered by the recognition of the deferred tax benefit, but the benefit was offset by amortization from the Crystal Rock merger that is not deductible for tax purposes. For a reconciliation of the effective and statutory expense, see Note 18 to our Notes to the Consolidated Financial Statements.
Based on the weighted average number of shares of common stock outstanding of 21,091,837 (basic) and 22,035,269 (diluted) during 2002, net income was $.12 per share - basic and $.11 per share - diluted. This compares to $.06 per share under both methods in 2001.
As discussed above, we periodically execute interest rate swaps as part of our strategy to curtail our interest rate risk. Such instruments are considered hedges under SFAS No. 133 and 137. Since the instrument is intended to hedge against variable cash flows, it is considered a cash flow hedge. As a result, the change in the fair value of the derivative is recognized as other comprehensive income (loss) until the hedged item is recognized in earnings. We did not enter into any new swap agreements during the year ended October 31, 2002. Cumulatively, the fair value of our three outstanding swaps increased $131,000 during the year resulting in a net decrease in value of $843,000 over the life of the instruments. This amount has been recognized as an adjustment to net income to arrive at comprehensive income as defined by the applicable accounting standards. Further, it has been recorded as a current liability and a decrease in owners' equity on our balance sheet.
LIQUIDITY AND CAPITAL RESOURCES
At October 31, 2003, we had working capital of $5,061,000. This represents an increase of $1,287,000 from the $3,774,000 of working capital on October 31, 2002. A significant amount of working capital was provided by the restructuring of our debt.
On March 5, 2003 we refinanced our senior credit facility with Webster Bank and other participants. The new credit facility refinanced $28.5 million of existing senior debt, provided a working capital line of $6.5 million for a term of two years, and makes available up to $15 million to be used for acquisitions and the partial repayment of our outstanding 12% subordinated notes. Of the $15 million, up to $10 million is available for acquisitions in our Home & Office delivery segment, and up to $5 million would have been available for the repayment of subordinated debt if we were able to achieve specified financial performance targets in fiscal year 2003. The targets were not met, so presently that portion of the facility is not available for repayment of subordinated debt.
The senior debt refinancing resulted in an improvement in working capital in two ways. First, it extended the amortization of the term loan, lowering payments in the earlier years, and thereby reclassifying less debt as current. Second, it rolled the existing line of credit balance into the term loan, thereby classifying it as long term debt.
In addition to the senior debt refinancing, we refinanced the 12% subordinated notes that were due in 2007 with principal payments due on a quarterly basis starting in fiscal year 2004. Under the new terms, the entire balance of the notes will be due and payable on May 31, 2008. No principal payments are scheduled prior to that date. Interest payments of $678,000 are made quarterly.
The line of credit balance was $1.5 million at the time of the refinancing. We borrowed up to $1.9 million from our operating line of credit as a source of cash during the year to fulfill operating and capital needs. This was repaid during the year. As of October 31, 2003, there was no outstanding balance on the operating line of credit and we had borrowed $1.6 million for acquisitions in our Home & Office segment. There is $921,000 committed for letters of credit on the operating line. During 2003, we applied $3.5 million to scheduled debt repayments. We were in compliance with all of our financial covenants for the year ended October 31, 2003.
On June 11, 2003, we entered into an interest rate "swap" agreement with Webster Bank in the notional amount of $10 million. The underlying debt for this agreement is the new credit facility with Webster Bank described above. The swap agreement fixes the interest rate for the notional amount for three years at 1.74% plus the interest rate spread defined by the agreement, currently 2%. On November 3, 2003, a separate swap agreement with Webster Bank matured. This agreement was for a notional amount of $8 million at an interest rate of 6.57% plus the applicable margin. As of the date of this report, the total amount of our senior debt with fixed swap rates is $18 million. Another $8 million of swapped debt will convert back to variable rates by July 2004. The new, lower-priced swap contract combined with the aging of the older contracts combined to reduce the unrealized loss that we book to recognize the value of these contracts. This effectively contributed to increasing working capital.
In addition to our senior and subordinated debt commitments, we have significant future cash commitments, primarily in the form of operating leases, that are not reported on the balance sheet. The following table sets forth these future commitments.
As of the date of this report, we have no other material contractual obligations or commitments.
Receivables increased as result of higher sales, but inventory decreased by $1.1 million as result of efficient management of transportation and storage. This provided cash from operations. We have reduced our deferred tax asset by $1,263,000 to reflect our utilization of net operating losses to offset taxes that would have been payable for the period. We have reduced the current portion and increased the long term portion of the deferred tax asset to reflect current estimates of future utilization. There is a total deferred tax asset of $2,249,000 as of October 31, 2003.
Net of acquisitions, we used $3.3 million for equipment purchases, consisting mostly of coolers, brewers, bottles and racks related to Home & Office distribution. Capital spending in fiscal
2003 was lower than the corresponding period in fiscal 2002 because of the bottling line installed last year. In addition to borrowing $1.6 million for acquisitions from our senior credit facility during 2003, we used $2.2 million of cash generated internally and gave notes to the sellers totaling $200,000 to complete the transactions. If the right opportunities become available, we anticipate using our capital resources and financing from outside sources to complete desirable acquisitions.
We commissioned and received an independent opinion concerning the fair value of our Home & Office reporting unit during fiscal years 2002 and 2003. The Home & Office segment is the unit through which acquisitions have been made and corresponding goodwill has been booked. For both years the assessment determined that there is no impairment of the goodwill that was booked as a result of these acquisitions.
Factors Affecting Future Cash Flow
Lower debt service requirements for the new senior and subordinated financing arrangements will provide more cash in future periods. However, we will not receive additional proceeds from refinancing our debt in future years as we did in 2003. Since we have relied on debt to finance our acquisition strategy, lower market interest rates have significantly reduced our interest costs. While interest rates are expected to stay low in the immediate future and until economic conditions improve, we continue to be exposed to market rates. See Item 7A
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risks relating to our operations result primarily from changes in interest rates and commodity prices, primarily the resin prices for PET bottles.
INTEREST RATE RISKS
At November 3, 2003, we had approximately $10,800,000 of long term debt subject to variable interest rates. Under the loan and security agreement with Webster Bank, we currently pay
interest at a rate of LIBOR plus a margin of 2%. A hypothetical 100 basis point increase in the LIBOR rate would result in an additional $108,000 of interest expense on an annualized basis. Conversely, a decrease would result in a proportionate interest cost savings.
We use interest rate "swap" agreements to curtail interest rate risk. The following table summarizes our current agreements:
In aggregate, we have fixed the interest rate on this $18,000,000 of debt at 5.58% until July 2004. Currently, we believe that this is above market rates but we expect our cumulative interest rates to be at or below market after July. We will continue to evaluate swap rates as agreements mature. They serve to stabilize our cash flow and expense but ultimately may cost more or less in interest than if we had carried all of our debt at a variable rate over the swap term. Our strategy is to keep the fixed and variable portions of our senior debt approximately equal to offset and minimize the respective risk of rising and falling interest rates. Future low rates may compel us to fix a higher portion to further stabilize cash flow and expenses as we monitor short and long term rates and debt balances.
COMMODITY PRICE RISKS
Plastic - PET
We have a four year agreement with our bottle supplier that allows them to pass on any resin price increases to us. These prices are related to supply and demand market factors for PET and, to a lesser extent, the price of petroleum, an essential component of PET. A hypothetical resin price increase of $.05 per pound would result in an approximate price increase per bottle of $.002 or, at current volume levels, $200,000 a year.
Coffee
The cost of our coffee purchases are dictated by commodity prices. We enter into contracts to mitigate market fluctuation of these costs by fixing the price for certain periods. Currently we have fixed the price of our anticipated supply through June 2004 at "green" prices ranging from $.61-$.74 per pound. We are not insulated from price fluctuations beyond that date. At our existing sales levels, an increase in pricing of $.10 per pound would increase our total cost for coffee $75,000. In this case, competitors that had fixed pricing might have a competitive advantage.
Diesel Fuel
We own and operate vehicles to deliver product to customers. The cost of fuel to operate these vehicles fluctuates over time. During fiscal 2003 we incurred $650,000 of fuel expense. Based on last year's consumption, a $0.10 increase per gallon in fuel cost would result in an increase to operating costs of approximately $60,000.
We also pay for fuel indirectly by hiring carriers to deliver product though we do not have contracts with them. While the impact of a change in prices is less predictable because of the absence of a contractual arrangement and varying hauling distances, we know that fuel prices affect
freight rates. Based on experience and estimates, a $.10 per gallon increase in fuel costs would result in additional freight cost of $30,000 per year.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Our Consolidated Financial statements and their footnotes are set forth on pages through.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
In 2003, the Company changed accountants and reported such changes on Form 8-K on May 12, 2003 and August 8, 2003.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
Our Chairman and Chief Executive Officer, our Chief Financial Officer, and other members of our senior management team have evaluated the effectiveness of our disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)). Based on such evaluation, our Chairman and Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures, as of the end of the period covered by this report, were adequate and effective to provide reasonable assurance that information required to be disclosed by the Company, including our consolidated subsidiaries, in reports that we file or submit under the Exchange Act, is recorded, processed, summarized and reported, within the time periods specified in the Commission's rules and forms.
The effectiveness of a system of disclosure controls and procedures is subject to various inherent limitations, including cost limitations, judgments used in decision making, assumptions about the likelihood of future events, the soundness of internal controls, and fraud. Due to such inherent limitations, there can be no assurance that any system of disclosure controls and procedures will be successful in preventing all errors or fraud, or in making all material information known in a timely manner to the appropriate levels of management.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by this Item is incorporated by reference from the Proxy Statement for our Annual Meeting of Stockholders scheduled to be held April 13, 2004.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION.
The information required by this Item is incorporated by reference from the Proxy Statement for our Annual Meeting of Stockholders scheduled to be held April 13, 2004.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
Information required by this Item is incorporated by reference from the Proxy Statement for our Annual Meeting of Stockholders scheduled to be held April 13, 2004.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
The information required by this Item is incorporated by reference from the Proxy Statement for our Annual Meeting of Stockholders scheduled to be held April 13, 2004.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES.
The information required by this Item is incorporated by reference from the Proxy Statement for our Annual Meeting of Stockholders scheduled to be held April 13, 2004.
PART IV
ITEM 15.
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.
a) Reports on Form 8-K during the quarter ended October 31, 2003.
A Report on Form 8-K was filed on August 8, 2003 to announce a change of independent accountants from Marcum & Kliegman LLP to Deloitte & Touche LLP.
A Report on Form 8-K was filed on September 15, 2003 in conjunction with the press release announcing our financial results for the third quarter of fiscal year 2003.
b) The following documents are filed as part of this report:
Financial Statements
Reference is made to the Financial Statements included in Item 8 of Part II hereof.
c) Exhibits as required by Item 601 of Regulation S-K:
* Relates to compensation
** The Securities and Exchange Commission has granted confidential treatment to certain omitted portions of this exhibit.
*** The form contains all material information concerning the agreement and the only differences are the name and the contact information of the director or officer who is party to the agreement.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Vermont Pure Holdings, Ltd. has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
VERMONT PURE HOLDINGS, LTD.
By: /s/ Timothy G. Fallon ------------------------------- Dated: January 29, 2004 Timothy G. Fallon, Chief Executive Officer, President, and Chairman of the Board of Directors
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
INDEPENDENT AUDITORS' REPORT
To the Board of Directors and Stockholders of Vermont Pure Holdings, Ltd. Randolph, VT
We have audited the accompanying consolidated balance sheet of Vermont Pure Holdings, Ltd. and subsidiaries (the "Company") as of October 31, 2003, and the related consolidated statements of operations, stockholders' equity, cash flows, and comprehensive income for the year then ended. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audit.
We conducted our audit in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Vermont Pure Holdings, Ltd. and subsidiaries as of October 31, 2003, and the results of their operations and their cash flows for the year then ended, in conformity with accounting principles generally accepted in the United States of America.
DELOITTE & TOUCHE LLP
January 21, 2004 Hartford, Connecticut
INDEPENDENT AUDITORS' REPORT
To the Board of Directors Vermont Pure Holdings, Ltd. Randolph, VT 05060
We have audited the accompanying consolidated balance sheet of Vermont Pure Holdings, Ltd. and Subsidiaries as of October 31 2002 and the related consolidated statements of operations, change in stockholders' equity and cash flows for year then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audit in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Vermont Pure Holdings, Ltd. and Subsidiaries at October 31, 2002, and the consolidated results of their operations and their cash flows for year then ended, in conformity with accounting principles generally accepted in the United States of America.
/s/ GRASSI & CO., CPAs, P.C. GRASSI & CO., CPAs, P.C. Certified Public Accountants
New York, New York December 13, 2002
INDEPENDENT AUDITORS' REPORT
To the Board of Directors Vermont Pure Holdings, Ltd. Randolph, VT 05060
We have audited the accompanying consolidated statement of operations, changes in stockholders equity and cash flows of Vermont Pure Holdings, Ltd and Subsidiaries for the year ended October 31, 2001. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated results of operations and cash flows of Vermont Pure Holdings, Ltd. and Subsidiaries for the year ended October 31, 2001, in conformity with accounting principles generally accepted in the United States of America.
s/ Feldman Sherb & Co., P.C. Feldman Sherb & Co., P.C Certified Public Accountants
New York, New York December 14, 2001
VERMONT PURE HOLDINGS, LTD. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
The attached notes are an integral part of these consolidated financial statements.
VERMONT PURE HOLDINGS, LTD. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
The attached notes are an integral part of these consolidated financial statements.
VERMONT PURE HOLDINGS, LTD. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
The attached notes are an integral part of these consolidated financial statements.
VERMONT PURE HOLDINGS, LTD. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
The attached notes are an integral part of these consolidated financial statements.
VERMONT PURE HOLDINGS, LTD. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
1. BUSINESS OF THE COMPANY
Vermont Pure Holdings, Ltd. and Subsidiaries (collectively, the "Company") is engaged in the production, marketing and distribution of bottled water. The Company's products are sold predominately in the Northeast as well as Mid-Atlantic and Mid-Western United States. Distribution is accomplished through a network of independent beverage distributors and with the Company's own trucks and employees.
2. SIGNIFICANT ACCOUNTING POLICIES
a. Basis of Presentation - The consolidated financial statements include the accounts of Vermont Pure Holdings, Ltd. and its wholly-owned subsidiaries, Vermont Pure Springs, Inc., Crystal Rock Spring Water Company ("Crystal Rock"), Excelsior Spring Water Company Inc. and Adirondack Coffee Services. All material inter-company profits, transactions, and balances have been eliminated in consolidation.
b. Cash Equivalents - The Company considers all highly liquid temporary cash investments, with an original maturity of three months or less to be cash equivalents.
c. Inventories - Inventories consist primarily of the packaging material, labor and overhead content of the Company's products. Such inventories are stated at the lower of cost or market using average costing.
d. Property and Equipment - Property and equipment are stated at cost net of accumulated depreciation. Depreciation is calculated on the straight-line method over the estimated useful lives of the assets, which range from three to ten years for equipment, and from ten to forty years for buildings and improvements.
e. Intangible Assets - The Company records goodwill in accordance with SFAS No. 142 (see footnote 4). The values of covenants not to compete are amortized over the terms of the related agreements.
f. Securities Issued for Services - The Company follows the accounting treatment prescribed by Accounting Principles Board Opinion No. 25 ("Accounting for Stock Issued to Employees") when accounting for stock-based compensation granted to employees and directors. It provides the required pro forma disclosures as if the fair value method under Statement of Financial Accounting Standards No. 123, "Accounting for Stock Based Compensation" ("SFAS No.123") was adopted. Any stock-based compensation awards to non-employees and non-directors are accounted for using the provisions of Emerging Issues No. 96-18 "Accounting for
Equity Instruments That Are issued to Other Than Employees for Acquiring, or in Conjunction With Selling Goods or Services."
In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure - an amendment of FASB Statement No. 123." SFAS No. 148 amends SFAS No. 123, "Accounting for Stock-Based Compensation," to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. The Company has adopted this pronouncement and is complying by continuing to apply Accounting Principles Board Opinion No. 25 "Accounting for Stock Issued to Employees," prominently disclosing the method of accounting for stock based compensation in annual and interim financial statements, and disclosing the effect of the method used in financial results.
Pro-forma information regarding net income and net income per share is presented below as if the Company had accounted for its employee stock options under the fair value method using SFAS No. 123, net of tax; such pro-forma information is not necessarily representative of the effects on reported net income for future years due primarily to option vesting periods and to the fair value of additional options in future years.
The weighted average fair value of the options granted for the respective fiscal years ended, using the Black-Scholes option pricing model, was $1.70, $2.26 and $2.29 respectively.
Assumptions used for estimating the fair value of the option on the date of grant under the Black-Scholes option pricing model are as follows for the fiscal years ended October 31, 2003, 2002 and 2001:
g. Net Income Per Share - Net income per share is based on the weighted average number of common shares outstanding during each period. Potential common shares are included in the computation of diluted per share amounts outstanding during each period that income is reported. In periods that the Company reports a loss, potential common shares are not included in the diluted earnings per share calculation since the inclusion of those shares in the calculation would be antidilutive.
h. Advertising Expenses - The Company expenses advertising costs at the time the advertising begins to run with the exception of advertising from which it derives direct responses from customers. The Company expenses direct response advertising, which consists of Yellow Page advertising, over a period of twelve months consistent with its expected period of future benefit based on historical responses. Prepaid advertising at October 31, 2003 and 2002 was $302,000 and $272,000, respectively, and is included in other current assets on the accompanying consolidated balance sheets.
i. Slotting Fees - Slotting fees are paid to individual supermarkets and supermarket chains to obtain initial shelf space for new products. Fees vary from store to store. The payment of slotting fees does not guarantee that the Company's product will be carried for any definite period of time. The Company pays for such fees either in cash, by providing free goods, or by issuing credits for previously sold goods. The cost of the slotting fees is valued at the amount of cash paid, or the fair value of the goods provided in exchange. The Company expenses slotting fees when the obligation is incurred.
j. Customer Deposits - Customers receiving home or office delivery of water pay the Company a deposit for the water bottle on receipt that is refunded upon return. The Company uses an estimate (based on historical experience) of the deposits it expects to refund over the next 12 months to determine the current portion of the liability and classifies the balance of the amount as a long term liability.
k. Income Taxes - The Company accounts for income taxes under the liability method. Under the liability method, a deferred tax asset or
liability is determined based upon the tax effect of the differences between the financial statement and tax basis of assets and liabilities as measured by the enacted rates that will be in effect when these differences reverse.
l. Use of Estimates - The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
m. Fair Value of Financial Instruments - The carrying amounts reported in the consolidated balance sheet for cash, trade receivables, accounts payable and accrued expenses approximate fair value based on the short-term maturity of these instruments. The carrying amount of the Company's borrowings also approximates fair value.
n. Impairment for Long-Lived and Intangible Assets - The Company reviews long-lived assets and certain identifiable intangible assets for impairment whenever circumstances and situations change such that there is an indication that the carrying amounts may not be recovered. Recoverability is assessed based on estimated undiscounted future cash flows. At October 31, 2003, the Company believes that there has been no impairment of its long-lived and intangible assets.
o. Revenue Recognition - Revenue is recognized when products are delivered to customers through the Company's home and office distribution channel. For consumer retail products, revenue is recognized upon shipment or delivery of the product based on the terms of the F.O.B. arrangements with the customer.
p. Shipping and Handling Costs - The Company classifies shipping and handling costs as a component of selling, general and administrative expenses. Shipping and handling costs were approximately $2,308,000, $2,030,000, and $1,403,000 for fiscal years ended October 31, 2003, 2002 and 2001, respectively. The Company does not charge these costs to its customers.
3. RECENT ACCOUNTING PRONOUNCEMENTS
In April 2003, FASB issued SFAS No. 149, "Amendment of Statement 133 on Derivative Instruments and Hedging Activities ("SFAS No. 149")." The statement amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities under SFAS No. 133. FAS No.149 is effective for contracts entered into or modified after June 30, 2003 except for the provisions that were cleared by the FASB in prior
pronouncements. The Company has determined that the adoption of this pronouncement has no material effect on its financial statements.
On May 15, 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity ("SFAS No. 150")". SFAS No. 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). SFAS No. 150 affects the issuer's accounting for three types of freestanding financial instruments:
* Mandatorily redeemable shares, which the issuing company is obligated to buy back in exchange for cash or other assets.
* Instruments that do or may require the issuer to buy back some of its shares in exchange for cash or other assets; includes put options and forward purchase contracts.
* Obligations that can be settled with shares, the monetary value of which is fixed, tied solely or predominantly to a variable such as a market index, or varies inversely with the value of the issuer's shares.
SFAS No. 150 does not apply to features embedded in a financial instrument that is not a derivative in its entirety. Most of the guidance in SFAS No. 150 is effective for all financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. The Company has determined that adoption of this pronouncement has no material effect on its consolidated financial statements.
4. GOODWILL AND AMORTIZATION
In July 2001, the FASB issued SFAS No. 141, "Business Combinations, ("SFAS No.141")" and SFAS No. 142, "Goodwill and Other Intangible Assets ("SFAS No. 142")." SFAS No. 141 is effective for all business combinations completed after June 30, 2001. SFAS No. 142 is effective for fiscal years beginning after December 15, 2001. Effective November 1, 2001, the Company elected early adoption of SFAS No. 142. SFAS No. 142 eliminates the amortization of goodwill and other intangible assets with indefinite lives. Intangible assets with lives restricted by contractual, legal, or other means will continue to be amortized over their useful lives (defined by SFAS No. 142 as the period over which the asset is expected to contribute to the future cash flows of the entity). Goodwill and other intangible assets not subject to amortization are tested for impairment annually or more frequently if events or changes in circumstances indicate that the asset might be impaired. The amount of impairment for goodwill and other intangible assets is measured as the excess of their carrying values over their implied fair values. The Company conducted assessments of the carrying value of its goodwill as required by SFAS No. 142 in the third quarter of fiscal 2003, and, as a result, the Company concluded that there was no current impairment of goodwill as of such date.
The Company will conduct assessments of the carrying value of its goodwill annually and when other indicators are present.
In accordance with SFAS No. 142, the Company discontinued amortization of goodwill effective November 1, 2001. The pro forma effects of the adoption of SFAS No. 142 on net income and basic and diluted earnings per share are as follows:
5. SEGMENTS
The Company prepares detailed information to evaluate its operations on a segment basis. It accounts for the business in three separate segments, "Retail", "Retail-Gallons" and "Home and Office".
The segments are identifiable based on the types of products and their distribution channels. The company considers Retail, Retail-Gallons and Home and Office to be three distinct segments because the operating results of each are compiled, reviewed and managed separately.
Retail - Characterized by the sale of water in small, portable containers that are constructed from clear polyethylene terephthalate ("PET") plastic. Bottle sizes range from 8 oz. to 1.5 L. These products are sold to wholesale beverage distributors, supermarkets and convenience stores.
Retail - Gallons - Characterized by the sale of water in medium-sized, portable containers that are constructed from HDPE plastic. Bottle sizes range from 1 gallon to 2.5 gallon. These products are sold to supermarket chains. The Company has this product packed by other companies and there is a different distribution pattern from other retail products as well as a distinct retail customer base.
Home and Office - Characterized by the sale of five-gallon reusable bottles of water and rental of water coolers delivered by the Company's trucks and employees, and other products that are sold through this distribution channel which are ancillary to the primary product, such as office refreshments.
The Company allocates costs directly when possible and uses various applicable allocation methods to allocate shared costs. There are no inter-segment revenues for the periods reported.
6. MERGERS AND ACQUISITIONS
During 2003, Vermont Pure Holdings, Ltd. made seven acquisitions and merged these into the Company's home and office operations in Connecticut.
The purchase price paid for the acquisitions was as follows:
The operating results of the acquired entities have been included in the accompanying statements of operations since their respective dates of acquisition.
Goodwill from the acquisitions has been calculated as follows:
The following table summarizes the pro forma consolidated condensed results of operations (unaudited) of the Company for the fiscal years ended October 31, 2003 and October 31, 2002 as though the acquisitions had been consummated at the beginning of the periods presented:
On November 1, 2001, Vermont Pure Holdings, Ltd. acquired substantially all the assets of Iceberg Springs Water, Inc. and merged it into the Company's home and office operations in Connecticut.
The purchase price paid for Iceberg Springs Water, Inc. was as follows:
Goodwill from the acquisition has been calculated as follows:
The stock price of the Company for purposes of the acquisition was $3.294 per share, resulting in the number of Vermont Pure Holdings, Ltd. common shares issued of 213,912. The stock price was determined by using the average of the daily stock prices from October 12, 2001 to October 25, 2001.
The following table summarizes the pro forma consolidated results of operations (unaudited) of the Company for the fiscal years ended October 31, 2002 and October 31, 2001 as though the acquisition had been consummated at the beginning of the periods presented:
7. ACCOUNTS RECEIVABLE
The Company reduces its receivables by an allowance for future uncollectible accounts. The activity in the allowance is as follows:
8. INVENTORIES
Inventories at October 31, consisted of:
9. PROPERTY AND EQUIPMENT
Property and equipment at October 31, consisted of:
Depreciation expense for the fiscal years ended October 31, 2003, 2002 and 2001 was $5,074,159, $4,398,432 and $3,690,675, respectively.
10. INTANGIBLE ASSETS
Major components of intangible assets at October 31, consisted of:
The changes in the carrying amount of goodwill for the fiscal years ending October 31, 2003 and 2002 are as follows:
11. ACCRUED EXPENSES
12. DEBT
During the twelve months ended October 31, 2003 the Company borrowed approximately $1,600,000 from its acquisition line of credit with Webster Bank. The rate of interest on the acquisition line is current 30 day LIBOR rate plus 200 basis points (3.2% at October 31, 2003) and is due April 1, 2005. The acquisition line is secured by a lien against all of the assets of Vermont Pure Holdings and its subsidiaries. As of October 31, 2003 there was no balance outstanding under the working capital line of credit. In addition, letters of credit totaling $636,264 secured by the line were issued on the Company's behalf, reducing the availability of the line by that amount.
a) Senior Debt Refinancing
On March 5, 2003 the Company refinanced its credit facility ("New Credit Facility") with Webster Bank and other participants. The New Credit Facility refinanced $28.5 million of existing senior debt, provides a working capital line of $6.5 million for a term of five years maturing February 29, 2008. The rate of interest on the New Credit Facility and working capital line is current 30 day LIBOR rate plus 200 basis points (3.2% at October 31, 2003) and is secured by a lien against all of the assets of Vermont Pure Holdings and its subsidiaries. The new facility makes available up to $15 million to be used for acquisitions and the partial repayment of the outstanding 12% subordinated notes. Of the $15 million, up to $10 million is available for acquisitions in the Company's Home and Office delivery segment, and up to $5 million is available for the repayment of subordinated debt if the Company is able to achieve specified financial performance targets in fiscal year 2003. The targets were not met in fiscal year 2003. There are no further scheduled principal payments on the subordinated debt until 2008 when the full senior facility is due.
The New Credit Facility amortizes the payback of the existing debt over five years and amortizes the payback of the new acquisition debt for three years after the first two years. During the first two years, interest only is paid on a monthly basis for amounts drawn down for acquisitions and sub-debt repayment (see section b). The operating line of credit will be renewed for two years for a total of $6,500,000. Interest on all borrowings will be tied to the Company's performance, but start off at the 30 day LIBOR plus 200 basis points, 3.2% at October 31, 2003.
Use of the proceeds related to acquisitions and retirement of sub-debt are restricted by the Company's attainment of certain covenants, requirements, and projections.
b) Subordinated Debt
As part of the merger agreement with the former shareholders of Crystal Rock, the Company issued notes in the amount of $22,600,000. The notes have an effective date of October 5, 2000, are for terms of seven years and bear interest at 12% per year. Scheduled repayments are made quarterly and are interest only for the seven year period unless specified financial targets are met. Payments of interest only of $678,000 are due quarterly with a principal payment of $22,600,000 due at maturity.
The notes are secured by all of the assets of the Company but specifically subordinated, with a separate agreement between the debt holders, to the senior debt described in Note 12. a) above.
Compliance with Financial Covenants of the Company's Bank Agreement
The Company's New Credit Facility agreement requires that it be in compliance with certain financial covenants at the end of each fiscal quarter. The Company was in compliance with all of its financial covenants at the end of each quarter during the fiscal year ended October 31, 2003.
c) Other Long Term Debt - The Company's other long term debt is as follows:
d) Annual maturities of debt as of October 31, 2003 are summarized as follows:
13. INTEREST RATE HEDGES
a) On November 3, 2000, April 2, 2001, July 24, 2001, and June 6, 2003 the Company entered into separate three year "swap" agreements with Webster Bank to fix a total of $26,000,000 of its senior debt with the bank. The agreements fix the variable LIBOR rate portion of the debt at 6.57%, 5.28%, 5.00% and 1.74% respectively. Under the Company's loan agreement with the bank, the current applicable margin is 2.00% resulting in a total fixed rate of 8.57%, 7.28%, 7.00% and 3.74% for each respective
agreement for the contract period. The margin is subject to change based on the Company's performance as outlined in the loan agreement with Webster Bank.
b) These instruments are considered hedges under SFAS No. 133 and 137. Since the instrument is intended to hedge against variable cash flows, it is considered a cash flow hedge. As a result, the change in the fair value of the derivative is recognized as comprehensive income (loss) until the hedged item is recognized in earnings. Cumulatively, the fair value of the Company's four outstanding swaps increased $807,394 during the year resulting in an unrealized loss net of tax of $35,504 as of October 31, 2003. The unrealized loss as of October 31, 2002 was $842,898.
14. STOCK BASED COMPENSATION
a) Stock Option Plan
In November 1993, the Company's Board of Directors adopted the 1993 Performance Equity Plan (the "1993 Plan"). The 1993 Plan authorizes the granting of awards for up to 1,000,000 shares of common stock to key employees, officers, directors and consultants. Grants can take the form of stock options (both qualified and non-qualified), restricted stock awards, deferred stock awards, stock appreciation rights and other stock based awards. During fiscal 2003, 2002, and 2001 there were no options issued under this plan.
On April 2, 1998 the Company's shareholders approved the 1998 Incentive and Non Statutory Stock Option Plan (the "1998 Plan"). In April 2003, the Company's shareholders approved an increase in the authorized number of shares to be issued from its 1998 Incentive and Non-Statutory Stock Option Plan from 1,500,000 to 2,000,000. This plan provides for issuance of up to 2,000,000 options to purchase the Company's common stock under the administration of the compensation committee of the Board of Directors. The intent of the plan is to reward options to officers, employees, directors, and other individuals providing services to the Company.
The following table summarizes the activity related to stock options and outstanding stock option balances during the last three fiscal years:
The following table summarizes information pertaining to outstanding stock options as of October 31, 2003:
Outstanding options and warrants include options issued under the 1993 Plan, the 1998 Plan and non-plan options and warrants. There were 2,018,045 exercisable options at a weighted average price of $2.80 per share and 1,698,252 exercisable options at a weighted average price of $2.51 per share as of October 31, 2002 and 2001, respectively.
Outstanding options have lives ranging from 5-10 years, vesting 1-5 years, and have exercise prices ranging from $1.81-$4.98 per share.
b) Employee Stock Purchase Plan
On June 15, 1999 the Company's shareholders approved the Vermont Pure Holdings, Ltd. 1999 Employee Stock Purchase Plan. On January 1, 2001, employees commenced participation in the plan. The Company issued 60,775, 62,740 and 62,415 common shares for the fiscal years ended October 31, 2003, 2002 and 2001, respectively.
15. RETIREMENT PLAN
The Company has a defined contribution plan which meets the requirements of Section 401(k) of the Internal Revenue Code. All employees of the Company who are at least twenty-one years of age are eligible to participate in the plan. The plan allows employees to defer a portion of their salary on a pre-tax basis and the Company contributes 25% of amounts contributed by employees up to 6% of their salary. Company contributions to the plan amounted to $102,000, $114,000, and $94,000 for the fiscal years ended October 31, 2003, 2002, and 2001, respectively.
16. COMMITMENTS AND CONTINGENCIES
a. Operating Leases
The Company's operating leases consist of trucks, office equipment and rental property.
Future minimum rental payments over the terms of various lease contracts are approximately as follows:
Rent expense was $2,134,527, $1,925,911, and $1,003,479 for the fiscal years ended October 31, 2003, 2002, and 2001, respectively.
b. Contingencies
In January 2003, the Company settled a suit alleging that a vendor did not adequately perform the services rendered in connection with approximately $500,000 of unpaid billings. In settling the suit, the Company agreed to pay $50,000 to the vendor in full settlement of the litigation. In conjunction with the settlement, the parties released each other from any further liability in the case. A gain of $150,000 was recognized in the first quarter of 2003 since the Company had set up a reserve for settlement of the suit that exceeded the final amount paid. The gain has been included as a reduction of selling, general and administrative expenses.
17. RELATED PARTY TRANSACTIONS
a) Directors and Officers
Three of the Company's major shareholders (former Crystal Rock shareholders) have employment contracts with the Company through October 5, 2005. Two are also directors. One contract entitles the shareholder to annual compensation of $25,000 as well as a leased Company vehicle. The other two contracts entitle the respective shareholders to annual compensation of $250,000 each and other bonuses and prerequisites.
The Company leases a 67,000 square foot facility in Watertown, CT and a 22,000 square foot facility in Stamford, CT from a Baker family trust. The lease expires in October 2010. Future minimum rental payments under these leases are as follows:
Fiscal year ending October 31,
b) Investment in Voyageur
The Company has an equity position in a software company named Computer Design Systems, Inc. (CDS), d/b/a Voyageur Software. One of the Company's directors is a member of the board of directors of CDS. The Company uses software designed, sold and serviced by CDS in its home and office delivery system to manage customer service, deliveries, inventory, billing and accounts receivable. During fiscal 2003, 2002 and 2001, the Company paid $113,193, $275,332 and $294,311, respectively, for service, software, and hardware. As of October 31, 2002, the Company had a note receivable from CDS dated August 1, 1998 for the principal amount of $120,000 with accrued interest of $43,650 and an original maturity date of August 15, 2003. At October 31, 2003 interest accrued on the note and due from CDS is $50,150. In October 2003, the Company exercised the option to convert the principal amount of the note into additional common shares of CDS during 2003. At October 31, 2003, the Company's share of CDS losses resulted in a net equity investment in CDS of $100,988 which represents approximately 24% of the common stock of CDS.
18. INCOME TAXES
The Company has approximately $8.5 million of available net operating loss carryforwards at October 31, 2003 expiring from 2005 through 2018.
The major deferred tax asset (liability) items at October 31, 2003 and October 31, 2002 are as follows.
Income tax expense differs from the amount computed by applying the statutory tax rate to net income before income tax expense as follows:
The following is the composition of income tax expense (benefit):
On September 3, 2003 the Company reached settlement with the Internal Revenue Service related to an audit of federal income tax for its Crystal Rock subsidiary for the tax year ending October 5, 2000. The settlement resulted in an increase in the Company's income taxes of $136,000. This amount has been included in income tax expense for 2003.
19. EARNINGS PER SHARE
As required by SFAS No. 128, the Company considers outstanding "in-the-money" stock options as potential common stock in its calculation of diluted earnings per share and uses the treasury stock method to calculate the applicable number of shares. The following calculation provides the reconciliation of the denominators used in the calculation of basic and fully diluted earnings per share:
In addition to the options used to calculate the effect of dilution, there were 185,000 options outstanding for the year ended October 31, 2003 that were not included in the dilution calculation because the options' exercise price exceeded the market price of the underlying common shares. For the comparable periods in 2002, all outstanding options were used to determine the effect of dilution because the market price exceeded the exercise prices. There where 1,294,134 outstanding options for the year ended October 31, 2001 that where not included in the dilution calculation because their exercise price exceeded the market price.
20. UNAUDITED QUARTERLY FINANCIAL DATA
The Company's unaudited quarterly financial data for the last two fiscal years is as follows:
21. CONCENTRATION OF CREDIT RISK
The Company maintains its cash accounts at various financial institutions. The balances at times may exceed federally insured limits. At October 31, 2003, the Company had cash in deposits exceeding the insured limit by approximately $835,000.
EXHIBITS TO VERMONT PURE HOLDINGS, LTD. ANNUAL REPORT ON FORM 10-K FOR THE FISCAL YEAR ENDED OCTOBER 31, 2003 EXHIBITS FILED HEREWITH