ITEM 1. BUSINESS
ORGANIZATION AND STRUCTURE
Packaging Dynamics Corporation (the "Company" or "Packaging Dynamics") is a Delaware corporation established as a holding company to own all of the interest in Packaging Dynamics Operating Company ("PDOC"). PDOC is a Delaware corporation which is the holding company for all our current operating subsidiaries. In this annual report, except where the context requires otherwise, the terms "we," "us" and "our" refer to Packaging Holdings, L.L.C. ("Packaging Holdings" or "PHLLC") and its subsidiaries for the periods as of and prior to the July 1, 2002 contribution of all of the Packaging Holdings limited liability company interests to Packaging Dynamics, and to Packaging Dynamics and its subsidiaries for the periods thereafter.
OVERVIEW
Packaging Dynamics Corporation was formed in 1998 to create a premier flexible packaging company providing value-added specialty packaging products for markets with attractive margins and growth rates. Since then, we have become a leading supplier of specialty converted paper, foil and film based products for use in a variety of end use markets. In 2004 we had net sales of $305 million. We operate nine manufacturing plants in eight states and employ approximately 1,350 people. We have two operating segments: Food Packaging and Specialty Laminations.
In September 2004, we acquired Papercon, Inc. ("Papercon"), a manufacturer and marketer of a broad range of paper and foil based specialty packaging products for foodservice, supermarket, quick service restaurant and packer processor customers. Papercon has manufacturing facilities in Atlanta, Georgia and near Dallas, Texas and Los Angeles, California. Papercon had net sales of approximately $85 million during 2003, the most recent fiscal year prior to its acquisition by the Company. The acquisition of Papercon significantly broadened the product line, customer base and geographic presence of the Food Packaging segment.
PRODUCTS AND MARKETS
FOOD PACKAGING
The Food Packaging segment converts paper, film and foil into a variety of specialty value-added food packaging products including specialty bags, specialty sheets and wraps, interfolded tissue, pan liners as well as a line of butcher, freezer and locker paper products. Our product line includes a broad range of products which are customized to meet the specific performance requirements of individual customers. We also produce a broad range of standard "stock products" for use across a range of customers and markets. Key markets served by the Food Packaging segment include foodservice distribution, restaurant (quick-service/QSR and fast-casual), supermarket, bakery, retail and packer processor. We believe that, within our key markets, we have the most comprehensive product line of any major competitor and have leading positions in many of our key products. The Food Packaging segment operates using the BagcraftPapercon trade name.
SPECIALTY LAMINATIONS
The Specialty Laminations segment produces laminated foil-paper structures which are engineered and manufactured to meet the requirements of specific customer applications. Our products are typically multi-layer laminated structures which include a variety of substrates (foil, paper, paperboard and film), adhesives and coatings. Our products are typically delivered in roll stock form for use by our customers to manufacture end products for sale to their customers. Representative products include base stock materials for the production of labels, bags, pouches, composite cans, lidding and blister packaging for use in food, consumer, medical and industrial packaging applications. In addition, we produce specialized facing material used by North American and European building materials manufacturers for the production of foam insulation. We
also produce foil sandwich wraps for a limited number of quick-service restaurant customers. The Specialty Laminations segment operates using the International Converter trade name.
BUSINESS STRATEGY
Our principal objective is to build on the original premise of Packaging Dynamics to create a premier flexible packaging company providing value-added specialty packaging products for markets with attractive margins and growth rates. Our strategy to achieve this objective is to grow sales and profits by expanding product capabilities, market participation and geographical presence. We expect to achieve long-term growth rates above industry norms by leveraging our broad product line, strong product development capabilities and national geographic presence. We believe that these characteristics provide us with an opportunity to expand our long-term customer relationships and presence in key markets -- many of which are experiencing long-term consolidation trends. An important part of our strategy is to continue making investments in new manufacturing technology to upgrade product capabilities, improve productivity and reduce overall product cost. Strategic acquisitions have been, and will continue to be, an important complement to our internal growth strategy. Since 2002 we have invested approximately $83 million to acquire 3 businesses which have significantly enhanced our product line, market participation and geographic presence.
NEW PRODUCT DESIGN AND DEVELOPMENT
An important element of our growth strategy is to develop new value-added products and product line extensions which meet or exceed the requirements of our customers. We have significant resources dedicated to product development in both our Food Packaging and Specialty Laminations segments. We have a strong reputation in the markets we serve for creativity, new product innovation and responsiveness to our customers. Our development programs are both customer driven and market driven. We seek to work closely with our customers to develop products which meet the needs of their specific application. We also seek to identify unfilled market needs and develop unique products to satisfy those needs. Our product development personnel have many years of experience in the field, and we believe we have the broadest product development capability within the markets in which we compete. A key component of our value proposition is to provide "Innovative Solutions" for our customers.
CONVERTING CAPABILITIES
We operate nine converting facilities in the United States including six facilities in the Food Packaging segment (one each in Illinois, Iowa, Kansas, Georgia, Texas, and California) and three in the Specialty Laminations segment (two in Ohio and one in Mississippi). Our national manufacturing and distribution platform allows us to produce nearly all of our products at multiple facilities and to efficiently serve the needs of customers on a local, regional and national scale. We believe that our national manufacturing presence provides us a unique competitive advantage with larger customers who value multi-plant production and national coverage as many of our competitors lack these capabilities.
The manufacturing of our products typically involves the conversion of substrates such as paper, foil and film into the products we sell to customers. Other raw materials used in our production processes include various types of inks, adhesives, coatings and wax. Our converting capabilities include extensive expertise in laminating, bag making, interfolding, waxing, slitting, sheeting, die cutting, tin tie as well as flexographic and gravure printing using water and solvent based inks. We have continued to invest to improve productivity, quality and overall product cost. During 2003 and 2004, we installed five new bag machines which deliver improved capabilities and product quality while operating at significantly higher speeds. We expect to continue to make investments to upgrade the capabilities of our converting assets to provide a long-term competitive advantage. We believe that new manufacturing technology will continue to offer attractive investment opportunities in each of our business segments.
COMPETITION
We operate in markets that are highly competitive with substantial competition in each of our product lines from numerous competitors of various sizes. Many of our competitors are significantly smaller privately-held companies which tend to have lower fixed costs and greater operating flexibility. A few of our competitors are smaller divisions or individual plants within larger companies with more extensive financial and other resources compared to Packaging Dynamics. We also face competition from alternative products including plastic-, board-, paper- and foil-based converted products which we do not currently produce or sell. In addition to price, competition is based on product quality, breadth of product offering, product innovation, supplier response time and complete order fulfillment.
EMPLOYEES
As of December 31, 2004, we employed approximately 1,350 people, 376 of whom are covered by collective bargaining agreements. Of our 376 unionized employees as of December 31, 2004, 66 employees are based in Belpre, Ohio and are represented by the United Steelworkers of America under a contract that expires in May 2005; 282 employees are based in Chicago, Illinois and are represented by the International Brotherhood of Teamsters Local 743 under a contract scheduled to expire in December 2005; and 28 employees are based in Iuka, Mississippi and are represented by the United Steelworkers of America under a contract that expires in August 2007. There have been no interruptions or curtailments of our operations due to labor disputes since our inception, and we believe that relations with our employees are good; however, as these labor contracts expire, there can be no assurances that there will be no strikes, work stoppages or other labor disputes as we negotiate such contracts.
RAW MATERIALS
Paper and aluminum foil have historically represented the largest portion of our raw materials. Generally, these raw materials are readily available from a wide variety of suppliers. Costs for all of the significant raw materials used by us tend to fluctuate with various economic factors which generally affect us and our competitors. During 2003, the Company made a strategic decision to shut down the Detroit paper mill, which had provided approximately 45-50% of the paper we consumed. The Company has entered into supply arrangements that provide for both a secure supply of paper and the opportunity to continue to work to lower the cost of paper through lower basis weights, consolidation of grades and product development. The Company contracts to buy aluminum ingot, attempting to match purchases to contracted sales volume where possible. The Company locks in the cost of converting ingot to foil on an annual basis. The Company believes that its scale of purchases of both foil and paper provides it with a competitive advantage in the markets in which each competes. Prices and lead times for aluminum foil and paper fluctuate with changes in market conditions, in some instances adversely to us. The availability of raw materials was adequate during 2004.
INTELLECTUAL PROPERTY
We own a number of U.S. patents and trademarks that collectively are important to our business, but no single one of which is material to us. We believe that our intellectual property rights and licensing rights are adequate for our business and have an active program to maintain these rights.
CUSTOMERS, SALES AND BACKLOG
We have relationships with numerous customers in each of our product categories. Although we do not currently have a single customer that accounts for 10% or more of our net sales, the loss of one or more of our largest customers, while not anticipated, could have a material adverse effect on our financial condition or results of operations. In general, we believe that the backlog of orders is not material to an understanding of our business.
ENVIRONMENTAL MATTERS AND GOVERNMENT REGULATION
Since many of our packaging products are used in the food industry, we are subject to the manufacturing standards of the U.S. Food and Drug Administration. Historically, compliance with the standards of the food industry has not had a material effect on our earnings, capital expenditures or competitive position. There can be no assurance, however, that compliance with those standards will not have a material adverse effect on our future operating results or financial condition.
Our manufacturing operations are subject to federal, state and local regulations governing the environment and the discharge of materials into air, land and water, as well as the handling and disposal of solid and hazardous wastes. As is the case with manufacturers in general, if a release of hazardous substances occurs on or from our properties or any associated offsite disposal location, or if contamination from prior activities is discovered at any of our properties, we may be held liable. From time to time, we are involved in regulatory proceedings and inquiries relating to compliance with environmental laws, permits and other environmental matters. We believe that we are in material compliance with applicable environmental regulations and do not believe that costs of compliance, if any, will have a material adverse effect on our financial condition, results of operation, or liquidity. In 2005 we will have additional costs related to our ongoing program to clear the site, recover assets and dispose of the Detroit property, although the total amount of such costs are not currently estimable. There can be no assurance, however, that items will not require additional expenditures beyond those that are anticipated and that additional expenditures, if any, would not have a material adverse effect on our operating results or financial condition.
FINANCIAL INFORMATION ABOUT SEGMENTS AND GEOGRAPHIC AREAS
We operate within, and sell to customers throughout, the U.S., Canada and Europe in two operating segments -- Food Packaging and Specialty Laminations. The Food Packaging segment converts paper, film and foil into a variety of specialty value-added food packaging products. The Specialty Laminations segment produces multi-layer laminated structures from a variety of substrates (foil, paper, paperboard and film), adhesives and coatings for use in various food, consumer, medical and industrial packaging applications as well as the production of insulation for the building materials market. See Note 7 to the Company's annual consolidated financial statements for further information.
MERGER AND DISTRIBUTION
On March 18, 2002, the board of directors of Ivex Packaging Corporation ("Ivex") approved a merger agreement providing for the merger of Ivex with a wholly-owned subsidiary of Alcoa Inc. ("Alcoa"). As a result of the merger, Ivex became a wholly-owned subsidiary of Alcoa on July 1, 2002. The merger was conditioned upon, among other things, the prior distribution to Ivex stockholders and option holders of Ivex's 48.19% ownership interest in Packaging Holdings. To facilitate the distribution, Ivex formed Packaging Dynamics, a C-corporation for income tax purposes, to be the holding company for all of the ownership interests in Packaging Holdings. In preparation for the distribution, Ivex and the other members of Packaging Holdings exchanged their ownership interests in Packaging Holdings for common stock of Packaging Dynamics. On July 1, 2002, Ivex distributed its shares of Packaging Dynamics to its stockholders and certain of its option holders immediately prior to the merger. The consolidated financial statements of Packaging Dynamics presented herein include the results of consolidated operations, financial position and cash flows of Packaging Holdings.
Also in connection with the merger and distribution, a new holding company structure was created by contributing all of the limited liability company interests of Packaging Holdings to Packaging Dynamics, a C-corporation for income tax purposes, in exchange for the common stock of Packaging Dynamics; the $12,500 12% subordinated note payable to Ivex, plus accreted interest, totaling approximately $19,238 was canceled; and a consulting agreement with Ivex was canceled. The impact of the distribution is reflected on the Consolidated Statements of Stockholders' Equity and Other Comprehensive Income (Loss) as formation of Packaging Dynamics Corporation. The impact on Stockholders' Equity of the distribution includes (i) an increase of $19,238 resulting from the cancellation of the $12,500 12% subordinated note payable to Ivex;
(ii) a decrease of $9,200 resulting from additional deferred tax liabilities due to Packaging Dynamics' C-corporation status; (iii) an increase of $423 resulting from the repayment of certain advances and obligations of members of Packaging Holdings; and (iv) a decrease of $366 resulting from expenses associated with the transaction. In the preceding discussion, dollar amounts are stated in thousands.
On July 1, 2002, the Company issued 9,437,750 shares of common stock in connection with the merger and distribution. Prior to July 1, 2002, the Company ownership consisted of membership units. Accordingly, no earnings per share information has been presented for any period prior to July 1, 2002.
In September 2003, in conjunction with the refinancing of our senior credit facility, we merged Packaging Holdings with Packaging Dynamics, L.L.C., a Delaware limited liability company and parent company of all our operating subsidiaries and of which Packaging Holdings was a sole member, and converted the surviving limited liability company into a Delaware corporation which we named Packaging Dynamics Operating Company.
Our principal executive offices are located at 3900 West 43rd Street, Chicago, Illinois 60632, and our telephone number is (773) 843-8000. Our home page on the Internet is www.pkdy.com. We make our web site content available for informational purposes only. It should not be relied upon for investment purposes, nor is it incorporated by reference into this Form 10-K. Packaging Dynamics makes available free through its website its annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 via a direct link to the Securities and Exchange Commission's Internet site at www.sec.gov.
ITEM 2.
ITEM 2. PROPERTIES
Our principal properties consist of our manufacturing locations. Shown below are the locations of the principal properties which we own or lease. We believe our facilities are suitable and adequate for the purposes for which they are used and are adequately maintained.
OWNED FACILITIES
LEASED FACILITIES
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(1) Lease expires in 2026, subject to termination at our election in 2006, and from time to time thereafter, upon specified notice.
(2) Lease expires in 2009, subject to our right to extend the lease for two successive five-year periods upon our written notice to the lessor.
(3) Sublease expires in 2005, subject to our right to extend the lease for 54 consecutive annual renewal terms of one (1) year each through September 30, 2058 and one (1) final automatic renewal term of nine (9) years ending September 30, 2067.
(4) Lease expires in 2009, subject to our right to extend the lease for three successive five-year periods upon our written notice to the lessor.
(5) Sublease expires in 2006, subject to our right to extend the lease for one successive five-year period upon our written notice to the sublessor.
(6) Lease expires in 2008, subject to our right to extend the lease for one successive five-year period upon our written notice to the lessor.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
We are currently a party to various legal proceedings in various federal and state jurisdictions arising out of the operations of our business. The amount of alleged liability, if any, from these proceedings cannot be determined with certainty; however, we believe that our ultimate liability, if any, arising from the pending legal proceedings, as well as from asserted legal claims and known potential legal claims which are probable of assertion, taking into account established accruals for estimated liabilities, should not be material to our financial condition or results of operations.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of the security holders during the fourth quarter of fiscal year 2004.
EXECUTIVE OFFICERS OF THE COMPANY
Set forth below are the name, age, positions and offices held (as of the date hereof) and a brief account of the business experience for each executive officer of the Company.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Our common stock is traded on the NASDAQ Stock Market, under the ticker symbol PKDY. The high and low sales prices for the common stock by quarter during 2003 and 2004 as reported by the NASDAQ Stock Market are shown below.
The approximate number of shareholders of record of our common stock as of March 16, 2005 was 428 holders. On January 4, 2005 the Company paid a $0.065 cash dividend per share of common stock to shareholders of record as of December 15, 2004. Any payment of cash dividends in the future will be at the discretion of our Board of Directors and will depend upon the financial condition, capital requirements and our earnings as well as other factors that our Board of Directors may deem relevant.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The selected consolidated statement of operations data for each of the three years ended December 31, 2004, 2003 and 2002 and consolidated balance sheet data as of December 31, 2004 and 2003 for Packaging Dynamics Corporation have been derived from audited consolidated financial statements included elsewhere in this annual report. The selected consolidated statement of operations data for the years ended December 31, 2001 and 2000 and the selected consolidated balance sheet data as of December 31, 2002, 2001, and 2000 for Packaging Dynamics Corporation have been derived from audited consolidated financial statements not included in this annual report.
The selected financial data set forth below related to periods prior to July 1, 2002, do not reflect the many changes that occurred in our operations, capitalization and tax status in connection with and as a result of our new corporate holding company structure. The selected financial data are not necessarily indicative of what our results of operations or financial position would have been had we operated as an independent public company during the periods presented, nor is it necessarily indicative of our future results of operations or financial position. The selected financial data should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the audited consolidated financial statements and related notes included elsewhere in this annual report.
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(1) The financial data of Packaging Dynamics Corporation include the acquisition of the capital stock of Papercon, as of September 14, 2004, the net assets of the Iuka Lamination Division of Ormet Corporation ("Iuka"), as of December 4, 2003 and the common stock of Wolf Packaging, Inc. ("Wolf"), as of October 23, 2002.
(2) Prior to July 1, 2002, for income tax purposes, Packaging Holdings' federal and state taxable income, other than income generated by International Converter, Inc. ("ICI"), was reported by its members on their income tax returns as if the company were a partnership.
(3) On July 1, 2002, the Company issued 9,437,750 shares of common stock in connection with the merger and distribution. Prior to July 1, 2002, the Company ownership consisted of membership units. Accordingly, no earnings per share information has been presented for 2002, 2001 or 2000.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion addresses the consolidated financial statements of Packaging Dynamics Corporation (the "Company," "Packaging Dynamics", "we" or "our") which is a Delaware corporation established as a holding company to own all interests in Packaging Dynamics Operating Company ("PDOC"), a Delaware corporation which is the parent company of all our current operating companies.
The following discussion including the Summary and Outlook should be read in conjunction with our financial statements and accompanying notes thereto, and the other financial information included elsewhere in this annual report. This discussion contains forward-looking statements. Please see "Special Note Regarding Forward-Looking Statements" for a discussion of the uncertainties, risks and assumptions associated with these statements. In the discussion that follows, dollar amounts other than per share data are stated in thousands.
SUMMARY AND OUTLOOK
The business is generally experiencing solid performance in each operating segment. Over the next few quarters, the Company's primary focus will be on integrating the acquisition of Papercon into the Food Packaging segment. Other priorities include expanding sales of new and existing products, improving manufacturing productivity and reducing overall product costs. The Company is evaluating a number of specific capital investment opportunities to expand product capabilities and reduce production costs. If approved, these investments could result in total capital expenditures of approximately $10,000 in 2005 compared to $6,081 in 2004 and an estimated normalized range of $7,000 to $8,000 including Papercon. The Company is also continuing its efforts to identify and pursue acquisition candidates which have the potential to expand the Company's product capabilities, market participation and geographical presence.
The Company's results are typically weakest in the first quarter of the year due, in part, to seasonal factors impacting certain markets served by the Company's Food Packaging operating segment. In addition, the first quarter of 2005 will be impacted by weakness in sales by the Company's Specialty Laminations operating segment. This is primarily the result of a combination of global shortages of a key raw material used by the Company's building products customers in the production of their products and a strategic decision by the Company to focus its resources on a narrower set of building products customers in an effort to maximize long-term sales growth.
FINANCIAL PERFORMANCE
Our continuing operations are comprised of two operating segments -- Food Packaging and Specialty Laminations. The Food Packaging segment converts paper, film and foil into a variety of specialty value-added food packaging products. The Specialty Laminations segment produces multi-layer laminated structures from a variety of substrates (foil, paper, paperboard and film), adhesives and coatings for use in various food, consumer, medical and industrial packaging applications as well as the production of insulation for the building materials market. Our discontinued operation is the Specialty Paper segment which we exited during 2003 in connection with our decision to shut down the Detroit Paper mill.
The Company's management reporting system measures segment operating performance based on Segment Operating Income. Certain items, such as asset sales and disposals and the 2002 long-term incentive compensation charge are excluded from Segment Operating Income. Corporate administrative expenses are allocated to the segments on a direct basis where appropriate with the remainder being allocated based on revenues. See Note 7 to the Company's annual consolidated financial statements for further information.
FOOD PACKAGING
Net sales increased $40,171, or 23.2%, during 2004 compared to 2003. Papercon, which was acquired on September 14, 2004, contributed $31,736 of net sales in 2004. Excluding Papercon, the net sales increase in the period was attributable to a combination of unit volume growth in key end markets as well as the impact of raw material related pricing actions. Net sales increased $2,732, or 1.6%, during 2003 compared to 2002. The increase was primarily due to incremental sales volume related to the Wolf acquisition, partially offset by the impact of lower pricing resulting from shifts from foil to paper products by several customers in our foodservice markets and the strategic exit of certain products and customers in our distribution and retail markets.
Segment Operating Income increased $2,481, or 20.5%, in 2004 compared to 2003 and Segment Operating Income margin decreased to 6.8% from 7.0% during 2004 compared to 2003. The increase in operating income was primarily due to incremental operating income related to the Papercon acquisition as the impact of increased sales and cost initiatives in our base business were generally offset by increased raw material and employee related costs. In addition, 2004 results were negatively impacted by a lower margin on the inventory acquired in the Papercon acquisition, which, as a result of acquisition purchase accounting, was $234 higher than their manufactured cost.
Segment Operating Income increased $944, or 8.5%, in 2003 compared to 2002 and Segment Operating Income margin increased to 7.0% from 6.6% during 2003 compared to 2002. The increase was primarily due to increased sales as a result of the Wolf acquisition. The improved margin reflected the ongoing impact of our productivity investments in converting equipment; lower manufacturing overhead due to reduced overall staffing levels; and improving product mix as we exited unprofitable products and customers.
SPECIALTY LAMINATIONS
Net sales increased $21,734, or 29.5%, during 2004 compared to 2003. Approximately 85% of the 2004 sales growth is due to the Iuka plant which the Company acquired in December 2003. The remaining increase was attributable to a combination of unit volume growth in key end markets and raw material related pricing actions. Net sales increased $433, or 0.6%, during 2003 compared to 2002. The increase was primarily due to increased sales of products to building materials customers partially offset by reduced sales of food packaging products.
Segment Operating Income increased $1,394, or 21.4%, in 2004 compared to 2003 and Segment Operating Income Margin decreased to 8.3% from 8.8% during 2004 compared to 2003. The increase in operating income was due to the contribution of the Iuka plant acquired in 2003, the positive impact of volume increases, raw material related pricing actions and cost and productivity gains partially offset by raw material and other operating cost increases. Segment Operating Income increased $1,521, or 30.5%, in 2003 compared to 2002 and Segment Operating Income Margin increased to 8.8% from 6.8% during 2003 compared to 2002. This increase was primarily due to increased sales volume, improved sales mix and manufacturing cost and productivity improvements.
ASSET SALES AND DISPOSALS AND 2002 LONG TERM MANAGEMENT INCENTIVE CHARGE
We continue our efforts to upgrade the capabilities of our manufacturing operations and dispose of assets which are not needed to execute our business strategy. During 2004, we sold a parcel of unused property near one of our plants and recorded a gain of $55. During 2003 and 2002, we idled certain converting equipment in our Chicago, Illinois and Baxter Springs, Kansas manufacturing facilities due to the purchase of five new bag machines in 2003. The new bag machines have improved productivity on several product categories. These manufacturing improvements and certain other productivity improvements resulted in a loss in 2003 and 2002 of $813 and $1,510, respectively, on the sale or disposal of the equipment. Also, as discussed further in Note 10 to the Company's annual consolidated financial statements, we recorded a non-cash long-term incentive compensation charge of $2,667 during 2002.
INTEREST EXPENSE
Interest expense was $5,900 in 2004 compared to $5,674 in 2003. The increase in interest expense was primarily due to increased average outstanding indebtedness of approximately $56,000 as a result of the third quarter 2004 acquisition of Papercon, partially offset by overall lower average borrowing rates. The average interest rate on borrowings in 2004 was approximately 4.82% compared to 6.21% in 2003. In the third quarter of 2004, the Company expensed $150 of costs incurred in connection with amending the terms of its term debt to provide for the Papercon acquisition. In 2003, the Company expensed $1,146 of unamortized bank fees ($906 in continuing operations and $240 in discontinued operations) resulting from the Company's credit facility refinancing.
Interest expense during 2003 was $5,674 compared to $5,982 during the same period in 2002. The decrease in interest expense in 2003 compared to 2002 resulted primarily from decreased average outstanding indebtedness as a result of reductions in working capital and the forgiveness of the 12% Promissory Note payable to Ivex. The average interest rates on borrowings in 2003 was approximately 6.21% compared to 7.60% in 2002.
INCOME TAXES
The income tax provision for continuing operations was $6,566, $4,736, and $2,521 for 2004, 2003 and 2002, respectively. The Company's effective tax rate on income from continuing operations was 39.5%, 39.1% and 42.2% for 2004, 2003 and 2002, respectively. During 2004, due to the losses incurred related to the shutdown of the Detroit paper mill in 2003, we paid cash taxes only for U.S. alternative minimum tax, state taxes and U.S. income taxes on Papercon earnings for approximately one month following the acquisition date until Papercon became part of the Company's consolidated filing group.
On July 1, 2002, a new holding company structure was created by contributing all of the limited liability company interests of Packaging Holdings to Packaging Dynamics, a C-corporation for income tax purposes, in exchange for the common stock. Prior to the distribution, the members of Packaging Holdings reported federal and state taxable income on their income tax returns as if it were a partnership. ICI has remained a taxable C-corporation from the time we acquired it in July 1999 through the date of the distribution.
INCOME FROM CONTINUING OPERATIONS
Income from continuing operations was $10,056, $7,369 and $3,447 for 2004, 2003 and 2002, respectively. The 2004 increase resulted primarily from the following factors discussed above: incremental earnings from the Papercon and Iuka acquisitions; positive impacts from sales volume increases, raw material related pricing actions and manufacturing productivity initiatives in our base business; raw material and other cost increases; and a $55 gain on asset disposals in 2004 versus a loss on asset disposals of $813 in 2003. The 2003 increase was primarily due to the following factors discussed above: non-cash long-term incentive compensation expense of $2,667 recorded in 2002; a $697 reduction in loss on asset disposals; the impact of sales changes; and manufacturing cost and productivity initiatives.
DISCONTINUED OPERATIONS
Loss from discontinued operations in 2004 was $1,278 compared to a loss of $22,089 in 2003 and a loss of $2,516 in 2002. The net loss for 2004 represents the following: $2,317 ($1,401 after tax) of administrative expense associated with the ongoing program to clear the site, recover assets and dispose of the Detroit property; $398 ($241 after tax) of expense due to additional withdrawal liability from a multi-employer pension plan; and $602 ($364 after tax) of proceeds from the liquidation of equipment. In the third quarter of 2003, the Company recorded a $22,094 ($13,367 after tax) asset impairment charge and a $2,800 ($1,694 after tax) severance charge. In the fourth quarter of 2003, the Company recorded an additional charge of $1,965 ($1,189 after tax) primarily related to the write-down of parts and supplies inventories, the write-down of other current assets and for employee outplacement services, and a charge of $816 ($495 after tax) for withdrawal liability from a multi-employer pension plan. The remaining loss from discontinued operations during 2003 was the result of operating losses. In 2005 we will have additional costs related to our ongoing program to clear the site, recover assets and dispose of the Detroit property, although the total amount of such costs are not currently estimable. There can be no assurance, however, that items will not require additional expenditures beyond those that are anticipated and that additional expenditures, if any, would not have a material adverse effect on our operating results or financial condition.
DISCLOSURE ABOUT CRITICAL ACCOUNTING POLICIES
The preparation of financial statements in accordance with GAAP requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosures of contingent liabilities. A summary of the Company's significant accounting policies is included in Note 2 to the Company's annual consolidated financial statements. Certain of the Company's accounting policies are considered critical, as these policies are the most important to the depiction of the Company's financial statements and require significant, difficult or complex judgments by management, often employing the use of estimates about the effects of matters that are inherently uncertain. Estimation methodologies are applied consistently from year to year in material respects. The following is a summary of accounting policies management considers critical to the Company's consolidated financial statements. Management has discussed the development and selection of these critical accounting estimates with the Audit Committee of the Board of Directors and the Audit Committee has reviewed our disclosures relating to it in this Management's Discussion and Analysis.
REVENUE RECOGNITION
The Company recognizes revenue at the time title transfers to the customer (generally upon shipment of products). Our revenue recognition policies are in accordance with Staff Accounting Bulletin, or SAB, No. 104, "Revenue Recognition in Financial Statements." Shipping and handling costs are included as a component of cost of goods sold. Rebates and discounts expenses directly related to the sale are recorded as a reduction to net sales. The rebates and discounts accruals require the use of management estimates and the consideration of contractual arrangements subject to interpretation. Customer sales that reach certain award levels can affect the amount of such estimates, and actual results could differ from these estimates. Future market conditions may require increased incentive offerings, possibly resulting in an incremental reduction in net sales at the time the incentive is offered.
INVENTORIES
The Company states inventories at the lower of cost or market using the first-in, first-out, or FIFO, method to determine the cost of raw materials and finished goods. This cost includes raw materials, direct labor and manufacturing overhead. Valuing inventories at the lower of cost or market requires the use of estimates and judgment. Our policy is to evaluate all inventory quantities for amounts on-hand that are potentially in excess of estimated usage requirements, and to write down any excess quantities to estimated net realizable value. Inherent in estimates of net realizable value are manufacturing schedules, customer demand, possible alternative uses and ultimate realization of potentially excess inventory. Please refer to Schedule II --
Valuation and Qualifying Accounts in this Form 10-K for activity in the obsolescence reserve over the past three years.
ACCOUNTS RECEIVABLE
Accounts receivable from sales to customers are unsecured, and we value accounts receivable net of allowances for doubtful accounts. These allowances are based on estimates of the portion of the receivables that will not be collected in the future. However, the ultimate collectibility of a receivable is significantly dependent upon the financial condition of the individual customer, which can change rapidly and without advance warning.
We record an allowance for doubtful accounts as an estimate of the inability of our customers to make their required payments. We determine the amount of our allowance for doubtful accounts by looking at a variety of factors. First we examine an aging of the accounts receivable. The aging lists past due amounts according to invoice terms. In addition, we consider the current economic environment, the credit rating of the customers and general overall market conditions.
If we determine that a customer is unlikely to pay, we record a charge to bad debt expense in the income statement and an increase to the allowance for doubtful accounts. Please refer to Schedule II -- Valuation and Qualifying Accounts in this Form 10-K for activity in the allowance for doubtful accounts over the past three years.
We believe our allowance for doubtful accounts is adequate to cover any future non-payments of our customers. However, if economic conditions deteriorate significantly or one of our large customers was to declare bankruptcy, a larger allowance for doubtful accounts might be necessary.
LONG-LIVED ASSETS
Long-lived assets, including property, plant and equipment and finite-lived intangibles, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of assets may not be recoverable. If the expected future cash flows (undiscounted and without interest charges) are less than the carrying amount of the asset, an impairment loss is recognized in accordance with SFAS 144. In addition, the remaining amortization period for the impaired asset would be reassessed and revised if necessary.
Provisions for depreciation have been computed principally on the straight-line method over the estimated useful lives: generally 31 years for buildings, 15 to 31 years for improvements, 7 to 20 years for machinery and equipment and 3 to 5 years for computer software. The Company amortizes intangible assets with definitive lives over varying periods. Deferred financing fees are amortized using the effective interest method over the lives of the respective debt agreements. Customer contracts and customer relationships are amortized using the straight-line method over the estimated lives of the contracts and relationships. Covenants not to compete are amortized using the straight-line method over the lives of the agreements.
IMPAIRMENT OF GOODWILL
In accordance with SFAS 142, we evaluate our goodwill for impairment on an annual basis or whenever indicators of impairment exist. SFAS 142 requires that if the carrying value of a reporting unit for which goodwill exists exceeds its fair value, an impairment loss is recognized to the extent that the carrying value of the reporting unit goodwill exceeds the "implied fair value" of reporting unit goodwill.
As discussed in the notes to the financial statements, we have evaluated our goodwill for impairment and have determined that the fair value of our reporting units exceeds their carrying value, so we did not recognize an impairment of goodwill. Our reporting units are consistent with our operating segments. Goodwill of approximately $81,263 is shown on our balance sheet as of December 31, 2004.
We believe that the accounting estimate related to determining the fair value of our reporting units is a critical accounting estimate because: (1) it is highly susceptible to change from period to period because it requires company management to make assumptions about the future cash flows for each reporting unit over
several years in the future, and (2) the impact that recognizing an impairment would have on the assets reported on our balance sheet as well as our results of operations could be material. Management's assumptions about future cash flows for the reporting units require significant judgment and actual cash flows in the future may differ significantly from those forecasted today.
In estimating future cash flows, we use internally generated projections reviewed by management. We develop our projections based upon recent sales trends, discussions with our customers, planned timing of new product launches, forecasted capital expenditure needs, working capital needs, costing factors and many other variables. From these internally generated projections, a projection of cash flows is made based upon expected sales growth rates and capital and working capital requirements.
We believe our assumptions used in discounting future cash flows are appropriately conservative. Any increase in estimated cash flows would have no impact on the reported carrying amount of goodwill. However, if our current estimates of discounted cash flow had been approximately 40% lower for our Food Packaging reporting unit and approximately 65% lower for our Specialty Laminations reporting unit, the fair value of the reporting unit would have been lower than the carrying value thus requiring us to perform an impairment test to determine the "implied value" of goodwill.
STOCK-BASED COMPENSATION
As of December 31, 2004, we followed APB No. 25, "Accounting for Stock Issued to Employees," ("APB No. 25") and the related Interpretations in accounting for our stock option plans. SFAS No. 123, "Accounting for Stock-Based Compensation," ("SFAS No. 123") issued subsequent to APB No. 25, defines a "fair value based method" of accounting for employee stock options but allows companies to continue to measure compensation cost for employee stock options using the "intrinsic value based method" prescribed in APB No. 25.
In December 2004, the FASB issued SFAS No. 123 (revised 2004), "Share-Based Payment" ("SFAS 123R"), which replaces SFAS No. 123, "Accounting for Stock-Based Compensation," ("SFAS 123") and supercedes APB Opinion No. 25, "Accounting for Stock Issued to Employees." SFAS 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair values beginning with the first interim or annual period after June 15, 2005, with early adoption encouraged. The pro forma disclosures previously permitted under SFAS 123 no longer will be an alternative to financial statement recognition. Under SFAS 123R, we must determine the appropriate fair value model to be used for valuing share-based payments, the amortization method for compensation cost and the transition method to be used at date of adoption. The transition methods include prospective and retroactive adoption options. Under the retroactive option, prior periods may be restated either as of the beginning of the year of adoption or for all periods presented. The prospective method requires that beginning with the first quarter of adoption of SFAS 123R compensation expense will be recorded for stock options and restricted stock as such items vest, while the retroactive methods would record compensation expense for all stock options and restricted stock as they vest beginning with the first period restated. See Note 2 to the Company's annual consolidated financial statements for assumptions used in calculating the fair values of employee stock option plans.
We have not yet determined the method of adoption or the effect of adopting SFAS 123R, and have not determined whether the adoption will result in amounts that are similar to the current pro forma disclosures under SFAS 123. However, in accordance with SFAS No. 123, we have been disclosing in the Notes to the Consolidated Financial Statements the impact on our net income and earnings per share had we adopted the fair value based method. If we had adopted the fair value based method in 2004, our net income would have been $266 lower than reported or approximately $.02 diluted earnings per share lower than reported. If we had applied the fair value based method and recorded the additional after-tax expense of $266, it would not have had a significant impact on our liquidity and capital resources because the expense is non-cash. Further, "non- cash expenses relating to the granting of options" are excluded as an expense in determining EBITDA for purposes of our debt covenants.
INCOME TAXES
In the normal course of business, the Company is regularly audited by federal and state authorities, and is periodically challenged regarding the amount of taxes due. These challenges include questions regarding the timing and amount of deductions and the allocation of income among various tax jurisdictions. Management believes the Company's tax positions comply with applicable tax law and intends to defend its positions. In evaluating the exposure associated with various tax filing positions, the Company records reserves for uncertain tax positions, and management believes these reserves are adequate. The Company's effective tax rate in a given financial statement period could be impacted if the Company prevailed in matters for which reserves have been established, or was required to pay amounts in excess of established reserves.
In determining whether a valuation allowance is warranted, management evaluates factors such as prior earnings history, expected future earnings, carry-back and carry-forward periods, and tax strategies that could potentially enhance the likelihood of realization of a deferred tax asset. No valuation allowance is considered necessary as of December 31, 2004.
LIQUIDITY AND CAPITAL RESOURCES
At December 31, 2004, we had cash and cash equivalents of $1,175, and $46,561 was available under the revolving portion of our credit facility (the "Senior Credit Facility"), after taking into account $2,539 in letters of credit outstanding and $900 of revolver borrowings. Our working capital at December 31, 2004 was $29,965 compared to $16,410 at December 31, 2003 due primarily to the acquisition of Papercon.
Our primary short-term and long-term operating cash requirements are for debt service, working capital, capital expenditures and dividends. We expect to rely on cash generated from operations supplemented by revolver borrowings under the Senior Credit Facility to fund short-term and long-term cash requirements.
During the third quarter of 2004, the Company amended the Senior Credit Facility to provide for an additional $45,000 of Term B loans and an increase in the revolving credit facility to $50,000, up to $8,000 of which may be in the form of letters of credit. The revolving credit facility is due in 2008. As of December 31, 2004, the Term A Loan had an outstanding balance of $24,750 and will mature in 2008. The required aggregate annual payments, payable in quarterly installments, total $5,250 $6,250, $7,250 and $6,000 in 2005, 2006, 2007 and 2008, respectively. As of December 31, 2004, the Term B Loan had a outstanding balance of $83,829 and will mature in 2009. The aggregate annual payments, payable in equal quarterly installments, total $843 in years 2005 through 2008 and $80,459 in 2009. The revolver had a balance of $900 as of December 31, 2004.
The Company generated $17,327, $14,989 and $21,503 of cash from operating activities during 2004, 2003 and 2002, respectively. The increase from 2004 compared to 2003 was primarily due to incremental cash from operating activities from Papercon partially offset by a decrease in cash from discontinued operating activities. The decrease in cash from operating activities from 2003 compared to 2002 was primarily related to an increased investment in working capital.
Cash used by discontinued operating activities was $1,952 during 2004 compared with cash from discontinued operations of $2,532 and $4,356 during 2003 and 2002, respectively. The cash generated and used by discontinued operating activities is a result of ongoing efforts to clear the site and dispose of the Detroit property. Such costs are expected to continue until the property is sold.
Cash used by investing activities was $50,378, $12,321 and $13,909 during 2004, 2003 and 2002, respectively. The increase in cash used in continuing operations investing activities during 2004 was primarily associated with the Papercon acquisition. Cash used for additions to property, plant and equipment was $6,081, $6,272 and $2,265 in 2004, 2003 and 2002, respectively. Major capital expenditures in 2004 were for information technology upgrades, manufacturing equipment upgrades as well as building and office improvements. In 2003 capital expenditures included $2,842 of investment in new bag making equipment in our Food Packaging operating segment, increased investment in information technology infrastructure and upgrades to our manufacturing facilities.
Financing activities generated cash of $33,773 during 2004 compared to a use of $4,079 and $6,771 during 2003 and 2002, respectively. The cash generated in the current year was primarily related to the Senior Credit Facility borrowings in connection with the acquisition of Papercon. In October 2004, the Company reduced the revolver balance by $22,600 primarily by using the cash acquired in the Papercon acquisition. During 2004, the Company paid cash dividends of $1,978 compared with zero during 2003 and 2002. In addition, in December 2004, the Company announced a cash dividend of $0.065 per common share, $683 in the aggregate, which was paid on January 4, 2005 to shareholders of record on December 15, 2004.
Loans under the Senior Credit Facility are designated from time to time, at our election, either (1) as Eurodollar Rate Loans, which bear interest at a rate based on the London Interbank Offered Rate, or LIBOR, adjusted for regulatory reserve requirements, or (2) as Base Rate Loans, which bear interest at a rate based on the Federal Funds rate or the prime rate. The interest rate on Eurodollar Rate Loans is equal to LIBOR plus an applicable percentage that varies with the leverage ratio of the Company and its consolidated subsidiaries. The interest rate on Base Rate Loans is equal to a base rate equal to the greater of (1) the Federal Funds rate plus 1/2 of 1% or (2) the prime rate, plus an applicable percentage that varies with the leverage ratio of the Company and its consolidated subsidiaries.
Accordingly, Term A Loans and revolving loans bear interest at rates of up to 2.0% plus the base rate, in the case of Base Rate Loans, and up to 3.0% plus LIBOR, in the case of Eurodollar Loans. Term B Loans bear interest at rates of 2.0% plus the base rate, in the case of Base Rate Loans, and 3.0% plus LIBOR, in the case of Eurodollar Loans.
At December 31, 2004, the interest rates on borrowings under the Term A Loan and the Term B Loan were 3.0% plus LIBOR (1.98%) and 3.0% plus LIBOR (1.98%), respectively, compared with 3.0% plus LIBOR (1.15%) and 3.5% plus LIBOR (1.15%), respectively, at December 31, 2003. To reduce the impact of changes in interest rates on our variable rate debt, the Company has entered into interest rate derivative instruments, which are discussed in "Quantitative and Qualitative Disclosures About Market Risk".
Borrowings are collateralized by substantially all of the stock and assets of our operating subsidiaries. The revolving credit facility and Term A Loan will terminate on September 29, 2008 and the Term B Loan will terminate on September 29, 2009.
Under the Senior Credit Facility, as amended, we are required to comply on a quarterly basis with the following four financial covenants:
- under the leverage ratio covenant, as of the last day of each fiscal quarter, the ratio of total funded debt of the Company and its consolidated subsidiaries to consolidated EBITDA of the Company and its consolidated subsidiaries for the 12-month period then ended must not exceed specified levels, decreasing from 4.5 to 1 at December 31, 2004 to 4 to 1;
- under the senior secured leverage ratio covenant, as of the last day of each fiscal quarter, the ratio of total secured funded debt of the Company and its consolidated subsidiaries to consolidated EBITDA of the Company and its consolidated subsidiaries for the 12-month period then ended must not exceed specified levels, decreasing from 3.75 to 1 at December 31, 2004 to 3 to 1;
- under the fixed charge coverage ratio covenant, as of the last day of each fiscal quarter, for the 12-month period then ended, the ratio of consolidated EBITDA less capital expenditures and cash tax payments of the Company and its consolidated subsidiaries to cash interest expense and scheduled funded debt payments (excluding the $7,000 seller note issued in connection with the Papercon acquisition) of the Company and its consolidated subsidiaries must be equal to or greater than certain specified levels, increasing from 1.1 to 1 at December 31, 2004 to 1.2 to 1; and
- under the net worth covenant, Packaging Dynamics' consolidated net worth as of the last day of each fiscal quarter must be equal to or greater than 80% of the net worth as of September 30, 2003 increased on a cumulative basis by (1) as of the last day of each fiscal quarter, 50% of the consolidated net income of Packaging Dynamics (to the extent positive) for the fiscal quarter then ended, (2) 75% of the net cash proceeds from any equity issuance by Packaging Dynamics or any subsidiary of Packaging
Dynamics, and (3) 75% of the amount added to the equity of Packaging Dynamics in accordance with GAAP in connection with the Papercon acquisition.
For purposes of the Senior Credit Facility, as amended, consolidated EBITDA, calculated on a consolidated basis for Packaging Dynamics and its subsidiaries, consists of (1) net income from continuing operations, excluding the effect of any extraordinary or other non-recurring gains or losses or non-cash gains or losses (in each case, other than in connection with the sale and/or closure of the Detroit paper mill), plus (2) an amount which, in the determination of net income, has been deducted for interest expense, taxes, depreciation and amortization, non-cash expenses relating to the granting of options, cash and non-cash charges and/or losses with respect to the sale and/or closure of the Detroit paper mill, and charges related to the Papercon owner bonus program prior to the date of acquisition by the Company, minus (3) cash expenditures related to non-cash charges previously added back to net income in determining EBITDA (other than in connection with the closure of the Detroit paper mill), plus (4) the write-off of capitalized financing costs existing as of the closing of the Senior Credit Facility.
The Senior Credit Facility also contains various negative covenants that, among other things, require Packaging Dynamics and its subsidiaries to limit future borrowings and payments to related parties and restricts Packaging Dynamics' ability and the ability of its subsidiaries to merge or consolidate. In addition, the Senior Credit Facility prohibits changes in the nature of business conducted by the Company and its subsidiaries. The failure to comply with the covenants would result in a default under the Senior Credit Facility and permit the lenders under the Senior Credit Facility to accelerate the maturity of the indebtedness governed by the Senior Credit Facility.
The Senior Credit Facility includes terms that limit changes in our ownership structure. Modifications to the ownership structure outside the limits prescribed by such agreements could place us in default under these debt instruments. The Senior Credit Facility requires PDOC to maintain specified financial ratios and levels of tangible net worth as discussed above. PDOC was in compliance with those covenants as of December 31, 2004, the latest measurement date. The occurrence of any default of these covenants could result in acceleration of our obligations under the Senior Credit Facility ($109,479 as of December 31, 2004) and foreclosure on the collateral securing those obligations.
On October 23, 2002, the Company acquired the outstanding common stock of Wolf for the issuance of 166,667 shares of our common stock with a market value of $984 and cash of $9,275 (including the repayment of certain indebtedness and payment of costs related to the acquisition). Wolf is a manufacturer of foil and paper sandwich wraps located in Fort Madison, Iowa. Wolf is a significant supplier to the quick-service restaurant industry and generated annual revenues of approximately $23,000 during 2002. The acquisition was funded substantially with cash flows from operations.
On December 4, 2003, the Company acquired the net assets of the Iuka Lamination Division of Ormet Corporation. The Iuka Lamination Division consists of a single converting plant located in Iuka, Mississippi which produces laminated foil products for the insulation, food packaging and label stock markets. The business generated net sales of approximately $18,000 during 2003 and the purchase price was approximately $4,296. The acquisition is not considered significant and thus no pro forma financial information has been presented.
On September 14, 2004, the Company acquired Papercon, a manufacturer and marketer of a broad range of paper and foil based specialty packaging products for foodservice, supermarket, quick service restaurant and food processing customers, Papercon is headquartered at its Atlanta, Georgia manufacturing facility and also has manufacturing facilities near Dallas, Texas and Los Angeles, California. The acquisition of Papercon significantly broadens the Company's product line, customer base and geographic presence. The business generated net sales of approximately $85,480 during 2003 and the aggregate purchase price was approximately $66,421 comprised of $44,148 of cash (net of cash acquired), $11,575 of Packaging Dynamics common stock and a $7,000 note payable to the seller. The cash portion of the acquisition was funded with an increase in the borrowings under the Senior Credit Facility.
Disclosures about contractual obligations and commercial commitments are included in various parts of this Report, including Note 6 -- Long Term Debt and Note 11 -- Commitments and Contingencies to the consolidated financial statements. A summary of significant contractual obligations as of December 31, 2004 is as follows:
The Company does not have long-term supply agreements or capital commitments in addition to those discussed above.
RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
NEW ACCOUNTING PRONOUNCEMENTS
In November 2004, the FASB released FASB Statement No. 151, "Inventory Costs -- an amendment of ARB No. 43, Chapter 4" (which we refer to as "SFAS 151"). SFAS 151 is the result of the FASB's efforts to converge U.S. accounting standards for inventories with International Accounting Standards. SFAS 151 requires abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage) to be recognized as current-period charges. It also requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. SFAS 151 is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. We are currently evaluating the effect that the adoption of SFAS 151 will have on our consolidated results of operations and financial condition but do not expect SFAS 151 to have a material impact.
In December 2004, the FASB issued two FASB Staff Positions (FSP's) that provide accounting guidance on how companies should account for the effects of the American Jobs Creation Act of 2004 (the Act) that was signed into law on October 22, 2004. The Act could affect how companies report their deferred income tax balances. The first FSP is FSP FAS 109-1 (FAS 109-1); the second is FSP FAS 109-2 (FAS 109-2). In FAS 109-1, the FASB concludes that the tax relief (special tax deduction for domestic manufacturing) from the Act should be accounted for as a "special deduction" instead of a tax rate reduction. As a domestic manufacturer the Company will assess early in 2005 whether the Company is eligible for any tax deductions under this Act. FAS 109-2 gives a company additional time to evaluate the effects of the Act on any plan for reinvestment or repatriation of foreign earnings for purposes of applying FASB Statement No. 109, "Accounting for Income Taxes." We expect FAS 109-2 to have no impact.
In December 2004, the FASB issued SFAS No. 123 (revised 2004), "Share-Based Payment" ("SFAS 123R"), which replaces SFAS No. 123, "Accounting for Stock-Based Compensation," ("SFAS 123") and supercedes APB Opinion No. 25, "Accounting for Stock Issued to Employees." SFAS 123R and the expected related impact on the Company's financial statements is discussed more fully under the heading "Disclosures about Critical Accounting Policies -- Stock Based Compensation".
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We use interest rate swaps, collars and caps to modify our exposure to interest rate movements and to reduce borrowing costs. We have designated these instruments as cash flow hedges and consider these instruments effective at offsetting our risk to variable interest rates on debt. Our exposure to interest rate risk
consists of floating rate debt instruments that are benchmarked to LIBOR. As of December 31, 2004, we had interest rate instruments in effect with banks having notional amounts totaling $75,000 and varying maturity dates through December 31, 2007. We had an interest rate swap agreement with a notional value of $25,000 which became effective on December 31, 2003 and matures on December 29, 2006. This swap fixes our LIBOR rate for $25,000 of our Senior Credit Facility indebtedness at a rate of 2.91%. We also entered into an interest rate collar agreement with a notional amount of $20,000 which became effective on December 31, 2004 and matures on December 31, 2007. This collar will result in our paying market LIBOR rates for $20,000 of our Senior Credit Facility indebtedness from a floor of 3.08% to a cap of 5.00%. In addition to these two instruments, we had two interest rate caps of $15,000 each which became effective on December 31, 2004 for a cap premium of $376. These caps limit our LIBOR rate for $30,000 of our Senior Credit Facility indebtedness at a maximum rate of 4.00%. A 10% unfavorable movement in LIBOR would not expose us to material losses of earnings or cash flows.
Income or expense related to settlements under these agreements is recorded as adjustments to interest expense in our financial statements. The fair market value of our derivative instruments outlined above approximates a $471 asset as of December 31, 2004 and is based upon the amount at which it could be settled with a third party, although we have no current intention to trade any of these instruments and plan to hold them as hedges for the Senior Credit Facility. The changes in the fair market value of our derivative instruments, net of income tax, was recorded in other comprehensive income (loss).
Substantially all of our sales, including export sales, are denominated in United States Dollars in order to reduce our exposure to changes in foreign currency exchange rates.
SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS
Certain statements included in this annual report, including without limitation, "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Summary and Outlook, -- Financial Performance, -- Liquidity and Capital Resources, -- Recently Issued Accounting Pronouncements, and -- Quantitative and Qualitative Disclosure About Market Risk" constitute "forward-looking statements" within the meaning of the Private -- Securities Litigation Reform Act of 1995 (the "Reform Act"). Such forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause the actual results, performance or achievements of the Company to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. Among the factors that could cause results to differ materially from current expectations are: (i) changes in consumer demand and prices resulting in a negative impact on revenues and margins; (ii) raw material substitutions and increases in the costs of raw materials, utilities, labor and other supplies; (iii) increased competition in the Company's product lines; (iv) changes in capital availability or costs; (v) workforce factors such as strikes or labor interruptions; (vi) the ability of the Company and its subsidiaries to develop new products, identify and execute capital programs and efficiently integrate acquired businesses; (vii) the cost of compliance with applicable governmental regulations and changes in such regulations, including environmental regulations; (viii) the general political, economic and competitive conditions in markets and countries where the Company and its subsidiaries operate, including currency fluctuations and other risks associated with operating in foreign countries; and (ix) the timing and occurrence (or non-occurrence) of transactions and events which may be subject to circumstances beyond the control of Packaging Dynamics and its subsidiaries.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Report of Independent Registered Public Accounting Firm is included on page 24.
(a)(1) The following financial statements of Packaging Dynamics are included on pages 25 to 52.
- Consolidated Balance Sheets at December 31, 2004 and 2003
- Consolidated Statements of Operations for the Years ended December 31, 2004, 2003 and 2002
- Consolidated Statements of Stockholders' Equity/Members' Equity and Other Comprehensive Income (Loss) for the Years ended December 31, 2004, 2003 and 2002
- Consolidated Statements of Cash Flows for the Years ended December 31, 2004, 2003 and 2002
- Notes to the Consolidated Financial Statements
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of Packaging Dynamics Corporation
In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Packaging Dynamics Corporation and its subsidiaries (the "Company") at December 31, 2004 and 2003, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2004 in conformity with accounting principles generally accepted in the United States of America. 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 audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). 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, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
- -s- PricewaterhouseCoopers LLP PRICEWATERHOUSECOOPERS LLP
Chicago, Illinois March 30, 2005
PACKAGING DYNAMICS CORPORATION
CONSOLIDATED BALANCE SHEETS (DOLLARS IN THOUSANDS)
The accompanying notes are an integral part of this statement.
PACKAGING DYNAMICS CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS (DOLLARS IN THOUSANDS)
The accompanying notes are an integral part of this statement.
PACKAGING DYNAMICS CORPORATION
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY/MEMBERS' EQUITY AND OTHER COMPREHENSIVE INCOME (LOSS) (DOLLARS IN THOUSANDS)
The accompanying notes are an integral part of this statement.
PACKAGING DYNAMICS CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(DOLLARS IN THOUSANDS)
The accompanying notes are an integral part of this statement.
PACKAGING DYNAMICS CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS)
NOTE 1 -- ORGANIZATION AND BASIS OF PRESENTATION
Packaging Dynamics Corporation the ("Company" or "Packaging Dynamics") is a Delaware corporation established as a holding company to own all of the interest in Packaging Dynamics Operating Company ("PDOC"). PDOC is a Delaware corporation which is the holding company for all our current operating subsidiaries.
On March 18, 2002, the board of directors of Ivex Packaging Corporation ("Ivex") approved a merger agreement providing for the merger with Ivex of a wholly-owned subsidiary of Alcoa Inc. ("Alcoa"). As a result of the merger, Ivex became a wholly-owned subsidiary of Alcoa on July 1, 2002. The merger was conditioned upon, among other things, the prior distribution to Ivex stockholders and option holders of Ivex's 48.19% ownership interest in Packaging Holdings, L.L.C ("Packaging Holdings" or "PHLLC"). To facilitate the distribution, Ivex formed Packaging Dynamics, a C-corporation for income tax purposes, to be the holding company for all of the ownership interests in Packaging Holdings. In preparation for the distribution, Ivex and the other members of Packaging Holdings exchanged their ownership interests in Packaging Holdings for common stock of Packaging Dynamics. On July 1, 2002, Ivex distributed its shares of Packaging Dynamics to its stockholders and certain of its option holders immediately prior to the merger. The consolidated financial statements of Packaging Dynamics presented herein include the results of consolidated operations, financial position and cash flows of Packaging Holdings.
Also in connection with the merger and distribution, a new holding company structure was created by contributing all of the limited liability company interests of Packaging Holdings to Packaging Dynamics, a C-corporation for income tax purposes, in exchange for the common stock of Packaging Dynamics; the $12,500 12% subordinated note payable to Ivex, plus accreted interest, totaling approximately $19,238 was canceled; and a consulting agreement with Ivex was canceled. The impact of the distribution is reflected on the Consolidated Statements of Stockholders' Equity and Other Comprehensive Income (Loss) as Formation of Packaging Dynamics Corporation. The impact on Stockholders' Equity/Members' Equity of the distribution includes (i) an increase of $19,238 resulting from the cancellation of the $12,500 12% subordinated note payable to Ivex; (ii) a decrease of $9,200 resulting from additional deferred tax liabilities due to Packaging Dynamics' C-corporation status; (iii) an increase of $423 resulting from the repayment of certain advances and obligations of members of Packaging Holdings; and (iv) a decrease of $366 resulting from expenses associated with the transaction.
On July 1, 2002, the Company issued 9,437,750 shares of common stock in connection with the merger and distribution. Prior to July 1, 2002, the Company ownership consisted of membership units. Accordingly, no earnings per share information has been presented for any period prior to July 1, 2002.
In September 2003, in conjunction with the refinancing of the Senior Credit Facility, Packaging Holdings merged with Packaging Dynamics, L.L.C., a Delaware limited liability company which was the parent company of all the operating subsidiaries and of which Packaging Holdings was a sole member, and converted the surviving limited liability company into a Delaware corporation which was named Packaging Dynamics Operating Company.
The Company is a flexible packaging converter, supplying specialty converted paper, foil and film based products for use in a variety of end use markets. Our continuing operations operate within, and sell to customers throughout, the U.S., Canada and Europe in two operating segments -- Food Packaging and Specialty Laminations. The Food Packaging segment converts paper, film and foil into a variety of specialty value-added food packaging products. The Specialty Laminations segment produces multi-layer laminated structures from a variety of substrates (foil, paper, paperboard and film), adhesives and coatings for use in various food, consumer, medical and industrial packaging applications as well as the production of insulation
PACKAGING DYNAMICS CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
for the building materials market. Our discontinued operation is the Specialty Paper segment which we exited during 2003 in connection with our decision to shut down the Detroit Paper mill.
NOTE 2 -- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of Packaging Dynamics Corporation and its wholly-owned subsidiaries. Intercompany balances and transactions have been eliminated.
CASH AND CASH EQUIVALENTS
The Company considers any highly liquid instruments purchased with an original maturity date of three months or less to be cash equivalents.
REVENUE RECOGNITION
The Company recognizes revenue at the time title transfers to the customer (generally upon shipment of products) in accordance with Staff Accounting Bulletin No. 104, "Revenue Recognition in Financial Statements." Shipping and handling costs are included as a component of cost of goods sold. Rebates and discounts expenses directly related to the sale are recorded as a reduction to net sales. The rebates and discounts accruals require the use of management estimates and the consideration of contractual arrangements subject to interpretation. Customer sales that reach certain award levels can affect the amount of such estimates, and actual results could differ from these estimates.
INVENTORIES
Inventories are stated at the lower of cost or market as determined by the first-in, first-out (FIFO) method. Such cost includes raw materials, direct labor and manufacturing overhead. Inventories at December 31, 2004 and 2003 consisted of the following:
PROPERTY, PLANT AND EQUIPMENT
The Company capitalizes expenditures for additions and major improvements at cost and charges to operating expenses the cost of maintenance and repairs. Provisions for depreciation have been computed principally on the straight-line method, over the following estimated useful lives: generally 31 years for buildings, 15 to 31 years for improvements, 7 to 20 years for machinery and equipment and 3 to 5 years for computer software. During the second quarter of 2004, the Company changed the estimate of useful lives for certain major converting machinery and equipment from 12 years to 20 years resulting in a net reduction of annual depreciation expense of $110. Assets recorded under capital leases are amortized over the shorter of the life of the lease or useful life. Depreciation expense was $5,901, $6,709, and $7,543 for the year ended December 31, 2004, 2003 and 2002, respectively.
PACKAGING DYNAMICS CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The cost and accumulated depreciation relating to assets retired or otherwise disposed of are eliminated from the respective accounts at the time of disposition. The resulting gain or loss is included in the current operating results.
LONG-LIVED ASSETS
Long-lived assets, including property, plant and equipment and finite-lived intangibles, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of assets may not be recoverable. If the expected future cash flows (undiscounted and without interest charges) are less than the carrying amount of the asset, an impairment loss is recognized. Finite-lived intangibles, consisting of deferred financing costs, non-compete agreements and customer contracts, are capitalized and amortized over their useful lives which range from one to nine years.
The Company amortizes intangible assets with definitive lives over varying periods. Deferred financing fees are amortized using the effective interest method over the lives of the respective debt agreements. Customer contracts and customer relationships are amortized using the straight-line method over the estimated lives of the contracts and relationships. Covenants not to compete are amortized using the straight-line method over the lives of the agreements.
GOODWILL AND INDEFINITE-LIVED INTANGIBLE ASSETS
The Company records goodwill and intangible assets in accordance with Statement of Financial Accounting Standards ("SFAS") No. 142, "Goodwill and Other Intangible Assets." This statement eliminates the requirement for goodwill and intangible assets with indefinite lives to be amortized to expense over time but requires instead that such assets be tested for impairment at least annually, or as circumstances dictate.
Trademarks and trade names are considered to have indefinite lives. Goodwill, along with other indefinite lived intangibles, are reviewed annually during the fourth quarter for impairment or when events or circumstances indicate that an impairment exists. See Note 5 to the financial statements for additional information.
STOCK BASED COMPENSATION
At December 31, 2004, the Company has a stock-based compensation plan, which is described more fully in Note 10, "Employee Benefit Plans." The Company accounts for this plan under the recognition and measurement provisions of Accounting Principles Board Opinion ("APB") No. 25 "Accounting for Stock Issued to Employees," and related interpretations. Stock-based employee compensation cost is reflected in earnings to the extent that option grants under those plans had an exercise price below the market value of the underlying common stock on the date of grant. SFAS No. 123, "Accounting for Stock-Based Compensation," ("SFAS No. 123") issued subsequent to APB No. 25 and amended by SFAS No. 148, "Accounting for Stock-Based Compensation -- Transition and Disclosure," ("SFAS No. 148") defines a fair value based method of accounting for employees stock options but allows companies to continue to measure compensation cost for employee stock options using the intrinsic value based method described in APB No. 25.
PACKAGING DYNAMICS CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS No. 123 as amended by SFAS No. 148, to stock-based employee compensation.
The determination of compensation expense for the pro forma information was based upon the estimated fair value of the options on the date of grant using the Black-Scholes option pricing model with the following assumptions:
The weighted average fair values of options granted during 2004 and 2003 were $3.60 and $2.67 per share, respectively.
These costs may not be representative of the total effects on pro forma reported net income (loss) for future years. Factors that may impact disclosures in future years include the attribution of the awards to the service period, the vesting of stock options, timing of additional grants of stock option awards and number of shares granted for future awards.
EARNINGS PER SHARE
Basic earnings per share excludes dilution and is computed by dividing net income by the weighted average number of common shares outstanding during each period. Diluted earnings per share reflects the potential dilution that could occur if common stock options are exercised and is computed by dividing net income by the weighted average number of common shares outstanding, including common stock equivalent shares, issuable upon exercise of outstanding stock options, to the extent that they would have a dilutive effect on the per share amounts. Dilution of the Company's weighted average shares outstanding results from common stock issuable upon exercise of outstanding stock options.
In accordance with SFAS 128, "Earnings per Share," the denominator used in the diluted earnings per share calculation is based on the control number concept, which requires that the same number of potentially dilutive securities applied in computing diluted earnings per share from continuing operations be applied to all other categories of income or loss, regardless of their anti-dilutive effect on such categories.
PACKAGING DYNAMICS CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The following table details the calculation of basic and diluted earnings per share for continuing operations:
Prior to July 1, 2002 the Company ownership consisted of membership units. Accordingly, no earnings per share information has been presented for any period prior to July 1, 2002.
DERIVATIVES AND OTHER COMPREHENSIVE INCOME (LOSS)
The Company maintains interest rate derivative instruments (typically swaps or collars) that are designated as cash flow hedges to manage the market risk from changes in interest rates on a portion of its variable rate term loans. The Company recognizes all derivative instruments which are cash flow hedges as assets or liabilities at fair value, with the related gain or loss reflected within stockholders' equity through accumulated other comprehensive income (loss). Such instruments are recorded at fair value, and at December 31, 2004 and 2003, the net fair value approximates a $471 asset and a $394 liability, respectively. Net assets are included in other current assets and net liabilities are included in accrued liabilities within the accompanying consolidated balance sheet. Changes in fair value, based upon the amount at which the instrument could be settled with a third party, are recorded in other comprehensive income (loss) only to the extent of effectiveness. Any ineffectiveness on the instrument would be recognized in the consolidated statement of operations. The differentials to be received or paid under the instrument are recognized in income over the life of the contract as adjustments to interest expense.
RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
NEW ACCOUNTING PRONOUNCEMENTS
In November 2004, the FASB released FASB Statement No. 151, "Inventory Costs -- an amendment of ARB No. 43, Chapter 4" (which we refer to as "SFAS 151"). SFAS 151 is the result of the FASB's efforts to converge U.S. accounting standards for inventories with International Accounting Standards. SFAS 151 requires abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage) to be recognized as current-period charges. It also requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. SFAS 151 is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. We are currently evaluating the effect that the adoption of SFAS 151 will have on our consolidated results of operations and financial condition but do not expect SFAS 151 to have a material impact.
In December 2004, the FASB issued two FASB Staff Positions (FSP's) that provide accounting guidance on how companies should account for the effects of the American Jobs Creation Act of 2004 (the Act) that was signed into law on October 22, 2004. The Act could affect how companies report their deferred income tax balances. The first FSP is FSP FAS 109-1 (FAS 109-1); the second is FSP FAS 109-2 (FAS 109-2). In FAS 109-1, the FASB concludes that the tax relief (special tax deduction for domestic
PACKAGING DYNAMICS CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
manufacturing) from the Act should be accounted for as a "special deduction" instead of a tax rate reduction. As a domestic manufacturer the Company will assess early in 2005 whether the Company is eligible for any tax deductions under this Act. FAS 109-2 gives a company additional time to evaluate the effects of the Act on any plan for reinvestment or repatriation of foreign earnings for purposes of applying FASB Statement No. 109, "Accounting for Income Taxes." We expect FAS 109-2 to have no impact.
In December 2004, the FASB issued SFAS No. 123 (revised 2004), "Share-Based Payment" ("SFAS 123R"), which replaces SFAS No. 123, "Accounting for Stock-Based Compensation," ("SFAS 123") and supercedes APB Opinion No. 25, "Accounting for Stock Issued to Employees." SFAS 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair values beginning with the first interim or annual period after June 15, 2005, with early adoption encouraged. The pro forma disclosures previously permitted under SFAS 123 no longer will be an alternative to financial statement recognition. Under SFAS 123R, we must determine the appropriate fair value model to be used for valuing share-based payments, the amortization method for compensation cost and the transition method to be used at date of adoption. The transition methods include prospective and retroactive adoption options. Under the retroactive option, prior periods may be restated either as of the beginning of the year of adoption or for all periods presented. The prospective method requires that beginning with the first quarter of adoption of SFAS 123R compensation expense will be recorded for stock options and restricted stock as such items vest, while the retroactive methods would record compensation expense for all stock options and restricted stock as they vest beginning with the first period restated. We have not yet determined the method of adoption or the effect of adopting SFAS 123R, and have not determined whether the adoption will result in amounts that are similar to the current pro forma disclosures under SFAS 123.
CONCENTRATION OF CREDIT RISK
The Company performs ongoing credit evaluations of its customers and does not generally require collateral. The Company maintains allowances for potential credit losses based upon expected collectibility of all accounts receivable.
FAIR VALUE OF FINANCIAL INSTRUMENTS
The carrying amounts of financial instruments including cash and cash equivalents, accounts receivable, accounts payable and variable rate debt approximates their estimated fair value based either on the short-term maturity of these instruments or on market prices for the same or similar type of financial instruments. The fair market value and carrying value of the Company's interest rate swaps were a net gain of $471 and a net loss of $394 at December 31, 2004 and 2003, respectively. At December 31, 2004, the fair value of amounts payable under a non-compete agreement (twelve quarterly payments totaling $4,000) was estimated to be $3,698 determined by discounting the payments using a 5% discount rate. Also at December 31, 2004, the fair value of a $7,000 note payable on September 14, 2006 and bearing a 5% annual interest rate payable quarterly, was estimated to be $7,000.
INCOME TAXES
The Company provides for income taxes under the provisions of SFAS No. 109, "Accounting for Income Taxes." SFAS No. 109 requires the asset and liability approach in accounting for income taxes. Deferred income tax assets and liabilities are recorded based on the differences between the financial statement and tax base of assets and liabilities using enacted tax rates. Valuation allowances are provided against deferred tax assets, which are not likely to be realized.
PACKAGING DYNAMICS CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
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.
RECLASSIFICATION
Certain prior year amounts have been reclassified to conform to the current year's presentation.
NOTE 3 -- DISCONTINUED OPERATIONS
During the fourth quarter of 2003, the Company shut down its paper mill, located in Detroit, Michigan, and exited its Specialty Paper operation. In accordance with SFAS 144, "Accounting for the Impairment or Disposal of Long-Lived Assets" which establishes accounting and reporting standards for the impairment and disposal of long-lived assets and discontinued operations, the Specialty Paper operation is classified as a discontinued operation. The financial information presented for all prior periods has been reclassified to reflect the Specialty Paper operation as a discontinued operation in the Consolidated Statement of Operations.
Loss from discontinued operations in 2004 was $1,278 compared to a loss of $22,089 in 2003. The net loss for 2004 represents approximately $2,317 ($1,402 after tax) of administrative costs associated with the ongoing program to clear the site, recover assets and dispose of the Detroit property and additional withdrawal liability from a multi-employer pension plan recorded in the fourth quarter of 2004 of $398 ($241 after tax), offset by approximately $602 ($364 after tax) of proceeds from the liquidation of equipment. In the third quarter of 2003, the Company recorded a $22,094 ($13,367 after tax) asset impairment charge and a $2,800 ($1,694 after tax) severance charge based on SFAS No. 112, "Employers' Accounting for Postemployment Benefits." In the fourth quarter of 2003, the Company recorded an additional charge of $1,965 ($1,189 after tax) primarily related to the write-down of parts and supplies inventories, the write-down of other current assets and for employee outplacement services, and a charge of $816 ($495 after tax) for withdrawal liability from a multi-employer pension plan. The remaining loss from discontinued operations during 2003 was the result of operating losses. In 2005 we will have additional costs related to our ongoing program to clear the site, recover assets and dispose of the Detroit property, although the total amount of such costs are not currently estimable. There can be no assurance, however, that items will not require additional expenditures beyond those that are anticipated and that additional expenditures, if any, would not have a material adverse effect on our operating results or financial condition.
PACKAGING DYNAMICS CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The following table details selected income statement information for the Specialty Paper operation. Interest expense was allocated to the Specialty Paper operation based on the ratio of net assets over total debt plus equity.
The assets and liabilities associated with the Specialty Paper operation are included in the Consolidated Balance Sheet. The following table details selected balance sheet information for the Specialty Paper operation.
A summary of the changes in the reserves related to the severance and pension charges recorded in 2004 in connection with the Company's exit from the Specialty Paper operation is as follows:
PACKAGING DYNAMICS CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
NOTE 4 -- ACQUISITION
PAPERCON
On September 14, 2004, the Company completed the acquisition of 100% of the issued and outstanding shares of capital stock of 3141276 Canada Inc. from the sole shareholder (the "Seller") pursuant to an acquisition agreement dated August 6, 2004. 3141276 Canada Inc. is a Canadian corporation and the ultimate parent holding company of Papercon, Inc. (Papercon, Inc. and 3141276 Canada Inc. are collectively referred to as "Papercon"), a Georgia corporation, which conducts all of Papercon's business operations.
Papercon, a manufacturer and marketer of a broad range of paper and foil based specialty packaging products for foodservice, supermarket, quick service restaurant and food processor customers, is headquartered at its Atlanta, Georgia manufacturing facility and also has manufacturing facilities near Dallas, Texas and Los Angeles, California. The acquisition of Papercon significantly broadens the Company's product line, customer base and geographic presence.
Packaging Dynamics acquired Papercon for aggregate consideration of approximately $66,421, net of $22,650 of cash acquired and subject to adjustment, comprised of $44,148 of cash consideration (net of cash acquired), a $7,000 two year note with interest payable quarterly at a 5% annual interest rate, 833,333 shares of Packaging Dynamics common stock valued at $11,575 based upon the price of the Company's stock price near the August 6, 2004 acquisition announcement date, and approximately $3,698 representing the present value of amounts payable pursuant to a ten year non-competition agreement between the Company and Seller. In addition, the Company incurred $1,680 in other direct costs related to the acquisition, primarily accounting and legal expenses incurred in the second half of 2004.
The following table summarizes the allocation of the purchase price.
The Company considered the intangible assets that should be recognized apart from goodwill. The Company performed an internal review and retained the services of an outside appraisal firm to value intangibles. Intangible assets, as reflected above, are comprised of non-contractual customer relationships of $10,500 (20 year weighted average life), trade name of $4,800 (indefinite life), and a non-compete agreement of $3,698 (twelve quarterly payments totaling $4,000 discounted at a 5% annual interest rate). The non-compete agreement is deductible for tax purposes over a 15 year period. The remaining intangible assets and goodwill are not deductible for income tax purposes.
In addition, the purchase price allocation reflected in the table above is also subject to change based on the receipt of additional information with respect to the fair value of certain assets and obligations and the resolution of the net asset purchase price adjustment provision contained in the acquisition agreement. The final valuation of assets and liabilities and the associated purchase price allocation is expected to be completed as soon as possible. The purchase price adjustment process is ongoing and is expected to be resolved in 2005.
PACKAGING DYNAMICS CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The Company's financial statements include the results of operations and cash flows of Papercon from September 14, 2004, the effective date of acquisition. The following table summarizes certain supplemental unaudited pro forma financial information of the Company which was prepared as if the acquisition by the Company had occurred as of the beginning of the periods presented. The unaudited pro-forma financial information was prepared for comparative purposes only and does not purport to be indicative of what would have occurred had the acquisition been made at that time or of results which may occur in the future.
IUKA
On December 4, 2003, the Company acquired the net assets of the Iuka Lamination Division ("Iuka") of Ormet Corporation ("Ormet") for $4,296 comprised of $5,000 in cash paid at closing less $704 received during the second quarter of 2004 pursuant to a settlement agreement with Ormet, as approved by the United States Bankruptcy court presiding over Ormet's bankruptcy case, with respect to the working capital adjustment mechanism contained in the agreement of sale. In addition, the Company incurred $218 in other direct costs related to the acquisition. The acquisition is not considered significant and thus no pro forma financial information has been presented.
The following table summarizes the estimated fair values of the assets acquired and liabilities assumed at the date of acquisition.
WOLF
On October 23, 2002, the Company acquired the outstanding common stock of Wolf Packaging, Inc. ("Wolf") for the issuance of 166,667 shares of the Company's common stock with a fair market value on the
PACKAGING DYNAMICS CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
date of acquisition of $984 and cash of $9,275 (including the repayment of certain indebtedness and payment of costs related to the acquisition). Wolf is a manufacturer of foil and paper sandwich wraps located in Fort Madison, Iowa. Wolf is a significant supplier to the quick-service restaurant industry. The acquisition is not considered significant and thus no pro forma financial information has been presented.
The following table summarizes the estimated fair values of the assets acquired and liabilities assumed at the date of acquisition of Wolf.
The intangible assets are comprised of customer contracts of $380 (1.4 year weighted average life) and non-compete agreements of $100 (9.5 year weighted average life). Goodwill was not deductible for income tax purposes.
NOTE 5 -- GOODWILL AND INTANGIBLE ASSETS
Goodwill and intangible assets at December 31, 2004 consist of the following:
PACKAGING DYNAMICS CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Goodwill and intangible assets at December 31, 2003 consist of the following:
Goodwill for 2004, 2003, and 2002 is as follow:
Amortization expense for intangible assets subject to amortization was $347, $354, and $120 for the year ended December 31, 2004, 2003 and 2002, respectively. Amortization expense for the years 2005, 2006, 2007, 2008 and 2009 is estimated to be $906, $906, $906, $904 and $904, respectively.
NOTE 6 -- LONG-TERM DEBT
Long-term debt at December 31, 2004 and 2003 consists of the following:
SENIOR CREDIT FACILITY
During the third quarter of 2003, PDOC entered into a new credit facility (the "Senior Credit Facility") that provided for a Term A Loan and Term B Loan totaling $70,000 and a $40,000 revolving credit facility, up to $5,000 of which could be in the form of letters of credit.
PACKAGING DYNAMICS CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
During the third quarter of 2004, PDOC amended the Senior Credit Facility to provide for an additional $45,000 of Term B Loans, providing for a total of Term A and Term B Loans of $115,000 and an increase in the revolving credit facility to $50,000, up to $8,000 of which may be in the form of letters of credit. As of December 31, 2004, the Term A Loan had a balance of $24,750 and will mature in 2008. The required aggregate annual payments, payable in quarterly installments, total $5,250 $6,250, $7,250 and $6,000 in years 2005 through 2008, respectively. As of December 31, 2004, the Term B Loan had a balance of $83,829 and will mature in 2009. The aggregate annual payments, payable in equal quarterly installments, total $843 in years 2005 through 2008 and $80,459 in 2009. The revolver had a balance of $900 as of December 31, 2004. The revolving credit facility is due in 2008.
Loans under the Senior Credit Facility are designated from time to time, at our election, either (1) as Eurodollar Rate Loans, which bear interest at a rate based on the London Interbank Offered Rate, or LIBOR, adjusted for regulatory reserve requirements, or (2) as Base Rate Loans, which bear interest at a rate based on the Federal Funds rate or the prime rate. The interest rate on Eurodollar Rate Loans is equal to LIBOR plus an applicable percentage that varies with the leverage ratio of the Company and its consolidated subsidiaries. The interest rate on Base Rate Loans is equal to a base rate equal to the greater of (1) the Federal Funds rate plus 1/2 of 1% or (2) the prime rate, plus an applicable percentage that varies with the leverage ratio of the Company and its consolidated subsidiaries.
Accordingly, Term A Loans and revolving loans bear interest at rates of up to 2.0% plus the base rate, in the case of Base Rate Loans, and up to 3.0% plus LIBOR, in the case of Eurodollar Loans. Term B Loans bear interest at rates of 2.0% plus the base rate, in the case of Base Rate Loans, and 3.0% plus LIBOR, in the case of Eurodollar Loans.
At December 31, 2004, the interest rates on borrowings under the Term A Loan and the Term B Loan were 3.0% plus LIBOR (1.98%) and 3.0% plus LIBOR (1.98%), respectively, compared with 3.0% plus LIBOR (1.15%) and 3.5% plus LIBOR (1.15%), respectively, at December 31, 2003. As of December 31, 2004, we had interest rate derivative agreements with a group of banks having notional amounts totaling $75,000 and varying maturity dates through December 31, 2007. The interest rate swap agreements effectively fix our LIBOR rate for $25,000 of our Senior Credit Facility indebtedness at a rates of 2.91%. During 2004, the Company entered into an interest rate collar agreement with a notional amount of $20,000 which became effective on December 31, 2004 and matures on December 31, 2007. This collar will result in our paying market LIBOR rates for $20,000 of our Senior Credit Facility indebtedness from a floor of 3.08% to a cap of 5.00%. Additionally, the Company entered into two interest rate caps of $15,000 each that are effective December 31, 2004 for a cap premium of $376. These caps effectively limit LIBOR rate for $30,000 of our Senior Credit Facility indebtedness at a maximum rate of 4.00%.
Borrowings are collateralized by substantially all of the stock and assets of our operating subsidiaries. The revolving credit facility and Term A Loan will terminate on September 29, 2008 and the Term B Loan will terminate on September 29, 2009.
Under the Senior Credit Facility, as amended, we are required to comply on a quarterly basis with the following four financial covenants:
- under the leverage ratio covenant, as of the last day of each fiscal quarter, the ratio of total funded debt of the Company and its consolidated subsidiaries to consolidated EBITDA of the Company and its consolidated subsidiaries for the 12-month period then ended must not exceed specified levels, decreasing from 4.5 to 1 at December 31, 2004 to 4 to 1;
- under the senior secured leverage ratio covenant, as of the last day of each fiscal quarter, the ratio of total secured funded debt of the Company and its consolidated subsidiaries to consolidated EBITDA of the Company and its consolidated subsidiaries for the 12-month period then ended must not exceed specified levels, decreasing from 3.75 to 1 at December 31, 2004 to 3 to 1;
PACKAGING DYNAMICS CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
- under the fixed charge coverage ratio covenant, as of the last day of each fiscal quarter, for the 12-month period then ended, the ratio of consolidated EBITDA less capital expenditures and cash tax payments of the Company and its consolidated subsidiaries to cash interest expense and scheduled funded debt payments (excluding the $7,000 seller note issued in connection with the Papercon acquisition) of the Company and its consolidated subsidiaries must be equal to or greater than certain specified levels, increasing from 1.1 to 1 at December 31, 2004 to 1.2 to 1; and
- under the net worth covenant, Packaging Dynamics' consolidated net worth as of the last day of each fiscal quarter must be equal to or greater than 80% of the net worth as of September 30, 2003 increased on a cumulative basis by (1) as of the last day of each fiscal quarter, 50% of the consolidated net income of Packaging Dynamics (to the extent positive) for the fiscal quarter then ended, (2) 75% of the net cash proceeds from any equity issuance by Packaging Dynamics or any subsidiary of Packaging Dynamics, and (3) 75% of the amount added to the equity of Packaging Dynamics in accordance with GAAP in connection with the Papercon acquisition.
For purposes of the Senior Credit Facility, as amended, consolidated EBITDA, calculated on a consolidated basis for Packaging Dynamics and its subsidiaries, consists of (1) net income from continuing operations, excluding the effect of any extraordinary or other non-recurring gains or losses or non-cash gains or losses (in each case, other than in connection with the sale and/or closure of the Detroit paper mill), plus (2) an amount which, in the determination of net income, has been deducted for interest expense, taxes, depreciation and amortization, non-cash expenses relating to the granting of options, cash and non-cash charges and/or losses with respect to the sale and/or closure of the Detroit paper mill, and charges related to the Papercon owner bonus program prior to the date of acquisition by the Company, minus (3) cash expenditures related to non-cash charges previously added back to net income in determining EBITDA (other than in connection with the closure of the Detroit paper mill), plus (4) the write-off of capitalized financing costs existing as of the closing of the Senior Credit Facility.
The Senior Credit Facility also contains various negative covenants that, among other things, require Packaging Dynamics and its subsidiaries to limit future borrowings and payments to related parties and restricts Packaging Dynamics' ability and the ability of its subsidiaries to merge or consolidate. In addition, the Senior Credit Facility prohibits changes in the nature of business conducted by the Company and its subsidiaries. The failure to comply with the covenants would result in a default under the Senior Credit Facility and permit the lenders under the Senior Credit Facility to accelerate the maturity of the indebtedness governed by the Senior Credit Facility.
The Senior Credit Facility includes terms that limit changes in our ownership structure. Modifications to the ownership structure outside the limits prescribed by such agreements could place us in default under these debt instruments. The Senior Credit Facility requires Packaging Dynamics Operating Company ("PDOC") to maintain specified financial ratios and levels of tangible net worth. PDOC was in compliance with those covenants as of December 31, 2004, the latest measurement date. The occurrence of any default of these covenants could result in acceleration of our obligations under the Senior Credit Facility ($109,479 as of December 31, 2004) and foreclosure on the collateral securing those obligations.
The Senior Credit Facility limits and restricts the payment of dividends and distribution or transfer of assets by PDC and its subsidiaries. Dividends to shareholders may not exceed $4 million in any twelve month period. Additionally, any redemption or repurchase of capital stock of the Company other than as defined in the Senior Credit Facility is not permitted. As a result, substantially all of PDOC's net assets are restricted.
SELLER NOTE PAYABLE
On September 14, 2004, the Company issued a $7,000 note to the seller in connection with the acquisition of Papercon. The note matures on September 14, 2006 and bears an annual interest rate of 5%
PACKAGING DYNAMICS CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
payable quarterly. This note is unsecured and subordinated to the Senior Credit Facility. See Note 8 to the Company's annual consolidated financial statements for further information.
BAXTER SPRINGS FACILITY LOANS
At December 31, 2003 the Company had outstanding obligations under debt agreements with the U.S. Department of Housing and Urban Development, or HUD, in the form of promissory notes payable to the City of Baxter Springs. This loan was refinanced in the third quarter of 2003. The remaining unpaid principal of $700, bearing interest at 1.21%, was paid off in full on the maturity date in the third quarter of 2004.
MATURITIES
Maturities of long-term debt greater than one year outstanding at December 31, 2004 were:
NOTE 7 -- OPERATING SEGMENT INFORMATION
Our continuing operations operate within, and sell to customers throughout, the U.S., Canada and Europe in two operating segments -- Food Packaging and Specialty Laminations. The Food Packaging segment converts paper, film and foil into a variety of specialty value-added food packaging products. The Specialty Laminations segment produces multi-layer laminated structures from a variety of substrates (foil, paper, paperboard and film), adhesives and coatings for use in various food, consumer, medical and industrial packaging applications as well as the production of insulation for the building materials market. Corporate administrative expenses are allocated to the segments on a direct basis where appropriate with the remainder being allocated based on revenues. During 2004, approximately 90.0% of the Company's sales were to United States customers, with substantially all of the remaining 10% to customers in Europe.
PACKAGING DYNAMICS CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The reconciliation of Segment Operating Income to the Company's consolidated financial statements is as follows:
PACKAGING DYNAMICS CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
NOTE 8 -- RELATED PARTY TRANSACTIONS
As further discussed in Note 4 -- Acquisitions, pursuant to an acquisition agreement (the "Acquisition Agreement") dated August 6, 2004, Packaging Dynamics acquired 100% of the issued and outstanding shares of capital stock of 3141276 Canada Inc., the parent holding company of Papercon, Inc. ("Papercon"), from its sole shareholder (the "Seller"). The acquisition closed on September 14, 2004. Prior to the Papercon acquisition, the Seller was not affiliated with the Company. Effective with the closing, the Seller became an officer of the Company. In connection with the Papercon acquisition, the Company entered into the Acquisition Agreement and several related agreements with the Seller. Certain of these agreements obligate the Company to make payments to, or take other action for the benefit, of the Seller as discussed below.
Pursuant to the Acquisition Agreement, Packaging Dynamics acquired Papercon for aggregate consideration of approximately $66,421, net of $22,650 of cash acquired. The purchase price is subject to adjustment to the extent that the net assets of Papercon (as defined in the Acquisition Agreement) are less than $33,500.
The Company issued a $7,000 two year Seller Note to the Seller which is due and payable on September 14, 2006. The principal amount payable under the Seller Note will accrue interest at a rate of 5% per year, which will be due and payable in cash on a quarterly basis. The Company has the right to set-off against its payment obligations under the Seller Note for the full amount of any indemnification obligations required to be paid by the Seller under the Acquisition Agreement. Events of default under the Seller Note would include the Company's failure to make any payment that is not subject to a claim for set-off, a material breach of any of the Company's representations and warranties under the Seller Note that are not cured within 30 days of notice of such breach and the bankruptcy or general insolvency of the Company. In addition, a default by the Company under the Non-Competition Agreement would constitute a cross-default under the Seller Note. In the event of a default and upon written notice of the Seller (except in the case of default due to the bankruptcy or general insolvency of the Company, in which case written notice is not required), the balance of consideration due under the Seller Note would become immediately due and payable and would also accrue interest at a rate of 12% per year until such time as the event of default is cured by the Company (or waived by the Seller) or all amounts due are paid in full.
In connection with the Seller Note, the Seller entered into an intercreditor agreement with Bank of America, the administrative agent for the Company's credit facility, pursuant to which payments under the Seller Note are subordinated to payments under the Company's senior credit facility, as amended.
The Company entered into a Non-Competition Agreement with the Seller which provides, among other things, that for a period of ten years following the closing of the Acquisition, the Seller may not own, operate, manage, control, engage in, invest in or participate in any manner in, act as a consultant or advisor to, or render services for any other person or entity in any similar or competitive business as Packaging Dynamics and its subsidiaries (including Papercon) anywhere in the United States and Canada. Also, during this period, the Seller may not without the prior written consent of the Company, solicit or advise any customer or vendor of the Company to patronize a competitive business or curtail or withdraw their business with the Company or solicit for employment any person employed by the Company. The Company is required to make twelve (12) equal quarterly payments of $333 to the Seller under the Non-Competition Agreement commencing in December 2004. The Company has the right to set-off against its payment obligations under the Non-Competition Agreement the full amount of any indemnification obligations required to be paid by the Seller under the Acquisition Agreement. A failure by the Company to make any payment under the Non-Competition Agreement that is not subject to a claim for set-off, so long as the Seller has not breached the Non-Competition Agreement, would constitute an event of default. Additionally, the failure to pay any amount of principal or interest due under the Seller Note would constitute a cross-default under the Non-Competition Agreement. In the event of a default and upon written notice of the Seller, the balance of consideration due under the Non-Competition Agreement would become immediately due and payable and
PACKAGING DYNAMICS CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
would also accrue interest at a rate of 12% per year until such time as the event of default is cured by the Company (or waived by the Seller) or all amounts due are paid in full.
The Company and the Seller entered into a registration rights agreement, dated September 14, 2004 (the "Papercon Seller Registration Rights Agreement"), between the Company, the Seller and Packaging Investors, L.P. ("Packaging Investors"). The Company also amended its existing registration rights agreement (the "Initial Registration Rights Agreement") with, among others, Packaging Investors. Pursuant to the Papercon Seller Registration Rights Agreement, the Seller has the right, under certain circumstances, to require the Company to register his shares of Seller Common Stock for sale in the public markets. The Seller also has piggyback registration rights to include his shares in any registration statement which the Company files on its own behalf (other than for employee benefit plans and business acquisitions or corporate restructurings) or on behalf of other stockholders. The Company amended the Initial Registration Rights Agreement to provide for the piggyback registration rights granted to the Seller under the Papercon Seller Registration Rights Agreement. In addition, under the Papercon Seller Registration Rights Agreement, until the date on which the Seller ceases to own at least 5% of the outstanding shares of Seller Common Stock, at each annual meeting of stockholders, the Company has agreed to nominate or cause to be nominated the Seller for election to the board of directors of the Company. The Seller and Packaging Investors have agreed that until the date (a) on which Packaging Investors ceases to own at least 20% of the outstanding shares of Seller Common Stock, the Seller will vote any shares of Seller Common Stock then owned by him to nominate and elect the individual designated by Packaging Investors for election to the board of directors of the Company and (b) on which the Seller ceases to own at least 5% of the outstanding shares of Seller Common Stock, Packaging Investors will vote any shares of Seller Common Stock then owned by it to nominate and elect the Seller for election to the board of directors of the Company.
In connection with the Papercon acquisition, Papercon entered into a new lease (the "Lease") with respect to its Atlanta headquarters and facilities, effective as of September 14, 2004, with GHGA Properties, L.P. (the "Landlord"), a limited partnership wholly-owned and controlled by the Seller. The initial term of the Lease is five years and has options to renew for three additional five-year terms. The monthly rent for the initial and first renewal terms has been fixed at $49 and $52, respectively, with the subsequent renewal terms to be set at the market rate as agreed upon by the parties. The payment and performance of the obligations arising under the Lease are guaranteed pursuant to a separate guaranty by the Company in favor of Landlord. This arrangement was amended during the fourth quarter of 2004 and is reflected in the accompanying financial statements as an operating lease.
During 2004, the Company purchased paper from Valentine Paper, Inc. ("Valentine") in the normal course of its business. These purchases totaled approximately $3 million, or approximately 9% of Valentine's 2004 gross revenue. Certain of the Company's directors (Messrs. Bayly, Scotto and Tannura) and executive officers (Messrs. Gentili, Lawrence and Wartner) own in the aggregate approximately 20% of Valentine's outstanding ownership interests. Mr. Scotto and Mr. Tannura serve as Valentine's board of directors and Mr. Tannura serves as an officer of Valentine.
Pursuant to a consulting agreement, the Company paid Ivex an annual consulting fee for management and administrative services rendered to the Company by Ivex including financial, tax, accounting and legal services. During 2002 the Company recorded consulting fee expense of $250 related to this agreement. On July 1, 2002, the consulting agreement was canceled.
PACKAGING DYNAMICS CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
NOTE 9 -- INCOME TAXES
Packaging Dynamics' corporate structure is a C-corporation and, as such, the federal and state taxable income of the Company and its subsidiaries is recorded on the consolidated income tax returns of Packaging Dynamics. Prior to the distribution, the members of Packaging Holdings reported federal and state taxable income on their income tax returns. ICI had remained a taxable C-corporation from the time the Company acquired it in July 1999 through the date of the distribution.
The Company recognizes deferred tax assets and liabilities based on the differences between the financial statement and tax bases of assets and liabilities. In connection with the merger and distribution, Packaging Dynamics recorded deferred tax assets and liabilities associated with the differences between the financial statement and tax bases of its consolidated assets and liabilities. The increase in deferred tax liabilities in 2002 related to the change in tax status was approximately $9,200.
The components of the income tax provision on income from continuing operations shown in the consolidated statements of operations were as follows:
The provision recognized for income taxes relating to continuing operations differs from the amount determined by applying the U.S. federal income tax rate of 35% due to the following:
PACKAGING DYNAMICS CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Deferred tax liabilities (assets) were comprised of the following:
Realization of deferred income tax assets is dependent upon generating sufficient future taxable income in the periods in which the assets reverse or the benefits expire. The Company has $1,213 in net operating loss carryforwards that expire in 2023 and an AMT carryforward of $146. In the event of a change in ownership of the Company, these net operating loss carryovers may be limited. The Company has considered the weight of available evidence and concluded more likely than not that it will realize its recorded deferred tax assets and consequently no valuation allowance has been established.
On October 22, 2004 the President signed the American Jobs Creation Act of 2004 (the "Act"). The Act provides for a deduction for income from qualified domestic production activities, which will be phased in from 2005 through 2010. This provision also is subject to a number of limitations which effect the effective tax rate in 2005 and later. The Company has not yet determined the extent to which its effective rate will change.
NOTE 10 -- EMPLOYEE BENEFIT PLANS
The Company sponsors two 401(k) plans. All employees over twenty-one years of age are covered by one of these plans. Eligibility varies from three to six months following the date of hire. Matching contributions vary from 4% to 5% depending on the plan. The vesting period ranges from three years to five years. Company contributions were approximately $933, $823, and $784 for the years ended December 31, 2004, 2003 and 2002, respectively.
The Company sponsors a nonqualified deferred compensation plan into which eligible employees may elect to contribute a portion of their compensation. The Company may, but is not obligated to, make matching or incentive contributions to the plan. The plan was adopted on January 1, 2003 and Company contributions to the plan during 2004 and 2003 were $32 and $13, respectively.
2001 Long-Term Incentive Compensation Plan -- PHLLC had an unfunded 2001 Long-Term Incentive Compensation Plan (the "2001 LTIP") for certain key executives prior to the distribution. Under the terms of this plan, 3,000,000 incentive units, subject to adjustment, and representing 8.2% of the fully diluted outstanding limited liability shares, had been granted. The plan was designed to reward those individuals on
PACKAGING DYNAMICS CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
the increased equity value of PHLLC, and provided that 40% of the incentive units were earned on the effective date and the remaining 60% could have been earned based upon PHLLC's attainment of certain annual earnings targets. Participants in the plan vested on a pro-rata basis over three years from the plan's origination date. In the event PHLLC completed a transaction which caused a substantial change in ownership control, the plan provided for an accelerated vesting schedule. The plan was terminated during 2002.
2002 Long-Term Incentive Stock Plan -- On July 1, 2002, Packaging Dynamics granted to management, for incentive purposes and in consideration of their waiver of cash payments under the 2001 LTIP, stock options for the purchase of an aggregate of 814,787 shares of its common stock under the 2002 Long Term Incentive Stock Plan. Additionally, on July 1, 2002, Packaging Dynamics granted to certain former employees stock options for the purchase of an aggregate of 29,047 shares of its common stock under individual nonqualified stock option agreements in consideration of their waiver of cash payments under the 2001 LTIP. The options have an exercise price of $3.90 per share, which was below the fair market value of Packaging Dynamics' common stock on the grant date and 730,622 options, although fully vested, are not exercisable for three years after the grant date. Consequently, for such options the Company has the right to repurchase an executive's options if he terminates employment before the end of the three-year period. The Company recorded a non-cash compensation charge of $2,667 during the year ended December 31, 2002 related to these management incentive plans.
During 2002, 43,397 options were repurchased from former employees for approximately $124. These payments reduced the $2,667 incentive liability recorded in 2002. No options were repurchased in 2003 and 2004. Additional information relating to the plans was as follows:
Options exercisable under the 2002 Long Term Incentive Stock Plan were 93,342, 0 and 62,739 at December 31, 2004, 2003 and 2002, respectively.
PACKAGING DYNAMICS CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The following table summarizes information about stock options outstanding at December 31, 2004:
As of December 31, 2004, 2003 and 2002, there were 31,199, 357,867 and 599,563 shares available for grant, respectively. The weighted average fair value at date of grant for options whose exercise price was less than the market price of the stock on the date of grant during 2003 and 2002 was $2.08 and $4.25, respectively. There were no options granted in 2004 for which the exercise price is less than the market price on the date of grant during 2004. The weighted average fair value at date of grant for options whose exercise price was equal to the market price of the stock on the grant date during 2004 and 2003 was $3.60 and $2.93, respectively. There were no options granted in 2002 for which the exercise price was equal to the market price on the date of grant. There were no options granted in 2004, 2003 or 2002 for which the exercise price was greater than the market price on the date of grant. No options were granted prior to July 1, 2002.
NOTE 11 -- COMMITMENTS AND CONTINGENCIES
LEGAL PROCEEDINGS
The Company is currently a party to various legal proceedings in various federal and state jurisdictions arising out of the operations of our business. The amount of alleged liability, if any, from these proceedings cannot be determined with certainty; however, we believe that our ultimate liability, if any, arising from the pending legal proceedings, as well as from asserted legal claims and known potential legal claims which are probable of assertion, taking into account established accruals for estimated liabilities, should not be material to our financial condition or results of operations.
LEASE COMMITMENTS
The Company occupies certain facilities under lease arrangements and leases certain machinery, automobiles, and equipment. Rental expense amounted to $1,707, $1,704 and $1,531 for the year ended December 31, 2004, 2003 and 2002, respectively.
PACKAGING DYNAMICS CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Future minimum rental commitments, including capital lease obligations, with noncancelable terms in excess of one year are as follows:
Accumulated amortization on capital leases as of December 31, 2004, 2003 and 2002 was $94, $19 and $0, respectively.
ENVIRONMENTAL MATTERS AND GOVERNMENT REGULATION
Since many of our packaging products are used in the food industry, we are subject to the manufacturing standards of the U.S. Food and Drug Administration. Historically, compliance with the standards of the food industry has not had a material effect on our earnings, capital expenditures or competitive position. There can be no assurance, however, that compliance with those standards will not have a material adverse effect on our future operating results or financial condition.
Our manufacturing operations are subject to federal, state and local regulations governing the environment and the discharge of materials into air, land and water, as well as the handling and disposal of solid and hazardous wastes. As is the case with manufacturers in general, if a release of hazardous substances occurs on or from our properties or any associated offsite disposal location, or if contamination from prior activities is discovered at any of our properties, we may be held liable. From time to time, we are involved in regulatory proceedings and inquiries relating to compliance with environmental laws, permits and other environmental matters. We believe that we are in material compliance with applicable environmental regulations and do not believe that costs of compliance, if any, will have a material adverse effect on our financial condition, results of operation, or liquidity. In 2005, we will have additional costs related to our ongoing program to clear the site, recover assets and dispose of the Detroit property, although the total amount of such costs are not currently estimable. There can be no assurance, however, that items will not require additional expenditures beyond those that are anticipated and that additional expenditures, if any, would not have a material adverse effect on our operating results or financial condition.
NOTE 12 -- ASSET SALES AND DISPOSALS
During 2004, we sold property within our Specialty Laminations operating segment which resulted in a gain of $55. During 2003 and 2002, the Company idled certain converting equipment in its Chicago, Illinois and Baxter Springs, Kansas manufacturing facilities due to the purchase of five new bag machines in 2003. These manufacturing improvements and certain other productivity improvements resulted in a loss in 2003 and 2002 of $813 and $1,510, respectively, on the sale or disposal of the equipment.
NOTE 13 -- RESTRUCTURING CHARGE
In January 2000, the Company commenced a restructuring plan, which resulted in a reduction in work force of 32 people. The restructuring charge included severance and other benefits related to this reduction in
PACKAGING DYNAMICS CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
force of $1,250. At December 31, 2004, 2003 and 2002, there was $0, $18 and $54, respectively, of severance and other benefits costs remaining to be paid in future periods.
The restructuring reserve activity was as follows:
NOTE 14 -- UNAUDITED QUARTERLY RESULTS
Summarized unaudited quarterly data for the years ended December 31, 2004 and 2003 were as follows:
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES
None.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES.
The Company's management, with the participation of the Company's Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company's disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the "Exchange Act")) as of the end of the period covered by this report. Based on such evaluation, the Company's Chief Executive Officer and Chief Financial Officer have concluded that the Company's disclosure controls and procedures were not effective as of December 31, 2004 due to the restatement of prior period information contained in Item 15(a)(2) Schedule I -- Condensed Financial Information as discussed below. Subsequent to December 31, 2004, the Company performed additional analysis and other post-closing procedures to ensure our consolidated financial statements were prepared in accordance with generally accepted accounting principles. Accordingly, management believes that the financial statements included in this report fairly present in all material respects our financial condition, results of operations and cash flows for the periods presented.
Subsequent to December 31, 2004, the Company determined that a restatement of the prior period (2002 and 2003) parent company only financial information contained in Item 15(a)(2) Schedule I -- Condensed Financial Information was necessary. As explained in Schedule I, Note 2 -- Restatement Adjustments, the restatement included adjustments to reflect the appropriate allocation of tax attributes between the parent and its wholly-owned subsidiaries and recording the parent's equity in the underlying net assets of its wholly-owned subsidiaries. The restatement had no impact on the Company's consolidated financial statements included in Item 8. The determination to restate the prior year information was made as a result of disclosure controls and procedures in effect subsequent to December 31, 2004 during the preparation of Schedule I for inclusion in the Company's 2004 annual report on Form 10-K.
In addition to our responsibilities with respect to an evaluation of our disclosure controls and procedures, we, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, are in the process of performing the assessments required by Section 404 of the Sarbanes-Oxley Act of 2002 and the related rules adopted by the SEC (collectively, the "Section 404 requirements"). In the event that we are deemed an Accelerated Filer for 2005, we will be required to include a report on management's assessment of the effectiveness of our internal control over financial reporting in our Annual Report on Form 10-K for the year ending December 31, 2005. Our independent auditor will also be required to attest to and report on management's assessment of the effectiveness of our internal control over financial reporting. We have been and are continuing to devote significant resources to prepare for the Section 404 requirements. There can be no assurances that once completed, management's assessment and the auditor's attestation will not report any material weaknesses in our internal control over financial reporting.
In connection with our response to the rules pertaining to the evaluation of our disclosure controls and procedures, as well as our response to the Section 404 requirements pertaining to the assessment of our internal controls over financial reporting, we are reviewing, documenting and testing our disclosure controls and procedures and our internal controls over financial reporting, and may from time to time make changes aimed at enhancing their effectiveness and to ensure that our systems evolve with our business. For example, we are using internal resources and third party service providers to assist us in evaluating, documenting and testing our key controls over financial reporting in preparation for management's assessment under the Section 404 requirements. These efforts are likely to lead to changes in our internal controls over financial reporting, including enhanced documentation of certain of these internal controls.
CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING.
Except as further described in the following paragraphs, there have not been any changes in the Company's internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the fiscal quarter to which this report relates that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting.
On September 14, 2004, the Company acquired Papercon. The results of Papercon's operations from the date of acquisition have been included in the Company's 2004 financial results. Prior to its acquisition by the Company, Papercon operated as an independent private company, was not subject to public company reporting requirements and had a limited amount of resources available for financial reporting and controls matters. The Company is conducting an ongoing review of Papercon's internal control over financial reporting and intends to make changes, where necessary, to conform Papercon's controls and procedures to the Company's controls and procedures and to ensure that such controls and procedures are effective and integrated appropriately.
During 2004, the Company implemented a new enterprise wide financial accounting software system at each of its facilities except the Papercon facilities acquired in September 2004. In the fourth quarter of 2004, implementation occurred at four facilities. The Company expects to implement the Company's financial and accounting software systems at Papercon during 2005.
ITEM 9B.
ITEM 9B. OTHER INFORMATION
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Information required by Item 10 of this Form 10-K is incorporated herein by reference from the Company's definitive Proxy Statement for the May 11, 2005 Annual meeting of Stockholders under the captions "Code of Business Conduct and Ethics," "Nomination and Election of Directors," "Principal Stockholders" and "Section 16(a) Beneficial Ownership Reporting Compliance;" and in Part I, Item 4, of this Form 10-K under the caption "Executive Officers of the Company."
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
Information required by Item 11 of this Form 10-K is incorporated herein by reference to the Company's definitive Proxy Statement for the May 11, 2005 Annual Meeting of Stockholders under the captions "Executive Compensation" and "Directors' Compensation for 2004."
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
Information required by Item 12 of this Form, is incorporated herein by reference to the Company's definitive Proxy Statement for the May 11, 2005 Annual Meeting of Stockholders under the captions "Principal Stockholders" and "Directors' Compensation for 2004."
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information required by Item 13 of this Form is incorporated by reference to the Company's definitive Proxy Statement for the May 11, 2005 Annual Meeting of Stockholders under the caption "Certain Relationships and Related Transactions."
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
Information required by Item 14 of this Form is incorporated herein by reference to the Company's definitive Proxy Statement for the May 11, 2005 Annual Meeting of Stockholders under the caption "Fees Paid to Independent Auditors."
PART IV
ITEM 15.
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a)(1) Financial Statements
See Item 8 -- Financial Statements and Supplementary Data
(a)(2) Schedules
- Schedule I -- Condensed Financial Information
- Schedule II -- Valuation and Qualifying Accounts and Reserves
All other schedules of Packaging Dynamics for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required, are inapplicable or have been disclosed in the notes to the consolidated financial statements and therefore have been omitted.
(a)(3) Exhibits
- ---------------
* Incorporated by reference to the Registrant's Form 10 filed on April 19, 2002.
** Incorporated by reference to the Registrant's Form 10/A Amendment No. 1 filed on May 21, 2002.
*** Incorporated by reference to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 2002.
**** Filed herewith.
(1) Management contract or compensatory plan or arrangement required to be filed as an Exhibit to this Form 10-K pursuant to Item 15 (c) of this report.
SIGNATURES
PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED ON MARCH 31, 2005.
PACKAGING DYNAMICS CORPORATION
By: /s/ FRANK V. TANNURA ------------------------------------ Name: Frank V. Tannura Title: Chairman and Chief Executive Officer
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 IN THE CAPACITIES INDICATED ON MARCH 31, 2005.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
ON
FINANCIAL STATEMENT SCHEDULES
To the Board of Directors of Packaging Dynamics Corporation:
Our audits of the consolidated financial statements referred to in our report dated March 30, 2005 appearing in the Packaging Dynamics Corporation Annual Report on Form 10-K also included an audit of the financial statement schedules listed in Item 15(a)(2) of this Form 10-K. In our opinion, these financial statement schedules present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements.
As discussed in Note 2 to Schedule I, Packaging Dynamics Corporation has restated its Packaging Dynamics Corporation Condensed Financial Information (Parent Company only) as of December 31, 2003 and for the years ended December 31, 2003 and 2002.
PricewaterhouseCoopers LLP Chicago, Illinois
March 30, 2005
PACKAGING DYNAMICS CORPORATION
SCHEDULE I -- CONDENSED FINANCIAL INFORMATION (PARENT COMPANY ONLY)
BALANCE SHEETS (DOLLARS IN THOUSANDS)
See Notes to Condensed Financial Information.
PACKAGING DYNAMICS CORPORATION
SCHEDULE I -- CONDENSED FINANCIAL INFORMATION (PARENT COMPANY ONLY)
STATEMENTS OF OPERATIONS (DOLLARS IN THOUSANDS)
See Notes to Condensed Financial Information.
PACKAGING DYNAMICS CORPORATION
SCHEDULE I -- CONDENSED FINANCIAL INFORMATION (PARENT COMPANY ONLY)
STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY/MEMBERS' EQUITY AND OTHER COMPREHENSIVE INCOME(LOSS) (DOLLARS IN THOUSANDS)
See Notes to Condensed Financial Information.
PACKAGING DYNAMICS CORPORATION
SCHEDULE I -- CONDENSED FINANCIAL INFORMATION (PARENT COMPANY ONLY)
STATEMENTS OF CASH FLOWS (DOLLARS IN THOUSANDS)
See Notes to Condensed Financial Information.
PACKAGING DYNAMICS CORPORATION
SCHEDULE I -- CONDENSED FINANCIAL INFORMATION (PARENT COMPANY ONLY) NOTES TO CONDENSED FINANCIAL INFORMATION (DOLLARS IN THOUSANDS)
NOTE 1 -- BASIS OF PRESENTATION
The condensed financial statements of Packaging Dynamics Corporation (Parent Company only) (PDC) are presented herein because the restricted net assets of the subsidiaries of PDC exceeded 25% of the consolidated net assets of PDC at December 31, 2004. Packaging Dynamics Operating Company (PDOC) a wholly owned subsidiary of PDC entered into a credit facility (as amended in August 2004) which limits and restricts the payment of dividends and distribution or transfer of assets by PDOC to PDC. See Note 6 to the consolidated financial statements of Packaging Dynamics Corporation for further information.
NOTE 2 -- RESTATEMENT ADJUSTMENTS
The prior period condensed financial information of PDC has been restated to reflect the appropriate allocation of tax attributes between the parent and its wholly-owned subsidiaries and recording the parent company's equity in the underlying net assets of its wholly-owned subsidiaries. The restatement impacted the 2003 and 2002 condensed financial statement as follows:
PACKAGING DYNAMICS CORPORATION
SCHEDULE I -- CONDENSED FINANCIAL INFORMATION -- (CONTINUED) (PARENT COMPANY ONLY) NOTES TO CONDENSED FINANCIAL INFORMATION (DOLLARS IN THOUSANDS)
NOTE 3 -- OTHER INFORMATION
See the notes to the consolidated financial statements of Packaging Dynamics Corporation in Item 8 for further information.
PACKAGING DYNAMICS CORPORATION
SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS AND RESERVES (DOLLARS IN THOUSANDS)
EXHIBIT INDEX
- ---------------
* Incorporated by reference to the Registrant's Form 10 filed on April 19, 2002.
** Incorporated by reference to the Registrant's Form 10/A Amendment No. 1 filed on May 21, 2002.
*** Incorporated by reference to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 2002.
**** Filed herewith.
(1) Management contract or compensatory plan or arrangement required to be filed as an Exhibit to this Form 10-K pursuant to Item 15 (c) of this report.