ITEM 1. Business
GENERAL
Salton, Inc. is a leading designer, marketer and distributor of branded, high quality small appliances, home decor and personal care products. Our product mix includes a broad range of small kitchen and home appliances, electronics for the home, tabletop products, time products, lighting products, picture frames and personal care and wellness products. We sell our products under our portfolio of well recognized brand names such as Salton(R), George Foreman(R), Westinghouse(TM), Toastmaster(R), Melitta(R), Russell Hobbs(R), Farberware(R), Ingraham(R) and Stiffel(R). We believe our strong market position results from our well-known brand names, our high quality and innovative products, our strong relationships with our customer base and our focused outsourcing strategy.
We currently market and sell our products in North America, South Africa, Europe, Asia, Australia, New Zealand, South America and the Middle East through an internal sales force and a network of independent commissioned sales representatives. We predominantly sell our products to mass merchandisers, department stores, specialty stores and mail order catalogs. Our customers include many premier retailers, such as JD Group (customer of AMAP), Target Corporation, Wal-Mart, Argos Limited, Sears, Masstores (customer of AMAP), J.C. Penney Company, Bed, Bath & Beyond, May Company Department Stores, Dixon Stores Group Limited and Kohl's Department Stores. We also sell certain of our products directly to consumers through paid half-hour television programs referred to as infomercials, our Internet websites and our retail outlets.
We outsource most of our production to independent manufacturers, located primarily in the Far East. The Company has substantial experience with and expertise in managing production relationships with third-party suppliers. We work with our suppliers to provide the lowest possible cost for our customers while maintaining reasonable gross margins for us.
Salton was incorporated in Delaware in October 1991. Our common stock traded on the NASDAQ National market under the symbol "SALT" until February 1999. The Company moved to the New York Stock Exchange at that time and our common stock has traded under the symbol "SFP" since. Our principal corporate offices are located at 1955 Field Court, Lake Forest, Illinois 60045.
Our fiscal year ends on the Saturday closest to June 30. Unless otherwise stated, references to years in this report relate to fiscal years rather than calendar years. The effect of the additional week in 2004 had an insignificant impact on results.
RECENT DEVELOPMENTS
DEBT EXCHANGE OFFER -- On August 26, 2005, we completed a private debt exchange offer for our outstanding 10 3/4% senior subordinated notes due 2005 ("2005 Notes") and our outstanding 12 1/4% senior subordinated notes due 2008 ("2008 Notes," and together with the 2005 Notes, the "Subordinated Notes"). We accepted for exchange an aggregate of approximately $75.0 million in principal amount of 2005 Notes (approximately 60.0% of the then outstanding 2005 Notes) and approximately $90.1 million in principal amount of 2008 Notes (approximately 60.1% of the outstanding 2008 Notes) that were validly tendered in the debt exchange offer.
Upon closing of the debt exchange offer, we issued an aggregate of approximately $99.1 million of senior second lien notes (the "Second Lien Notes"), 2,039,469 shares of our common stock, and 135,088 shares of our Series C preferred stock with a total liquidation preference of $13.5 million. The Second Lien Notes mature on March 31, 2008 and bear interest at LIBOR plus 7%, payable in cash on January 15th and July 15th of each year, with the first payment due on January 15, 2006. The Series C
preferred stock is generally non-dividend bearing and is mandatorily redeemable by us in cash at the liquidation amount on August 26, 2010. We also granted certain registration rights for approximately 1,837,455 shares of our common stock and 121,707 shares of our Series C preferred stock received by certain former holders of Subordinated Notes.
In connection with the debt exchange offer, we obtained the consent of the holders of a majority of the outstanding 2005 Notes and a majority of the outstanding 2008 Notes to amend the indentures governing such Subordinated Notes to eliminate substantially all of the restrictive covenants and certain events of default contained in such indentures. We have entered into supplements to the indentures governing the 2005 Notes and the 2008 Notes to reflect such amendments.
In the first quarter of fiscal 2006, we will record cancellation of indebtedness, or "COD," income of approximately $23.0 million, net of approximately $8.0 million of expenses and before income tax, as a result of the debt exchange offer.
SALE OF AMAP AND TABLETOP -- On September 29, 2005, we completed the sale of our 52.6% ownership interest in AMAP, a leading distributor and marketer of small appliances and other products in South Africa, to a group of investors led by Interactive Capital (Proprietary) Limited. In the first quarter of fiscal 2006, we received proceeds, net of expenses, of approximately $80.0 million in connection with the transaction. In the first quarter of fiscal 2006, we expect to record a gain of approximately $49.0 million before taxes. We expect to license and sell our George Foreman(R), Russell Hobbs(R) and Carmen(R) branded products in South Africa following the transaction.
On September 16, 2005, we completed the sale of certain tabletop assets to Lifetime Brands, Inc. for $14.2 million, which approximates book value, and is subject to post-closing adjustments. In connection with this transaction, we divested our Block(R) and Sasaki(R) brands, licenses to Calvin Klein(R) and Napa Style(TM) tabletop products and distribution of upscale crystal products under the Atlantis(R) brand. In addition, we entered into a new license with Lifetime Brands enabling it to market tabletop products under the Stiffel(R) brand.
Prior to May 15, 2003, our investment in AMAP was accounted for under the equity method. Since May 16, 2003, the date we increased our ownership interest from 30.8% to 52.6%, AMAP's financial results have been consolidated in accordance with accounting principles generally accepted in the United States of America ("GAAP") for financial statement presentation. Because management did not have a committed or approved plan to sell either our ownership interest in AMAP or the assets of the Tabletop business as of July 2, 2005, the operating results of these businesses have been included in our consolidated financial statements for 2005.
PRIVATE EXCHANGE -- On September 28, 2005, we completed a private exchange transaction with FMA CBO Funding III, LTD in which we issued $4.1 million of Second Lien Notes in exchange for $4.0 million of 2005 Notes.
OTHER STRATEGIC INITIATIVES -- As previously disclosed in an 8-K filed on August 30, 2005, we continue to explore strategic options to satisfy our liquidity needs and improve our overall balance sheet position, including the payment of the approximately $46.0 million in aggregate principal amount of 2005 Notes that remain outstanding after the debt exchange offer and subsequent private exchange, and enhance our operating performance. These strategic options include potential sales of other assets or businesses, the creation of new foreign debt, repurchase of outstanding Subordinated Notes in the open market and/or through privately negotiated transactions for cash or other securities (including Second Lien Notes, common stock and/or Series C preferred stock) and further reductions in expenses.
BUSINESS SEGMENT AND PRODUCT INFORMATION
Salton consists of a single operating segment which designs, sources, markets and distributes a diversified product mix for use in the home. Our product mix consists of small kitchen and home appliances, electronics for the home, tabletop products, time products, lighting products, picture frames and personal care and wellness products. We believe this segmentation is appropriate based upon Manage-
ment's operating decisions and performance assessment. Nearly all of our products are consumer goods within the housewares market, procured through independent manufacturers, primarily in the Far East. Our products are distributed through similar distribution channels and customer base using the marketing efforts of our Global Marketing Team.
BRAND PORTFOLIO
Our brand portfolio contains many time-honored traditions as well as recently established names within the international housewares industry. We believe this brand portfolio contains many brands with strong consumer recognition throughout the world. While many of our brands are owned, we continue to enhance our portfolio through licensing agreements and strategic alliances. Our brands include:
We develop and introduce a wide selection of new products and enhance existing products to satisfy the various tastes, preferences and budgets of consumers and to service the needs of a broad range of customers. Our product divisions include Small Appliances and Electronics for the home, Home Decor, and Personal Care and Wellness.
The following table sets forth the approximate amounts of our net sales by product division during the periods shown.
(1) Includes the results of AMAP since May 16, 2003.
SMALL APPLIANCES AND ELECTRONICS FOR THE HOME
We design, market and distribute an extensive line of small appliances and electronics for the home. These products consist of heating appliances, motor driven appliances, beverage makers, cookware and floor care. In addition, this division includes products offered by AMAP. These products consist primarily of electronic devices such as televisions, music and video equipment.
Within our small appliance and electronics division, Salton is known for the George Foreman branded product line which started as a single grill in 1995. Since 1995, Salton has sold over 70 million units of the George Foreman line worldwide. We have established the George Foreman name as a significant product brand, representing approximately 28.6%, 32.0%, and 44.0%, of our sales, in the fiscal year ended July 2, 2005, July 3, 2004, and June 28, 2003, respectively. In the first quarter of fiscal 2005, Salton launched the first series of the new George Foreman Grills with removable plates (The Next Grilleration). The new George Foreman "G5" Next Grilleration is expected to be on retailer's shelves in the second quarter of fiscal 2006. The "G5" features five interchangeable, dishwasher safe plates which can be used as a grill or griddle and for baking as well as making waffles.
HOME DECOR
This broad range of products consist of tabletop products, picture frames, time and lighting products marketed by our Salton At Home Division. Our time products include a variety of clocks and timers under well recognized brand names such as Ingraham, Westclox and Timex. Salton also markets lighting products under the Stiffel. On September 16, 2005, we completed the sale of certain tabletop assets to Lifetime Brands, Inc. for $14.2 million, which approximates book value, and is subject to post-closing adjustments. In connection with this transaction, we divested our Block(R) and Sasaki(R) brands, licenses to Calvin Klein(R) and Napa Style(TM) tabletop products and distribution of upscale crystal products under the Atlantis(R) brand. In addition, we entered into a new license with Lifetime Brands enabling it to market tabletop products under the Stiffel(R) brand.
PERSONAL CARE AND WELLNESS
Salton offers a broad range of personal care and wellness products. These products include health and fitness equipment, massagers, hair care, beauty, oral health care and relaxation items.
NEW PRODUCT DEVELOPMENT
We believe that the enhancement and extension of our existing products and the development of new products are necessary for our continued success and growth. We design style, features and functionality of our products to meet customer requirements for quality, performance, product mix and pricing. We work closely with both retail customers and suppliers to identify consumer needs and preferences and to generate new product ideas. We evaluate new ideas and seek to develop and acquire new products and improve existing products to satisfy industry requirements and changing consumer preferences.
STRATEGIC ALLIANCES
We continue to pursue strategic alliances which enable us to (a) further expand the scope of our product offerings and (b) benefit from the manufacturing expertise and/or strong brand names of our strategic partners. During fiscal 2005, we continued in several joint product development relationships with third parties to develop, market and distribute new products.
These joint product relationships include the arrangement with Melitta North America, Inc., to develop and market the Melitta One:One Coffeemaker, which uses Melitta coffee pods to make an individual mug of fresh coffee in less than 60 seconds.
We also have a joint product relationship with the Columbian Coffee Federation, the non-profit organization behind the Juan Valdez brand, and Italian manufacturer Rossi Corporation SRL to market and distribute a coffee brewing system utilizing single-serve pods of Columbian specialty coffee in the United States and major global markets.
The foregoing strategic alliances provide the opportunity for recurring revenues through the sale of coffee and tea pods. There are arrangements for sharing the profits derived from each of these strategic alliances once all expenses incurred by Salton and/or the other members of the alliance, are reimbursed from cash flow generated by such alliances. Each of these strategic alliances generally provides for certain license fees and royalties to our strategic partners and contain minimum sales requirements and other obligations that, if not satisfied, may result in termination of the strategic alliance.
CUSTOMERS AND DISTRIBUTION CHANNELS
We currently market and sell our products in North America, South Africa, Europe, Asia, Australia, New Zealand, South America and the Middle East through an internal sales force, a network of commissioned sales representatives and distributions to mass merchandisers, department stores, specialty stores and mail order catalogs. We also sell products directly to consumers through infomercials, Internet websites and our own retail outlets.
We provide promotional support for our products with the aid of television, radio and print advertising, cooperative advertising with retailers and in-store displays and product demonstrations. We believe that these promotional activities are important to strengthening our brand name recognition.
Our total net sales to our five largest customers during fiscal 2005 were 36.5% of net sales, with JD Group (customer of AMAP) representing 12.2% of our net sales, Target Corporation representing 9.2% of our net sales and Wal-Mart representing 6.2% of our net sales. Our total net sales to our five largest customers during fiscal 2004 were 36.1% of net sales, with JD Group (customer of AMAP) representing 10.4% of our net sales, Target Corporation representing 9.1% of our net sales and Wal-Mart representing 8.1% of our net sales. In fiscal 2003, our total net sales to our five largest customers were 39.3% of net sales, with Wal-Mart representing 12.5% of our net sales and Target Corporation representing 11.9% of our net sales.
During fiscal 2005, 2004, and 2003, sales recorded outside of North America accounted for 58.5%, 50.6%, and 30.7% of total net sales, respectively. These figures include shipments directly imported to customers in North America. See Note 15 of the Notes to Consolidated Financial Statements for information regarding revenues of the Company's geographic areas for each of the three fiscal years ended July 2, 2005, July 3, 2004, and June 28, 2003.
SOURCES OF SUPPLY
Most of our products are manufactured to our specifications by manufactures located primarily in the Far East. We believe that we maintain good business relationships with our overseas manufacturers.
We do not maintain long-term purchase contracts with manufacturers and operate principally on a purchase order basis. We believe we are not currently dependent on any single manufacturer. However, one supplier located in China accounted for 23.3% of our product purchases during 2005, 23.7% of our product purchases during 2004, and 33.2% of purchases in 2003. We believe that the loss of any one supplier would not have a long term material adverse effect on our business because other suppliers with which we do business would be able to increase production to fulfill our requirements. However, the loss of a supplier could, in the short term, adversely affect our business until alternative supply arrangements are secured.
BACKLOG
Although we obtain firm purchase orders from our customers, customers typically do not make firm orders for delivery of products more than 30 to 90 days in advance. In addition, customers may reschedule or cancel firm orders. Therefore, we do not believe that the backlog of expected product sales covered by firm purchase orders is a meaningful measure of future sales.
COMPETITION
We compete in the global housewares market. While the Domestic and Western European markets are strongly developed, the remainder of the global market is less developed and offers, we believe, significant opportunities for business expansion. We compete with established companies, some of which have substantially greater facilities, personnel, financial and other resources than we have. Competition is based upon price, access to retail shelf space, product features and enhancements, brand names, new product introductions and marketing.
The retail industry continues to consolidate leaving fewer retail outlets and increased competition for shelf space. We expect retailers will continue to consolidate their vendor base by dealing primarily with a smaller number of suppliers that can offer a diversified product mix, meet logistical and volume requirements and offer comprehensive levels of customer service and marketing support. We believe our competitive pricing, high level of customer service, strategic acquisitions and alliances, as well as our portfolio of well recognized brand names, new technology and innovative products, position us to compete and benefit from this environment.
SEASONALITY
Due to holiday buying patterns, sales are traditionally higher in the second fiscal quarter than in the other quarterly periods and the Company typically earns a disproportionate share of operating income in this quarter.
TRADEMARKS, PATENTS AND LICENSING ARRANGEMENTS
We hold numerous patents and trademarks registered in the United States and foreign countries for various products and processes. We have registered certain of our trademarks with the United States Patent and Trademark Office and we consider these trademarks to be of considerable value and of material importance to our business. The Company's right to use these trademarks continues as long as it uses these names.
Salton maintains many licensing and contractual relationships to market and distribute products under specific names and designs. These licensing arrangements generally require certain license fees and royalties. Some of our agreements contain minimum sales requirements that, if not satisfied, may result in the termination of the agreements. Some of our agreements contain minimum royalty payments, which are reflected in the Commitments and Contingencies table in Management's Discussion and Analysis of Financial Conditions and Results of Operations.
REGULATION
We are subject to federal, state and local regulations concerning consumer products safety. Foreign jurisdictions also have regulatory authorities overseeing the safety of consumer products. In general, we have not experienced difficulty complying with such regulations and compliance, with them, has not had an adverse effect on our business. Our small electric appliance products sold in the United States are listed by Underwriters Laboratory, Inc. (UL) or ETL; and similar products sold in other countries are listed with local organizations similar to UL if required.
PRODUCT WARRANTIES
Our products are generally sold with a limited one-to-three year warranty from the date of purchase. In the case of defects in material workmanship, we agree to replace or repair the defective product without charge while under the warranty time frame.
EMPLOYEES
As of August 1, 2005, we employed approximately 2,466 persons, including approximately 1,325 persons employed in South Africa by Amalgamated Appliance Holdings Limited.
ADDITIONAL INFORMATION
We file annual, quarterly and periodic reports, proxy statements and other information with the SEC. You may obtain and copy any document we file with the SEC at the SEC's public reference room at 450 Fifth Street, NW., Washington, D.C. 20549. You may obtain information on the operation of the SEC's public reference facilities by calling the SEC at 1-800-SEC-0330. You can request copies of these documents, upon payment of a duplicating fee, by writing to the SEC at its principal office at 450 Fifth Street, N.W., Washington, D.C. 20549-1004. The SEC maintains an Internet website at http://www.sec.gov that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC. Our SEC filings are accessible through the Internet at that website.
Our reports on Forms 10-K, 10-Q and 8-K, and amendments to those reports, are available for download, free of charge, as soon as reasonably practicable after these reports are filed with the SEC, at our website at http://www.saltoninc.com. The content of our website is not a part of this report. You may
request a copy of our SEC filings, at no cost to you, by writing or telephoning us at: Salton, Inc., 1955 Field Court, Lake Forest, Illinois 60045, attention: Marc Levenstein, Assistant Secretary, telephone: (847) 803-4600. We will not send exhibits to the documents, unless the exhibits are specifically requested and you pay our fee for duplication and delivery. In addition, the Company has made the following available free of charge through its website at http://www.saltoninc.com:
- - Audit Committee Charter
- - Compensation Committee Charter
- - Nominating and Corporate Governance Committee Charter
- - Corporate Governance Guidelines, and
- - Code of Business Conduct and Ethics.
RISK FACTORS
Prospective investors should carefully consider the following risk factors, together with the other information contained in this annual report on Form 10-K, in evaluating us and our business before purchasing our securities. In particular, prospective investors should note that this annual report on Form 10-K contains forward-looking statements within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act and that actual results could differ materially from those contemplated by such statements. See "Cautionary Statement Regarding Forward-Looking Information." The factors listed below represent certain important factors which we believe could cause such results to differ. These factors are not intended to represent a complete list of the general or specific risks that may affect us. It should be recognized that other risks may be significant, presently or in the future, and the risks set forth below may affect us to a greater extent than indicated.
OUR SUBSTANTIAL INDEBTEDNESS, EVEN AFTER OUR RECENTLY COMPLETED DEBT EXCHANGE OFFER AND SUBSEQUENT PRIVATE EXCHANGE, COULD ADVERSELY AFFECT OUR FINANCIAL HEALTH AND PREVENT US FROM FULFILLING OUR PAYMENT OBLIGATIONS.
Even after our debt exchange offer and subsequent private exchange, we continue to have a significant amount of indebtedness relative to our equity size. As of September 23, 2005, we had total consolidated indebtedness of approximately $382.7 million, including approximately $147.7 million under our senior secured credit facility, $103.1 million of Second Lien Notes, approximately $46.0 million of 2005 Notes and approximately $59.6 million of 2008 Notes, excluding $2.7 million related to the fair value of a monetized fixed to floating interest rate swap on the 2008 Notes, and $1.0 million for the loan notes to Pifco shareholders that are fully cash collateralized. We may incur additional indebtedness in the future, including through additional borrowings under the second lien credit agreement (which permits the issuance of up to an aggregate of $110.0 million principal amount of Second Lien Notes) and our senior secured credit agreement, subject to availability.
Our ability to service our debt obligations and to fund planned working capital needs and capital expenditures will depend upon our future operating performance, which will be affected by prevailing economic conditions in the markets we serve and financial, business and other factors, certain of which are beyond our control. Based on our fiscal year 2006 operating plan, we believe existing sources of liquidity will be sufficient to meet cash needs during 2006. Notwithstanding our beliefs, we can not assure you that our business will generate sufficient cash flow from operations or that future borrowings will be available under our senior secured credit facility or other sources of funds in an amount sufficient to enable us to service our indebtedness or to fund our other liquidity needs. If we are unable to satisfy such liquidity needs, we could be required to adopt one or more alternatives, such as reducing or delaying capital expenditures, borrowing additional funds, restructuring indebtedness, selling other assets or operations and/or reducing expenditures for new product development, cutting other costs, and some of such actions would require the consent of our senior lenders, the holders of the Second Lien Notes and/or the holders of the Subordinated Notes. Notwithstanding our beliefs, we can not assure you that any of such actions could be effected, or if so, on terms favorable to us, that such actions would enable us to continue to satisfy our liquidity needs, that such actions would not dilute the ownership interest of stockholders and/or that such actions would be permitted under the terms of our senior secured credit facility, the second lien credit agreement or the indentures governing the Subordinated Notes.
Our high level of debt could have important consequences for you, such as:
- - our debt level makes us more vulnerable to general adverse economic and industry conditions;
- - our ability to obtain additional financing for acquisitions, or to fund future working capital, capital expenditures or other general corporate requirements may be limited;
- - we will need to use a substantial portion of our cash flow from operations for the payment of the principal of, and interest on, our indebtedness (thereby reducing the amount of money available to fund working capital, capital expenditures or other general corporate purposes);
- - our flexibility in planning for, or reacting to, changes in our business and the industry in which we compete may be limited; our debt level could impact our ability to maintain favorable credit terms with our suppliers;
- - our debt level could limit our ability or increase the costs to refinance indebtedness; and
- - our debt level may place us at a competitive disadvantage to our less leveraged competitors.
OUR DEBT INSTRUMENTS CONTAIN RESTRICTIVE COVENANTS THAT COULD ADVERSELY AFFECT OUR BUSINESS BY LIMITING OUR FLEXIBILITY.
Our senior secured credit agreement, the second lien credit agreement and the indentures governing the Subordinated Notes impose restrictions that affect, among other things, our ability to incur debt, pay dividends, sell assets, create liens, make capital expenditures and investments, merge or consolidate, enter into transactions with affiliates, and otherwise enter into certain transactions outside the ordinary course of business. Our senior secured credit agreement and the second lien credit agreement also require us to maintain specified financial ratios, including a minimum EBITDA and a consolidated fixed charge coverage ratio. Our ability to continue to comply with these covenants and restrictions may be affected by events beyond our control. If we are unable to comply with the terms of our senior secured credit agreement, the second lien credit agreement or our indentures, or if we fail to generate sufficient cash flow from operations, or to refinance our debt as described below, we may be required to refinance all or a portion of our indebtedness or to obtain additional financing. If cash flow is insufficient and refinancing or additional financing is unavailable because of our high levels of debt and the debt incurrence restrictions under our senior secured credit agreement and/or the second lien credit agreement, we may default on our debt instruments. In the event of a default under the terms of any of our indebtedness, the debt holders may accelerate the maturity of our obligations, which could cause defaults under our other obligations.
WE MUST REPAY OR REPURCHASE OUR 2005 NOTES MATURING IN DECEMBER 2005 THAT REMAIN OUTSTANDING AFTER THE DEBT EXCHANGE OFFER AND SUBSEQUENT PRIVATE EXCHANGE.
We have approximately $46.0 million of 2005 Notes with a maturity date of December 15, 2005 that remain outstanding after the debt exchange offer and subsequent private exchange. We expect to use cash flow from operations, borrowings under our senior secured credit facility and funds from other strategic options to repay, repurchase and/or redeem the outstanding 2005 Notes and satisfy our other liquidity needs. The other strategic options may include sales of assets or businesses, the creation of new foreign debt and repurchases of outstanding Subordinated Notes in the open market and/or through privately negotiated transactions for cash or other securities (including Second Lien Notes, common stock and/or Series C preferred stock). The availability and success of any of these strategic options will depend on a number of factors, some of which relate to our financial condition and performance, and some of which are beyond our control, such as prevailing interest rates and general economic conditions. We cannot assure you that any of such options could be effected, or if so, on terms favorable to us, that such options would enable us to repay the 2005 Notes that remain outstanding after the debt exchange offer and subsequent private exchange or satisfy our liquidity needs or that such options would be permitted under the terms of our senior secured credit facility, the second lien credit agreement or the indentures governing our Subordinated Notes.
WE HAVE EXPERIENCED A DECLINE IN DOMESTIC MARKET SALES AND HAVE IMPLEMENTED A DOMESTIC RESTRUCTURING PLAN.
Although our consolidated sales have remained relatively unchanged in fiscal 2005 as compared to fiscal 2004, our domestic sales have declined during this period. While the comparative decline in domestic sales was smaller in the second half of fiscal 2005, indicating an improvement in domestic sales over the course of the fiscal year, they are still not sufficient to cover our domestic operating expenses and interest due on our indebtedness. On May 12, 2005, we announced that we are ahead of schedule to achieve $40.0 million in cost reductions from our domestic operations and that we are initiating a second cost
reduction program to remove an additional $25.0 million in costs from our domestic operations. We expect that $15.0 million of these cost savings will be realized in fiscal 2006 and $10.0 million will be realized in fiscal 2007. The cost savings will principally come from a rationalization of operations, brands and SKUs and the costs related to them.
Although the restructuring of our domestic operations through workforce layoffs, consolidation of facilities and reduction of certain marketing and advertising programs has reduced our operating expenses, such actions may have an adverse effect on our domestic sales. In addition, our current and prospective customers and suppliers may decide to delay or not purchase or supply our products due to the perceived uncertainty caused by our indebtedness and the domestic restructuring plan.
We may be required to take charges in the future relating to our restructuring plan, which could have a material and adverse effect on our operating results. We cannot assure you that the domestic restructuring plan will allow us to better align our domestic cost structure with our current sales levels.
OUR INTERNATIONAL OPERATIONS, AND EXPANSION OF THESE OPERATIONS, SUBJECTS US TO ADDITIONAL BUSINESS RISKS AND MAY CAUSE OUR PROFITABILITY TO DECLINE DUE TO INCREASED COSTS.
During fiscal 2005, 2004 and 2003, sales recorded outside of North America accounted for 58.5%, 50.6% and 30.7% of total net sales, respectively. Our pursuit of international growth opportunities may require significant investments for an extended period before returns on these investments, if any, are realized. International operations are subject to a number of other risks and potential costs, including:
- - the risk that because our brand names may not be locally recognized, we must spend significant amounts of time and money to build a brand identity without certainty that we will be successful;
- - local and economic conditions;
- - unexpected changes in regulatory requirements;
- - inadequate protection of intellectual property in foreign countries;
- - foreign currency fluctuations;
- - transportation costs;
- - adverse tax consequences; and
- - political and economic instability, as a result of terrorist attacks, natural disasters or otherwise.
We cannot assure you that we will not incur significant costs in addressing these potential risks.
OUR MARGINS HAVE BEEN ADVERSELY IMPACTED BY INCREASES IN RAW MATERIAL PRICES.
The cost of our products has been impacted by long-term increases in the price of petroleum based plastic materials, steel and corrugated materials. Although we have increased the prices of certain of our goods to our customers, we cannot assure you that we will be able to pass all of these cost increases on to our customers. As a result, our margins may continue to be adversely impacted by such cost increases.
OUR ABILITY TO OBTAIN PRODUCTS MAY BE ADVERSELY IMPACTED BY WORLDWIDE DEMAND ON RAW MATERIAL.
Our products are predominately made form petroleum based plastic materials, steel and corrugated materials. Our suppliers contract separately for the purchase of them. We can provide no assurance that our sources of supply will not be interrupted should our suppliers not be able to obtain these materials due to Worldwide demand or other events that interrupt material flow.
IF WE WERE TO LOSE ONE OR MORE OF OUR MAJOR CUSTOMERS, OR SUFFER A MAJOR REDUCTION OF ORDERS FROM THEM, OUR FINANCIAL RESULTS WOULD SUFFER.
Our success depends on our sales to our significant customers. Our total net sales to our five largest customers during fiscal 2005 were 36.5% of net sales, with JD Group (customer of AMAP) representing 12.2% of our net sales, Target Corporation representing 9.2% of our net sales and Wal-Mart representing 6.2% of our net sales. Our total net sales to our five largest customers during fiscal 2004 were 36.1% of net sales, with JD Group (customer of AMAP) representing 10.4% of our net sales, Target Corporation representing 9.1% of our net sales and Wal-Mart representing 8.1% of our net sales. Our total net sales to our five largest customers during fiscal 2003 were 39.3% of net sales, with Wal-Mart representing 12.5% of our net sales and Target Corporation representing 11.9% of our net sales. We do not have long-term agreements with our major customers, and purchases are generally made through the use of individual purchase orders. A significant reduction in purchases by any of these major customers or a general economic downturn in retail sales could have a material adverse effect on our business, financial condition and results of operations.
OUR DEPENDENCE ON FOREIGN SUPPLIERS SUBJECTS US TO THE RISKS OF DOING BUSINESS ABROAD.
We depend upon unaffiliated foreign companies for the manufacture of most of our products. Our arrangements with our suppliers are subject to the risks of doing business abroad, including:
- - import duties;
- - trade restrictions;
- - production delays due to unavailability of parts or components;
- - increase in transportation costs and transportation delays, including those resulting from terrorist activity, Hurricanes Katrina and Rita;
- - work stoppages;
- - foreign currency fluctuations; and
- - political and economic instability and civil unrest, which could lead to the business failure of major suppliers.
Any reduction in trade credit from our suppliers could materially adversely affect our operations and financial condition.
We depend on the continuing willingness of our suppliers to extend credit to us to finance our inventory purchases. If suppliers become concerned about our ability to generate liquidity and service our debt, they may delay shipments to us or require payment in advance. Because of our limited access to sources of liquidity, any such actions by our suppliers could have a material adverse effect on our ability to continue our business.
THE SMALL HOUSEHOLD APPLIANCE INDUSTRY IS HIGHLY COMPETITIVE AND WE MAY NOT BE ABLE TO COMPETE EFFECTIVELY.
We believe that competition is based upon several factors, including:
- - price;
- - access to retail shelf space;
- - product features and enhancements;
- - brand names;
- - new product introductions; and
- - marketing support and distribution approaches.
We compete with established companies, some of which have substantially greater facilities, personnel, financial and other resources than we have. Significant new competitors or increased competition from existing competitors may adversely affect our business, financial condition and results of operations.
IF THE HOUSEWARES SECTOR OF THE RETAIL INDUSTRY CONTINUES TO EXPERIENCE AN ECONOMIC SLOWDOWN, OUR FINANCIAL RESULTS WILL BE ADVERSELY AFFECTED.
We sell our products to consumers through major retail channels, primarily mass merchandisers, department stores, specialty stores and mail order catalogs. As a result, our business and financial results can fluctuate with the financial condition of our retail customers and the retail industry. The current general slowdown in the retail sector has adversely impacted our net sales of products, our operating margins and our net income. If such conditions continue or worsen, including any further weakness in consumer confidence as a result of terrorist activity, Hurricanes Katrina and Rita or otherwise, it could have a material adverse effect on our business, financial condition and results of operations.
The current general slowdown in the retail sector has resulted in, and we expect it to continue to result in, additional pricing and marketing support pressures on us. Certain of our retail customers have filed for bankruptcy protection in recent years. We continually monitor and evaluate the credit status of our customers and attempt to adjust sales terms as appropriate. Despite these efforts, a bankruptcy filing by, or other adverse change in the financial condition of, a significant customer could adversely affect our financial results.
LONG LEAD TIMES, POTENTIAL MATERIAL PRICE INCREASES AND CUSTOMER DEMANDS MAY CAUSE US TO PURCHASE MORE INVENTORY THAN NECESSARY.
Due to manufacturing lead times and a strong concentration of our sales occurring during the second fiscal quarter, as well as potential material price increases, we may purchase products and thereby increase inventories based on anticipated sales and forecasts provided by our customers and our sales personnel. In an extended general economic slowdown, we cannot assure you that our customers will order these inventories as anticipated.
IF WE DO NOT ATTRACT AND RETAIN SKILLED PERSONNEL, OUR ABILITY TO GROW AND DEVELOP OUR BUSINESS WILL SUFFER.
Our continued success will depend significantly on the efforts and abilities of David C. Sabin, Chairman; Leonhard Dreimann, Chief Executive Officer; William B. Rue, President and Chief Operating Officer; and David Mulder, Executive Vice President, Chief Administrative Officer and Senior Financial Officer. The loss of the services of one or more of these individuals could have a material adverse effect on our business. In addition, as our business develops and expands, we believe that our future success will depend greatly on our ability to attract and retain highly qualified and skilled personnel. We do not have, and do not intend to obtain, key-man life insurance on our executive officers.
THE INTERESTS OF OUR SIGNIFICANT STOCKHOLDER MAY CONFLICT WITH OTHER STOCKHOLDERS' INTERESTS.
As of July 2, 2005, Centre Partners Management LLC and entities directly or indirectly controlled by Centre Partners beneficially owned in the aggregate approximately 27.0% of our common stock, including 3,529,412 shares of common stock issuable upon conversion of the $40.0 million of Series A convertible preferred stock owned by Centre Partners' entities. Centre Partners is able to exercise significant influence with respect to the election of directors or major corporate transactions such as a merger or sale of all or substantially all of our assets. Centre Partners generally has the right to designate two directors as long as it and its affiliates own at least 12.5% of the total voting power of our outstanding common stock and one director as long as it and its affiliates own at least 7.5% of the total voting power of our outstanding common stock.
On September 15, 2008, we are required to exchange all of the outstanding shares of Series A convertible preferred stock currently held by Centre Partners' entities for an aggregate of $40.0 million in cash or shares of our common stock with a market value (based on 95% of the average of the daily closing prices per share of the common stock for the twenty consecutive trading days immediately ending two days preceding the redemption date) equal to $40.0 million.
The interests of the Centre Partners' entities may conflict with other stockholders' interests.
WE MAY INCUR SUBSTANTIAL INCOME TAX LIABILITY OR LOSE TAX ATTRIBUTES AS A RESULT OF THE DEBT EXCHANGE OFFER AND THE SALE OF AMAP.
In the first quarter of fiscal 2006, we will record cancellation of indebtedness, or "COD," income of approximately $23.0 million, net of approximately $8.0 million of expenses and before income tax, as a result of the debt exchange offer.
To the extent that we are considered solvent from a tax perspective immediately before the completion of the debt exchange offer and realize COD, our current net operating losses and our net operating losses from prior years that we have carried forward may offset all or a portion of the COD income. COD income realized in excess of the available operating losses that we have carried forward will result in a tax liability. We believe that our net operating losses and net operating loss carryforwards will offset all, or substantially all, of any COD income attributable to the exchange offer.
We will not recognize COD income to the extent we are considered insolvent from a tax perspective immediately before the completion of the debt exchange offer. If and to the extent COD income is excluded from taxable income due to insolvency, we will generally be required to reduce certain of our tax attributes, including, but not limited to, net operating losses and loss carryforwards. This may result in a significant reduction in our net operating loss tax benefits; but in no event will the reduction exceed the amount of net operating losses and net operating loss carryforwards utilized to offset COD income as set forth above, if all of our COD income is recognized and our net operating losses are not subject to any limitation under Section 382 of the Internal Revenue Code of 1986, as amended (the "Code"). Taxable income will result to the extent COD income exceeds the amount by which we are considered to be insolvent immediately before the completion of the exchange offer.
We also expect to record a gain of approximately $49.0 million in connection with the sale of our interest in AMAP. We believe that our net operating losses and net operating loss carryforwards that have not been used to offset the COD income as described above will offset all, or substantially all, of the net gain on the sale of our interest in AMAP.
We do not believe that our net operating losses are subject to limitations under Section 382 of the Code as of the date hereof, because we do not believe that Salton has undergone an "ownership change" under Section 382 of the Code. However, the analysis of whether we have undergone an "ownership change" is subject to certain legal and factual uncertainties. Further, we cannot assure you that an "ownership change" will not occur as a result of purchases of our common stock disclosed to us subsequent to the date hereof. Thus, a risk exists that we could have substantial tax liability as a result of the sale of AMAP and/or completion of certain other of our strategic initiatives.
OUR CREDIT RATINGS HAVE BEEN DOWNGRADED AND COULD BE DOWNGRADED FURTHER.
Our credit ratings on our senior subordinated debt have been downgraded several times during the last two years. On July 14, 2005, Standard & Poor's withdrew its "D" corporate credit and "D" subordinated debt ratings.
Such downgrades can have a negative impact on our liquidity by reducing attractive financing opportunities and could make our efforts to raise capital more difficult and have an adverse impact on our financial condition and results of operation.
IF WE HAVE TO EXPEND SIGNIFICANT AMOUNTS TO REMEDIATE ENVIRONMENTAL LIABILITIES, OUR FINANCIAL RESULTS WILL SUFFER.
Prior to 2003, we manufactured certain of our products at our owned plants in the United States and Europe. Our previous manufacturing of products at these sites exposes us to potential liabilities for environmental damage that these facilities may have caused or may cause nearby landowners. During the ordinary course of our operations, we have received, and we expect that we may in the future receive, citations or notices from governmental authorities asserting that our facilities are not in compliance with, or require investigation or remediation under, applicable environmental statutes and regulations. Any citations or notices could have a material adverse effect on our business, results of operations and financial condition.
THE SEASONAL NATURE OF OUR BUSINESS COULD ADVERSELY IMPACT OUR OPERATIONS.
Our business is highly seasonal, with operating results varying from quarter to quarter. We have historically experienced higher sales during the second fiscal quarter primarily due to increased demand by customers for our products attributable to holiday sales. This seasonality has also resulted in additional interest expense for us during this period due to an increased need to borrow funds to maintain sufficient working capital to finance product purchases and customer receivables for the seasonal period. Lower sales than expected by us during this period, a lack of availability of product, a general economic downturn in retail sales or the inability to service additional interest expense due to increased borrowings could have a material adverse effect on our business, financial condition and results of operations.
PRODUCT RECALLS OR LAWSUITS RELATING TO DEFECTIVE PRODUCTS COULD ADVERSELY IMPACT OUR FINANCIAL RESULTS.
We face exposure to product recalls and product liability claims in the event that our products are alleged to have manufacturing or safety defects or to have resulted in injury or other adverse effects. We cannot assure you that we will be able to maintain our product liability insurance on acceptable terms, if at all, or that product liability claims will not exceed the amount of our insurance coverage. As a result, we cannot assure you that product recalls and product liability claims will not adversely affect our business.
THE INFRINGEMENT OR LOSS OF OUR PROPRIETARY RIGHTS COULD HAVE AN ADVERSE EFFECT ON OUR BUSINESS.
We regard our copyrights, trademarks, service marks and similar intellectual property as important to our success. We rely on copyright and trademark laws in the United States and other jurisdictions to protect our proprietary rights. We seek to register our trademarks in the United States and elsewhere. These registrations could be challenged by others or invalidated through administrative process or litigation. If any of these rights were infringed or invalidated, our business could be materially adversely affected.
We license various trademarks and trade names from third parties for use on our products. These licenses generally place marketing obligations on us and require us to pay fees and royalties based on net sales or profits. Typically, each license may be terminated if we fail to satisfy minimum sales obligations or if we breach the license. The termination of these licensing arrangements could adversely affect our business, financial condition and results of operations.
WE MAY BE SUBJECT TO LITIGATION AND INFRINGEMENT CLAIMS, WHICH COULD CAUSE US TO INCUR SIGNIFICANT EXPENSES OR PREVENT US FROM SELLING OUR PRODUCTS.
We cannot assure you that others will not claim that our proprietary or licensed products are infringing their intellectual property rights or that we do not in fact infringe those intellectual property rights. If someone claimed that our proprietary or licensed products infringed their intellectual property rights, any resulting litigation could be costly and time consuming and would divert the attention of management and key personnel from other business issues. We also may be subject to significant damages or an injunction
against use of our proprietary or licensed products. A successful claim of patent or other intellectual property infringement against us could harm our financial condition.
COMPLIANCE WITH GOVERNMENTAL REGULATIONS COULD SIGNIFICANTLY INCREASE OUR OPERATING COSTS OR PREVENT US FROM SELLING OUR PRODUCTS.
Most federal, state and local authorities require certification by Underwriters Laboratory, Inc., an independent, not-for-profit corporation engaged in the testing of products for compliance with certain public safety standards, or other safety regulation certification prior to marketing electrical appliances. Foreign jurisdictions also have regulatory authorities overseeing the safety of consumer products. Our products, or additional electrical appliances which may be developed by us, may not meet the specifications required by these authorities. A determination that we are not in compliance with these rules and regulations could result in the imposition of fines or an award of damages to private litigants.
THE REQUIREMENTS OF COMPLYING WITH THE SARBANES-OXLEY ACT MAY STRAIN OUR RESOURCES, AND OUR INTERNAL CONTROL OVER FINANCIAL REPORTING MAY NOT BE SUFFICIENT TO ENSURE TIMELY AND RELIABLE EXTERNAL FINANCIAL REPORTS.
We are subject to various regulatory requirements, including the Sarbanes-Oxley Act of 2002. We have incurred, and expect to continue to incur, substantial costs related to our compliance with the Sarbanes-Oxley Act. The Sarbanes-Oxley Act requires, among other things, that we maintain effective disclosure controls and procedures, corporate governance standards and internal control over financial reporting. Section 404 of the Sarbanes-Oxley Act requires that management furnish a report annually regarding our internal control over financial reporting. Among other things, the report will contain (1) an assessment and statement as to the effectiveness of our internal control over financial reporting, which must include disclosure of any material weaknesses in our internal control over financial reporting and (2) a statement that our auditors have issued an attestation report on management's assessment of such internal control. In order to maintain and improve the effectiveness of our disclosure controls and procedures and internal control over financial reporting, significant resources and management oversight have been, and will continue to be, required. We have devoted additional financial resources, time and personnel to legal, financial and accounting activities to ensure our ongoing compliance with public company reporting requirements. In the future, if our management identifies one or more material weaknesses in our internal control over financial reporting, as prescribed by Section 404, we may be unable to assert that our internal control over financial reporting is effective as of the end of the preceding year or our auditors may be unable to attest that our management's report is fairly stated or to express an opinion on the effectiveness of our internal controls, even if our auditors issue an unqualified opinion on our financial statements for the preceding fiscal year. If the auditors are unable to provide an unqualified attestation of our assessment of our internal control over financial reporting, it could result in a loss of investor confidence in our financial reports, adversely affect our stock price and our ability to access the capital markets or borrow money, and may subject us to sanctions or investigation by regulatory authorities.
OUR STOCK PRICE MAY CONTINUE TO BE VOLATILE.
The trading price of our common stock is subject to significant fluctuations in response to variations in quarterly operating results; changes in earnings estimates by analysts; announcements of new products by us or our competitors; changes in the domestic and international economic, political and business conditions; general conditions in the housewares industry; the recent lack of confidence in corporate governance and accounting practices; the open short interest in our Common Stock; our ability to continue the listing of our common stock on New York Stock Exchange; and other events or factors. In addition, the stock market in general has experienced extreme price and volume fluctuations that have affected the market prices for many companies that have been unrelated to the operating performance of these companies. These market fluctuations have adversely affected and may continue to adversely affect the market price of our common stock.
In connection with the debt exchange offer, on August 26, 2005 we issued 2,039,469 shares of common stock and granted certain registration rights for approximately 1,837,455 of these shares. The issuance of these shares of common stock may further increase the price volatility, particularly when some of the shares are registered with the SEC. The sale of such shares, or the potential for such sales, could adversely affect the price of our common stock and create greater volatility in the price of our common stock.
OUR COMMON STOCK COULD BE DELISTED BY THE NEW YORK STOCK EXCHANGE IF WE DO NOT COMPLY WITH ITS CONTINUED LISTING STANDARDS.
Our common stock is listed on the New York Stock Exchange, or NYSE. The NYSE recently amended its continued listing standards to require that all listed companies maintain an average global capitalization of at least $25 million over a consecutive 30 trading-day period or undergo prompt suspension and delisting procedures. This amended continued listing standard was effective as of July 29, 2005. On June 30, 2005, we received a letter from the NYSE which contained "an early warning" of potential non-compliance with the foregoing amended continued listing standards. We have subsequently been removed from the "early warning" status as our market capitalization has increased due to the issuance of 2,039,469 shares of common stock in the debt exchange offer and an increase in the market price per share of common stock. We cannot assure you that we will continue to satisfy the NYSE continued listing standards.
Delisting of our common stock would likely cause a reduction in the liquidity of an investment in our common stock. Delisting also could reduce the ability of holders of our common stock to purchase or sell our securities as quickly and inexpensively as they would have been able to do had our common stock remained listed. This lack of liquidity also could make it more difficult for us to raise capital in the future.
TAKEOVER DEFENSE PROVISIONS WHICH WE HAVE IMPLEMENTED MAY ADVERSELY AFFECT THE MARKET PRICE OF OUR COMMON STOCK.
Our stockholder rights plan and various provisions of Delaware corporation law and of our corporate governance documents may inhibit changes in control not approved by our board of directors and may have the effect of depriving stockholders of an opportunity to receive a premium over the prevailing market price of our common stock in the event of an attempted hostile takeover or may deter takeover attempts by third parties. In addition, the existence of these provisions may adversely affect the market price of our common stock. These provisions include:
- - a classified board of directors;
- - a prohibition on stockholder action through written consent;
- - a requirement that special meetings of stockholders be called only by the board of directors;
- - availability of "blank check" preferred stock.
WE DO NOT ANTICIPATE PAYING DIVIDENDS.
We have not paid dividends on our common stock and we do not anticipate paying dividends in the foreseeable future. We intend to retain future earnings, if any, to finance the expansion of our operations and for general corporate purposes, including future acquisitions. In addition, our senior secured credit facility and the second lien credit agreement contain restrictions on our ability to pay dividends on our capital stock.
ITEM 2.
ITEM 2. Properties
Salton leases its principal executive offices based in Lake Forest, Illinois. A summary of Salton's principal leased operating facilities is as follows:
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(1) Subsequent to year end, the Company transferred the lease of this warehouse in conjunction with the sale of the Tabletop Business. (See Note 20 "Subsequent Events").
(2) Properties of AMAP.
In addition, Salton owns the following properties:
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(1) Property of AMAP.
(2) Subsequent to year end, the Company completed the sale of this warehouse (see Note 5, "Assets Held for Sale").
We believe the reduced number of facilities and renovation projects will be suitable and adequate for our current level of operations, as well as support future growth.
ITEM 3.
ITEM 3. Legal Proceedings
SECURITIES CLASS ACTION LAWSUITS
In May 2004, two stockholder lawsuits, named Mariss Partners, LLP v. Salton, Inc., Leonhard Dreimann and David M. Mulder, and Warren Beeler v. Salton, Inc., Leonhard Dreimann and David Mulder, were filed in the United States District Court for the Northern District of Illinois against the Company and certain Salton executives. The complaints allege that the defendants violated the federal securities laws, specifically Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 of the Securities and Exchange Commission, by making certain alleged false and misleading statements. The plaintiffs seek unspecified damages on behalf of a purported class of purchasers of our securities during the period from November 11, 2002 through May 11, 2004. The Company believes that these lawsuits are without merit and that it has compelling defenses to the allegations contained in the complaints. Salton
intends to vigorously defend the Company against the claims. The outcome of the class action lawsuits cannot be predicted with certainty, however, Salton does not believe that this matter will have a material adverse affect on its business, financial condition or results of operations. Therefore, no amounts have been accrued for such claims. The plaintiffs have voluntarily dismissed the Mariss Partners lawsuit on September 3, 2004.
PHILIPS
In June 2003, the Company received a letter from Philips Domestic Appliances and Personal Care B.V. (Philips) accusing Salton of interfering in a contractual relationship between Philips and a manufacturing source for Salton, Electrical and Electronics (E&E), misappropriating trade secrets and infringing other unspecified intellectual property rights in connection with its development and marketing of the One:One single serve coffee maker. On August 14, 2003, Salton filed a complaint in the United States District Court for the Northern District of Illinois seeking a declaratory judgment that the Company had not infringed the alleged trade secret rights of Philips and had not tortuously interfered with the contractual relationship between Philips and E&E.
Philips response was to file a series of lawsuits against Salton in the United States, the UK and Hong Kong claiming patent infringement, misappropriation of trade secrets and copyright violations. Generally, the Philips' suits alleged that E&E misappropriated trade secrets, infringed intellectual property and that E&E breached its contract with Philips in the process of developing and manufacturing the One:One coffee maker for Salton.
On May 2005, Salton, E&E and Philips entered into a settlement agreement which required E&E to make a payment of 1.5 million Euros to Philips. Salton was not required to make any payments to Philips in connection with the settlement.
PRODUCT LIABILITY
On or about October 27, 2004, a lawsuit entitled DiNatale vs. Salton was filed in the New York State Supreme Court against the Company. The plaintiffs, who seek unspecified damages, allege that they were injured by water contaminated with lead taken from a tea kettle sold by the Company under its Russell Hobbs brand. The plaintiffs' attorney had been seeking to convert the lawsuit into a class action suit; no class action suit has been filed to date. The manufacturer of the product and its insurer are defending this lawsuit. The Company's attorneys and its insurers are cooperating in the defense of the lawsuit.
After receiving notice of a lawsuit, the Company voluntarily suspended selling the product. The Company believes that, at substantially the same time, the two retailers who had purchased the kettle from the Company also suspended selling the product. The Company believes that only a limited number of the kettles were sold to consumers.
The Company voluntarily contacted the U.S. Food and Drug Administration ("FDA") and shared its information and test results concerning the product with the agency. The Company issued a recall of the product. The manufacturer has agreed to compensate the Company for its legal costs and out of pocket expenses in connection with the recall and to supply replacement products.
In connection with the tea kettle matter, the Company reviewed other products received from the same manufacturer and subsequently notified the FDA that some manufacturing runs of another coffee maker product might have a lead content above FDA allowed standards. As a result, the FDA requested the Company to recall the product. The Company has done so, the retailer to whom the product was sold has cooperated in returning for credit its unsold units of the product. The manufacturer has agreed to compensate the Company for the costs that it may incur.
The outcome of the foregoing legal matters cannot be predicted with certainty, however Salton does not believe that these actions will have a material adverse affect on its business, financial condition or results of operations. Therefore, no amounts have been accrued for such claims.
HOMEPLACE OF AMERICA
Homeplace of America, a company in liquidation under the United States Bankruptcy Code, brought a lawsuit for recovery of preferential payments made to Salton and its subsidiary, Toastmaster, during the 90 day "preference" period prior to Homeplace filing for bankruptcy. Homeplace's total claimed preferences were approximately $4.0 million. After a trial during November 2004 in the U.S. Bankruptcy Court for the District of Delaware, the Court determined the Company's liability to be approximately $1.6 million. The plaintiff and Salton have agreed that Salton may satisfy this judgment by paying a total of approximately $1.5 million over time as follows: $0.1 million on or before July 1, 2005; $0.1 million on or before August 1, 2005; $0.15 million on or before September 1, 2005; $0.15 million on or before October 3, 2005; $0.5 million on or before November 1, 2005; and $0.5 million on or before December 1, 2005. We have made all such required payments as of September 15, 2005.
ENVIRONMENTAL
The Company has accrued approximately $0.2 million for the anticipated costs of environmental remediation at four of our current and previously owned sites. Although such costs could exceed that amount, Salton believes any such excess will not have a material adverse effect on the financial condition or annual results of operations of the Company.
OTHER
The Company is a party to various other actions and proceedings incident to its normal business operations. The Company believes that the outcome of any such litigation will not have a material adverse effect on our business, financial condition or results of operations. The Company also has product liability and general liability insurance policies in amounts believed to be reasonable given its current level of business. Although historically the Company has not had to pay any material product liability claims, it is conceivable that the Company could incur claims for which we are not insured.
ITEM 4.
ITEM 4. Submissions of Matters to a Vote of Security Holders
None
ITEM 4A. Executive Officers of the Registrant
Our executive officers and their respective ages as of September 9, 2005, are as follows:
DAVID C. SABIN has served as Chairman of the Company since September 1991 and has served as Secretary and a director of the Company since its inception in August 1988 and is a founder of the Company.
LEONHARD DREIMANN has served as Chief Executive Officer and a director of the Company since its inception in August 1988 and is a founder of the Company. From 1988 to July 1998, Mr. Dreimann served as President of the Company. From 1987 to 1988, Mr. Dreimann served as president of the Company's predecessor Salton, Inc., a wholly-owned subsidiary of SEVKO, Inc. Prior to 1987, Mr. Dreimann served as managing director of Salton Australia Pty. Ltd., a distributor of Salton brand kitchen appliances.
WILLIAM B. RUE has been a director of the Company since August 1998. Mr. Rue has served as President of the Company since August 1998, as Chief Operating Officer of the Company since December 1994 and as Chief Financial Officer and Treasurer of the Company from September 1988 to January 1999.
He is also a founder of the Company. From 1985 to 1988, he was Treasurer of SEVKO, Inc. and from 1982 to 1984 he was Vice President-Finance of Detroit Tool Industries Corporation. Prior to that time, Mr. Rue had been employed since 1974 by the accounting firm of Touche Ross & Co.
DAVID M. MULDER serves as the Executive Vice President, Chief Administrative Officer and Senior Financial Officer. Mr. Mulder is the Principal Accounting and Financial Officer and has responsibility for U.S. operations, U.S. information technology and U.S. human resources. Prior to joining the Company, Mr. Mulder recently served as Chief Financial and Administrative Officer of KoSa, an international manufacturing company in Houston, Texas. From 1995 to 2000, he held a number of senior level positions at Fruit of the Loom, a consumer products company. Mr. Mulder's most recent position at Fruit of the Loom was a corporate Executive Vice President and the Chief Executive Officer of their European division.
PART II
ITEM 5.
ITEM 5. Market for the Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
The registrant's common stock has traded on the New York Stock Exchange under the symbol "SFP" since February 26, 1999. From October 1991 until February 25, 1999, our common stock traded on the NASDAQ National Market under the symbol "SALT." The following table sets forth, for the periods indicated, the high and low sales prices for the common stock as reported on the New York Stock Exchange.
DIVIDENDS
We have not paid dividends on our common stock and we do not anticipate paying dividends in the foreseeable future. We intend to retain future earnings, if any, to finance the expansion of our operations and for general corporate purposes, including future acquisitions. In addition, our senior secured credit agreement and the second lien credit agreement contain restrictions on our ability to pay dividends on our capital stock.
STOCKHOLDER RIGHTS PLAN
On June 28, 2004, the Board of Directors of Salton adopted a stockholder rights plan (the "Rights Plan") pursuant to which a dividend consisting of one preferred stock purchase right (a "Right") was distributed for each share of Common Stock held as of the close of business on July 9, 2004, and is to be distributed to each share of Common Stock issued thereafter until the earlier of (i) the Distribution Date (as defined in the Rights Plan), (ii) the Redemption Date (as defined in the Rights Plan) or (iii) June 28, 2014. The Rights Plan is designed to deter coercive takeover tactics and to prevent an acquirer from gaining control of us without offering fair value to our stockholders. The Rights will expire on June 28, 2014, subject to earlier redemption or exchange as provided in the Rights Plan. Each Right entitles the holder thereof to purchase from us one one-thousandth of a share of a new series of Series B Junior Participating Preferred Stock at a price of $45.00 per one one-thousandth of a share, subject to adjustment. The Rights are generally exercisable only if a Person (as defined) acquires beneficial ownership of 20 percent or more of our outstanding Common Stock.
A complete description of the Rights, the Rights Agreement between us and UMB Bank, N.A., as Rights Agent, and the Series B Junior Participating Preferred Stock is hereby incorporated by reference from the information appearing under the caption "Item 1. Description of the Registrant's Securities to be Registered" contained in the Registration Statement on Form 8-A filed on June 28, 2004.
COMMON STOCK
The Certificate of Incorporation authorizes the issuance of 40,000,000 common shares, par value $0.01 per share. As of September 2, 2005, there were approximately 338 holders of record of our common stock.
CONVERTIBLE PREFERRED STOCK
The Certificate of Incorporation authorizes the issuance of 2,000,000 preferred shares, par value $0.01 per share.
We have 40,000 outstanding shares of convertible preferred stock. The convertible preferred stock is generally non-dividend bearing; however, if we breach in any material respect any of our material obligations in the preferred stock agreement or the Certificate of Incorporation relating to the convertible preferred stock, the holders of convertible preferred stock are entitled to receive quarterly cash dividends on each share of convertible preferred stock from the date of such breach until it is cured at a rate per annum equal to 12 1/2% of the Liquidation Preference as defined below. The payment of dividends is limited by the terms of our senior secured credit agreement and the second lien credit agreement.
Each holder of the convertible preferred stock is generally entitled to one vote for each share of Salton common stock which such holder could receive upon the conversion of the convertible preferred stock. Each share of convertible preferred stock is convertible at any time into that number of shares of Salton common stock obtained by dividing $1,000 by the Conversion Price in effect at the time of conversion. The "Conversion Price" is equal to $11.33, subject to certain anti-dilution adjustments.
In the event of a Change of Control (as defined), each holder of shares of convertible preferred stock has the right to require us to redeem such shares at a redemption price equal to the Liquidation Preference plus an amount equivalent to interest accrued thereon at a rate of 7.0% per annum compounded annually on each anniversary date of July 28, 1998 for the period from July 28, 1998 through the earlier of the date of such redemption or July 28, 2003.
In the event of a liquidation, dissolution or winding up of the Company, whether voluntary or involuntary, holders of the Convertible Preferred Stock are entitled to be paid out of the assets of the Company available for distribution to its stockholders an amount in cash equal to $1,000 per share, plus the amount of any accrued and unpaid dividends thereon (the "Liquidation Preference"), before any distribution is made to the holders of any Salton common stock or any other of our capital stock ranking junior as to liquidation rights to the convertible preferred stock.
We may optionally convert in whole or in part, the convertible preferred stock at any time on and after July 15, 2003 at a cash price per share of 100% of the then effective Liquidation Preference per share, if the daily closing price per share of our common stock for a specified 20 consecutive trading day period is greater than or equal to 200% of the then current Conversion Price. On September 15, 2008, we will be required to exchange all outstanding shares of convertible preferred stock at a price equal to the Liquidation Preference per share, payable at the Company's option in cash or shares of Salton common stock.
As of September 2, 2005 there were 40,000 shares of the convertible preferred stock outstanding, held by 7 shareholders of record. There is no established market for the convertible preferred stock.
ITEM 6.
ITEM 6. Selected Financial Data
The following financial data as of and for the fiscal years ended July 2, 2005, July 3, 2004, June 28, 2003, June 29, 2002 and June 30, 2001 have been derived from and should be read in conjunction with, our audited consolidated financial statements, including the notes thereto.
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(1) Includes the effect of costs related to our U.S. restructuring plan and other items excluded from senior management's assessment of the operating performance of Salton's business (See "U.S. Restructuring Plan" in Management's Discussion and Analysis of Financial Condition and Results of Operations) which on a combined basis, decreased income before income taxes $73.2 million, $57.0 million after tax ($5.06 per basic share).
(2) AMAP's results from May 16, 2003 onward have been consolidated with Salton's financial statements.
(3) Excludes $0.9 million in fiscal 2005, $4.5 million in fiscal 2004, $4.6 million in fiscal 2003, and $18.2 million in fiscal 2002 related to the loan notes to Pifco shareholders which were fully cash collateralized and excludes $7.1 million is fiscal 2005, $9.6 million in fiscal 2004, $12.1 million in fiscal 2003, and $8.4 million in fiscal 2002 related to the fair value of a monetized fixed to floating interest rate swap on the notes due 2008.
ITEM 7.
ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
INTRODUCTION
Salton designs, markets and distributes small home appliances and electronics for the home, home decor and personal care products under recognized brand names in the International Housewares Industry. Our product mix consists of kitchen and home appliances, electronics, time products, tabletop products, lighting products, picture frames and personal care and wellness products. In recent years, we have expanded our international presence and strengthened our product offerings through strategic acquisitions and alliances as well as internal international growth.
RECENT DEVELOPMENTS
PRIVATE DEBT EXCHANGE
On August 26, 2005, we completed a private debt exchange offer for the outstanding 2005 Notes and the outstanding 2008 Notes. We accepted for exchange an aggregate of approximately $75.0 million in principal amount of 2005 Notes (approximately 60.0% of the then outstanding 2005 Notes) and approximately $90.1 million in principal amount of 2008 Notes (approximately 60.1% of the outstanding 2008 Notes) that were validly tendered in the debt exchange offer.
Upon closing of the debt exchange offer, we issued an aggregate of approximately $99.1 million in principal amount of senior second lien notes (the "Second Lien Notes"), 2,039,469 shares of Salton common stock and 135,088 shares of Series C preferred stock with a total liquidation preference of $13.5 million. The Second Lien Notes mature on March 31, 2008 and bear interest at LIBOR plus 7.0%, payable in cash on January 15th and July 15th of each year, with the first payment due on January 15, 2006. The Series C preferred stock is generally non-dividend bearing and is mandatorily redeemable by us in cash at the liquidation amount on August 26, 2010. We also granted certain registration rights for approximately 1,837,455 shares of Salton common stock and 121,707 shares of Series C preferred stock received by certain former holders of Subordinated Notes.
In connection with the debt exchange offer, we obtained the consent of the holders of a majority of the outstanding 2005 Notes and a majority of the outstanding 2008 Notes to amend the indentures governing such Subordinated Notes to eliminate substantially all of the restrictive covenants and certain events of default contained in such indentures. We have entered into supplements to the indentures governing the 2005 Notes and the 2008 Notes to reflect such amendments.
As a consequence of the debt exchange offer:
- - We reduced our total interest-bearing debt by approximately $66.0 million;
- - We reduced the aggregate principal amount of 2005 Notes outstanding immediately after the closing of the debt exchange offer to approximately $50 million;
- - We increased the aggregate number of outstanding shares of common stock by 2,039,469 or approximately 18% of the 11,376,292 shares of common stock outstanding immediately prior to the debt exchange offer;
- - We issued 135,088 shares of Series C preferred stock with a total liquidation preference of $13.5 million;
- - Mr. Lester C. Lee, a new independent director designated by certain former holders of the Subordinated Notes, was elected to serve on our board of directors; and
- - In the first quarter of fiscal 2006 we will record a pre-tax gain on cancellation of indebtedness of approximately $23.0 million, net of approximately $8.0 million of expenses, and before income tax.
SALE OF AMAP AND TABLETOP
On September 29, 2005, we completed the sale of our 52.6% ownership interest in AMAP, a leading distributor and marketer of small appliances and other products in South Africa, to a group of investors led by Interactive Capital (Proprietary) Limited. In the first quarter of fiscal 2006, we received proceeds, net of expenses, of approximately $80.0 million in connection with the transaction. In the first quarter of fiscal 2006, we expect to record a gain of approximately $49.0 million before taxes. We expect to license and sell our George Foreman(R), Russell Hobbs(R) and Carmen(R) branded products in South Africa following the transaction.
On September 16, 2005, we completed the sale of certain tabletop assets to Lifetime Brands, Inc. for $14.2 million, which approximates book value, and is subject to post-closing adjustments. In connection with this transaction, we divested our Block(R) and Sasaki(R) brands, licenses to Calvin Klein(R) and Napa Style(TM) tabletop products and distribution of upscale crystal products under the Atlantis(R) brand. In addition, we entered into a new license with Lifetime Brands enabling it to market tabletop products under the Stiffel(R) brand.
Prior to May 15, 2003, our investment in AMAP was accounted for under the equity method. Since May 16, 2003, the date we increased our ownership interest from 30.8% to 52.6%, AMAP's financial results have been consolidated in accordance with accounting principles generally accepted in the United States of America ("GAAP") for financial statement presentation. Because management did not have a committed or approved plan to sell either our ownership interest in AMAP or the assets of the Tabletop business as of July 2, 2005, the operating results of these businesses have been included in our consolidated financial statements for 2005.
PRIVATE EXCHANGE
On September 28, 2005, we completed a private exchange transaction with FMA CBO Funding III, LTD, in which we issued $4.1 million of Second Lien Notes in exchange for $4.0 million of 2005 Notes.
OTHER STRATEGIC OPTIONS
As previously disclosed in an 8-K filed on August 30, 2005, we continue to explore strategic options to satisfy our liquidity needs and improve our overall balance sheet position, including the payment of the approximately $46.0 million in aggregate principal amounts of 2005 Notes that remain outstanding after the debt exchange offer and subsequent private exchange, and enhance our operating performance. These strategic options include potential sales of assets or businesses, the creation of new foreign debt, repurchases of outstanding Subordinated Notes in the open market and/or through privately negotiated transactions for cash or other securities (including Second Lien Notes, common stock and/or Series C preferred stock) and further reductions in expenses.
YEAR IN REVIEW
In 2005, Salton focused its efforts on cost reductions, near-term liquidity needs and investment for future growth. Significant savings of approximately $50.0 million were achieved domestically as a result of the cost reductions. However, sales were adversely impacted early in the year by inventory shortages and later in the year by uncertainty among our suppliers and customers, both domestically and internationally, as attention turned to our ability to repay and/or refinance the 2005 Notes. This uncertainty continued to increase during the fourth quarter when we utilized the 30 day grace period to pay interest due on the 2005 Notes in order to review our strategic options for refinancing the 2005 Notes. Additionally, foreign sales in the second-half were impacted as a result of an overall softness in the retail market, especially in Europe.
U.S. RESTRUCTURING PLAN
As part of an effort to improve our domestic operations, we have successfully implemented our U.S. restructuring plan in an effort to better align domestic operating costs with current sales levels. Through our cost reduction programs and consolidation of U.S. operations, we have reduced domestic expenses by more than $50.0 million. This is over $10.0 million above the expected $40.0 million we announced one year ago. As announced in the fourth quarter of fiscal 2005, we plan to implement a second U.S. cost reduction program to reduce domestic operations by an additional $25.0 million with $15.0 million to be realized in 2006 and $10.0 million to be realized in 2007.
FISCAL YEAR 2005
We recorded certain pretax charges as part of the finalization of the (fiscal 2004) initial U.S. Restructuring Plan as follows:
- - $1.0 million for consulting and legal fees, termination and severance costs and costs involved in the closure of certain distribution facilities.
FISCAL YEAR 2004
We completed the initial phase of this U.S. restructuring plan by reducing headcount in the domestic operations by approximately 25.0% in the fourth quarter of fiscal 2004.
In connection with the U.S. restructuring plan and subsequent valuation reviews in light of those decisions, we recorded certain pretax charges in the fourth quarter of 2004 as follows:
- - $20.2 million write-down of certain inventory identified for liquidation as part of the Company's decision to rationalize warehouse and distribution facilities
- - $6.5 million of intangible asset impairment charge associated with trademarks affected by the restructuring plan
- - $3.8 million fixed assets charge related primarily to tooling
- - $1.7 million write-down of costs associated with several marketing programs that were discontinued
- - $1.2 million in consulting and legal costs directly associated with the development and implementation of the U.S. restructuring plan; and
- - $0.5 million in termination and severance costs associated with the headcount reduction in the U.S.
Other items impacting the 2004 fiscal year-end results include:
- - $34.3 million impairment charge consisting of consolidated goodwill and certain other indefinite lived intangible assets (See "Impairment Loss on Goodwill and Intangible Assets").
- - $6.9 million valuation allowance against certain foreign income tax credits
- - $5.0 million pre-tax loss on the early extinguishment of debt
The restructuring costs and other items listed above affected comparability of reported operating income, net income and earnings per share for fiscal year 2005 and 2004.
RESULTS OF OPERATIONS
The following table sets forth our results of operations as a percentage of net sales for the years ended:
(1) Includes $24.0 million (2.2% of net sales) of fourth quarter restructuring costs (See "U.S. Restructuring Plan").
(2) Consists of an aggregate of $40.9 million of impairment charges (See "Impairment Loss on Goodwill and Intangible Assets").
2005 COMPARED TO 2004
NET SALES AND GROSS PROFIT
Salton's annual worldwide sales were $1.1 billion in each of 2005 and 2004. Sales from our foreign subsidiaries increased $60.3 million, which included $41.1 million of foreign currency fluctuation gain. These increases were offset by a $66.0 million decline in our domestic sales, which were adversely impacted in the first half of the year by inventory shortages and lower retail purchases over the prior year and the uncertainty of our suppliers and customers resulting from our increased liquidity issues in the second half of the year. Fiscal 2005 sales of the new George Foreman Grills with removable plates (The Next Grilleration) had a positive impact on domestic sales, which helped offset the decline faced in the domestic market.
Gross profit for 2005 declined $10.7 million from $253.6 million in 2004 to $242.9 million in 2005. The 2004 gross profit included $24.0 million of fourth quarter charges in connection with the U.S. restructuring plan announced on May 11, 2004. As a percent of net sales, gross profit was 22.7% in 2005 compared to 23.5% in 2004, a decrease of 0.8%. The decrease would have been greater if the fourth quarter charges in connection with our U.S. restructuring plan were excluded from gross profit for the fiscal year 2004. The fiscal 2005 decreases are primarily a result of a higher volume of AMAP sales at substantially lower margins due to the nature of their business in the electronics industry as well as global material cost increases in plastics, steel and corrugated materials, partially offset by a $10.5 million domestic decline in distribution expenses primarily as a result of our U.S. cost reduction programs. The outlook for material costs remains uncertain. Although we have recently implemented price increases on certain products to compensate for higher material costs, the impact of the price increases is uncertain due to potential reactions of our competitors and the uncertainty of consumer acceptance.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES
Selling, general and administrative expenses decreased to 22.5% of net sales or $240.9 million in 2005 compared to 25.4% of net sales or $273.3 million for 2004. U.S. operations reduced selling, general and administrative expenses by $52.3 million. These decreases were partially offset by $11.5 million in international increases driven by our European expansion and growth in South Africa as well as $8.4 million from foreign currency increases.
Domestic selling, general and administrative expense decreases for fiscal year 2005 were primarily driven by a $32.8 million decline in promotional expenditures for television, royalty expense, certain other media and cooperative advertising, and trade show expenses. The $32.8 million decreases included a
$20.6 million reduction in cooperative advertising and an $11.0 million decrease in direct and infomercial advertising expenditures. In addition, we reduced selling, general and administrative salary expenses by $7.5 million. These decreases were primarily from the efforts of our cost reduction programs.
IMPAIRMENT LOSS ON GOODWILL AND INTANGIBLE ASSETS
At the end of the fourth quarter of fiscal year 2005, we performed the annual impairment test required by SFAS No. 142, "Goodwill and Other Intangible Assets." Upon completion of the test, it was determined that a pre-tax impairment charge of $3.2 million was necessary to reflect management's decisions regarding certain underperforming product lines and related trademarks.
At the end of the third quarter of fiscal 2004, management determined that the combination of the shortfall in meeting projected operating results along with the Company's inability to meet its financial debt covenant requirements for its senior secured credit facility and a downgrade in its debt rating could have an adverse affect on the comparison of fair value to carrying value for goodwill and other intangible assets. An interim impairment test was conducted at that time and we determined that the implied fair value of goodwill and the fair value of certain other indefinite lived intangible assets were less than their carrying values. We recorded a non-cash impairment charge totaling $34.3 million pre-tax or $29.9 million net of tax, consisting of consolidated goodwill of $28.2 million and certain other indefinite lived intangible assets associated with iCEBOX, of $6.1 million. Upon completion of its annual impairment test at the end of the fourth quarter 2004, we determined that an additional charge of $6.5 million was necessary against trademarks impacted by the adoption of its U.S. restructuring plan.
RESTRUCTURING COSTS
As a result of our U.S. restructuring plan, we incurred $1.0 million in restructuring costs during 2005 consisting of consulting and legal costs as well as termination and severance costs associated with the U.S. headcount reduction. See "U.S. Restructuring Plan" for a discussion of certain pretax charges in the fourth quarter of fiscal 2004 in connection with our U.S. restructuring plan.
NET INTEREST EXPENSE
Net interest expense was $53.3 million for fiscal 2005 and $40.2 million for fiscal 2004. Our rate of interest on amounts outstanding under the revolver, term loan and senior subordinated debt was a weighted average annual rate of 9.8% in fiscal 2005 compared to 8.9% in fiscal 2004. The average amount of all debt outstanding was $475.5 million for fiscal 2005 compared to $413.5 million for fiscal 2004.
INCOME TAXES
Income tax expense was a tax benefit of $10.1 million in fiscal 2005, compared to a tax benefit of $20.1 million in fiscal 2004. The effective tax benefit rate for federal, state, and foreign income taxes was approximately 18.2% in 2005 versus approximately (18.7)% in 2004. The effective tax benefit rate in 2005 is lower than the statutory U.S. Federal and State rates due to $5.5 million of additional U.S. tax provided on the accumulated earnings of the South African subsidiary that was sold subsequent to year end, $2.4 million of additional tax adjustments to certain year end deferred tax accounts related to various prior periods and foreign rates which differ from those in the U.S. In 2004 the tax benefit rate differed from the statutory U.S. Federal and State rates due to $13.3 million of non-deductible goodwill that was written off as a result of an impairment charge, $6.9 million of tax reserves provided as a valuation allowance against certain foreign income tax credits that have a ten year life for U.S. tax purposes and the effect of foreign rates that differ from those in the U.S.
2004 COMPARED TO 2003
NET SALES AND GROSS PROFIT
Salton reached $1.1 billion in net sales for 2004 compared to the $894.9 million reported in 2003. The largest increase was the inclusion of a full year of AMAP's results which amounted to $206.4 million of additional sales. In addition, Salton had $29.2 million of exchange rate gain and $12.6 million of other foreign sales increases. The other foreign sales increases were primarily driven by the George Foreman and Russell Hobbs product lines. While Foreman sales continued to increase internationally, domestic volume decline in the first half of the year was the primary reason for a $66.5 million decrease in domestic sales for the fiscal year.
Gross profit for 2004 declined $4.0 million from $257.6 million in 2003 to $253.6 million in 2004. As a percent of net sales, it was 23.5% in 2004 compared to 28.8% in 2003, a decrease of 5.3%. These decreases are attributed to a $65.2 million decline in domestic gross profit associated with a volume and mix shift from higher margin George Foreman products to lower margin new products such as the Westinghouse electrics, Melitta One:One and various other new products introduced at the International Housewares Show. As part of the $65.2 million of domestic decline in operations, we incurred $24.0 million of fourth quarter charges in connection with the U.S. restructuring plan announced on May 11, 2004. These costs included inventory and tooling write-downs associated with the Company's decision to rationalize warehouse and distribution facilities and exit certain marketing programs. The decreases caused by domestic gross profit declines and U.S. restructuring costs were partially offset by a $44.7 million increase due to the inclusion of a full year of AMAP's gross profit, $9.6 million in foreign currency gains and $6.9 million in other foreign gross profit increases associated with growth and expansion of our international subsidiaries.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES
Selling, general and administrative expenses increased to 25.4% of net sales or $273.3 million in 2004 compared to 23.3% of net sales or $208.2 million for 2003. The $65.1 million increase in selling, general and administrative was due to increases of $39.7 million driven by international growth from expansion, including $22.4 million from AMAP and $9.8 million from other foreign increases as the Company launched new products internationally and expanded operations on the European Continent and in Brazil. The remaining $7.5 million were of international increases attributed to foreign currency fluctuations.
Selling, general and administrative expenses for domestic operations increased $25.4 million. As a result of approximately $30.0 million of additional expenditures for television, royalty expense, certain other media and cooperative advertising and trade show expenses. Of the $30.0 million, approximately $8.0 million related to cooperative advertising and promotional activities associated with an aggressive retailer position following product shortages during the holidays. It was management's intention to drive additional sales through significant new product introductions. We had varied success on the new product launches and continued to experience declines in overall domestic sales in the first three quarters, which was the primary driver of the U.S. restructuring plans, launched in the fourth quarter. As part of those plans, we incurred a $1.7 million charge associated with the termination of certain advertising and marketing programs as part of our U.S. restructuring plan. These increases from domestic operations were offset by $6.3 million of various other insignificant decreases in other selling, general and administrative expense categories.
IMPAIRMENT LOSS ON GOODWILL AND INTANGIBLE ASSETS
Effective with the beginning of fiscal year 2003, we adopted SFAS No. 142, "Goodwill and Other Intangible Assets". Upon adoption of SFAS No. 142, we discontinued the amortization of goodwill and indefinite lived intangible assets. Goodwill and intangible assets that are not amortized are subject to a fair-value based impairment test on an annual basis or more frequently if circumstances indicate a potential impairment.
The annual test for impairment of goodwill and other intangible assets is conducted during the fourth quarter of each fiscal year. At the beginning of 2004, management believed that projected operating results would validate the amount of goodwill and other intangible assets on the financial statements. As discussed in our 2003 Annual Report on Form 10-K filed with the Securities and Exchange Commission, shortfalls in future operating results or the application of more conservative market assumptions could have an adverse affect on the comparison of fair value to carrying value for goodwill and other intangible assets. Management determined that the combination of the shortfall beginning in the third quarter in meeting projected operating results along with the our inability to meet financial debt covenants required for the senior secured credit facility for two consecutive quarters and a downgrade in the debt rating could have such an adverse effect, and as such, an interim impairment test was necessary. A valuation of goodwill and other intangible assets was conducted. The valuation incorporated performance through the third quarter. The valuation did not incorporate the future U.S. restructuring plan that management started in the fourth quarter of fiscal 2004.
As a result, we determined that the implied fair value of goodwill and the fair value of certain other indefinite lived intangible assets were less than their carrying values. We recorded a non-cash impairment charge totaling $34.3 million pre-tax or $29.9 million net of tax, consisting of consolidated goodwill of $28.2 million and certain other indefinite lived intangible assets associated with iCEBOX of $6.1 million.
In conjunction with the U.S. restructuring plan and extensive individual product line reviews, we completed our annual test for impairment of indefinite lived intangible assets as of the end of the fourth quarter. As a result, we determined that an additional charge of $6.5 million was necessary against trademarks impacted by the U.S. restructuring plan.
RESTRUCTURING COSTS
As a result of our U.S. restructuring plan, we incurred $1.7 million in restructuring costs consisting of $1.2 million for consulting and legal costs directly associated with the development and implementation of the restructuring plan and $0.5 million associated with the termination and severance cost as a result of a 25.0% U.S. headcount reduction in the fourth quarter.
NET INTEREST EXPENSE
Net interest expense was $40.2 million for both fiscal 2004 and fiscal 2003. Our rate of interest on amounts outstanding under the revolver, term loan and senior subordinated debt was a weighted average annual rate of 8.9% in fiscal 2004 and 8.4% in fiscal 2003. The average amount of all debt outstanding was $413.5 million for fiscal 2004 compared to $444.4 million for fiscal 2003. This was a result of lower average borrowings under the current and former revolver and term loan agreement and our repayment of certain other obligations.
LOSS ON EARLY EXTINGUISHMENT OF DEBT
During the fourth quarter of fiscal year 2004, the Company incurred a non-cash pretax charge of $5.0 million for the write-off of unamortized financing costs under the previous credit agreement. (See Liquidity discussion surrounding new financing arrangements).
FAIR MARKET VALUE ADJUSTMENT ON DERIVATIVES
Salton Europe uses foreign exchange contracts to hedge anticipated foreign currency transactions, primarily U.S. dollar inventory purchases. The contracts generally mature within one year and are designed to limit exposure to exchange rate fluctuations. In fiscal 2003, we recognized a pre-tax benefit for an increase in the fair market value of the derivatives of $2.5 million, or $1.8 million net of tax, from foreign exchange contracts that did not qualify as cash flow hedges for accounting purposes in accordance with U.S. GAAP. All subsequent foreign exchange contracts entered into by the Company met the conditions of SFAS No. 133 to qualify as cash flow hedges and were recorded as such.
INCOME TAXES
Income tax expense was a tax benefit of $20.1 million in fiscal 2004 as compared to income tax expense of $2.7 million in fiscal 2003. The effective tax rate (benefit) for federal, state, and foreign income taxes was approximately (18.7)% in 2004 versus approximately 24.6% in 2003. The effective tax rate (benefit) in 2004 is less than the fiscal 2003 tax rate primarily because of $13.3 million of non-deductible goodwill that was written off as a result of an impairment charge in 2004 and $6.9 million of tax reserves provided as a valuation allowance against certain foreign income tax credits that have a five year life for U.S. tax purposes.
LIQUIDITY AND CAPITAL RESOURCES
CASH FLOW FROM OPERATIONS
Our primary sources of liquidity are our cash flow from operations and borrowings under our senior secured credit facility. In 2005, Salton's operations used $17.3 million in cash flow, compared with proceeds of $23.1 million in 2004. This decrease is primarily a result of a reduction in our accounts payable. Our accounts payable balances declined as a result of tightening credit terms in the second half of fiscal 2005 as the Company faced the December maturity of its $125.0 million 2005 bonds and restructuring alternatives. On June 15, 2005, the Company announced that it would utilize the 30 day grace period under the indentures to pay interest due on the 2005 notes. This interest was paid on July 14, 2005. However, as a result of these uncertainties, the Company has experienced tightening credit terms from its sources of supply.
Our results of operations for the periods discussed have not been significantly affected by inflation or foreign currency fluctuation. We generally negotiate our purchase orders with our foreign manufacturers in United States dollars. Thus, our cost under any purchase order is not subject to change after the time the order is placed due to exchange rate fluctuations. However, the weakening of the United States dollar against local currencies could result in certain manufacturers increasing the United States dollar prices for future product purchases. Given the seasonal nature of our business, borrowings and availability tend to be highest in mid-Fall and early winter.
The Company also currently uses foreign exchange contracts to hedge anticipated foreign currency transactions, primarily U.S. dollar inventory purchases. The contracts generally mature within one year and are designed to limit exposure to exchange rate fluctuations, primarily the British Pound Sterling, South African Rand and Australian Dollar against United States dollars.
INVESTING ACTIVITIES
In 2005, we had $17.2 million in proceeds from the sale of property and investments, primarily from the sale of a distribution warehouse in Europe. We subsequently entered into an operating lease agreement of this warehouse. In addition, we incurred approximately $9.3 million for capital expenditures.
FINANCING ACTIVITIES
We had net proceeds from worldwide credit facilities of $27.8 million. These proceeds were offset by $2.6 million of financing costs associated with refinancing activities and $2.3 million in distributions to minority shareholders.
SENIOR SECURED CREDIT FACILITY
On June 15, 2004, we entered into amended and restated senior secured credit facility with Silver Point Finance, LLC which currently provides us with the ability to borrow up to approximately $188 million pursuant to a revolving line of credit, letters of credit and a $100.0 million term loan. Advances under the revolving line of credit are primarily based upon percentages of eligible accounts receivable and inventories. The facility has a maturity date of December 31, 2007 and is subject to a prepayment premium of 4.50% if the facility is repaid by June 15, 2006 and 3.50% if the facility is repaid thereafter.
As of September 23, 2005, we had borrowed $147.7 million under the senior secured credit facility and had approximately $6.5 million available under this facility for future borrowings.
Borrowings under our senior secured credit facility accrue interest, at our option, at either: LIBOR, plus 6.0% (or 5.0% after March 31, 2006), equaling 10.0% at September 26, 2005; or the Base Rate (prime rate), plus 4.0% (or 3.0% after March 31, 2006), equaling 10.75% at September 26, 2005. The Company has the option to convert any base rate loan to LIBOR rate loan. LIBOR rate loans are to be no lower than a rate of 7.0%.
Our senior indebtedness contains a number of significant covenants that, among other things, restrict our ability to dispose of assets, incur additional indebtedness, prepay other indebtedness, pay dividends, repurchase or redeem capital stock, enter into certain investments, enter into sale and lease-back transactions, make certain acquisitions, engage in mergers and consolidations, create liens, or engage in certain transactions with affiliates and otherwise restrict our corporate and business activities. In addition, under our senior secured credit facility, we are required to comply with a minimum EBITDA and consolidated fixed charge coverage ratio. We are also required to deposit all proceeds from collection of accounts receivable and sale of collateral with an account under the exclusive dominion and control of the senior lenders.
We are required by the terms of a fourth amendment dated September 22, 2005 to our senior secured credit facility to prepay the outstanding principal amount of the original $100.0 million term loan included therein with the proceeds received in connection with the sale of certain of our tabletop assets and the sale of our 52.6% ownership interest in AMAP.
Under the terms of the senior secured credit facility, as amended by the fourth amendment, we are required to request one or more additional term loans on or prior to October 4, 2005; provided that the sum of the outstanding principal amount of the original term loan and these additional term loans must equal $100.0 million. We are required by the terms of the senior secured credit facility, as amended by the fourth amendment, to: (1) the first approximately $24.9 million of our borrowings under the additional term loan to prepay the outstanding amount of the revolving line of credit under the senior secured credit facility; and (2) place $50.0 million of such borrowings into an interest-bearing cash collateral account. We may use the remaining proceeds of the additional term loan for general corporate purposes.
Subject to certain terms and conditions, including the absence of any default or event of default, we may use the $50.0 million cash collateral account to purchase, prepay or redeem the outstanding 2005 Notes. To the extent that we issue Second Lien Notes and/or equity in exchange for 2005 Notes prior to the maturity of the 2005 Notes, we are permitted to obtain funds from the cash collateral account in an amount equal to the reduction of the principal amount of the 2005 Notes affected by such exchange.
Events of default under our senior secured credit facility include, but are not limited to: (a) our failure to pay principal or interest when due; (b) our material breach of any representation or warranty; (c) covenant defaults; (d) our default with respect to any other debt with an outstanding principal amount in excess of $1.0 million if the effect thereof is to accelerate or permit the acceleration of such debt; and (e) events of bankruptcy.
The senior secured credit facility is secured by all of our tangible and intangible assets and all of the tangible and intangible assets of our domestic subsidiaries and a pledge of the capital stock of our domestic subsidiaries and the capital stock of certain of our foreign subsidiaries. The senior secured credit facility is unconditionally guaranteed by each of our direct and indirect domestic subsidiaries.
SECOND LIEN CREDIT AGREEMENT
On August 26, 2005, in connection with the closing of our debt exchange offer, we entered into a second lien credit agreement with The Bank of New York, as agent, which provides for the issuance of up to $110 million aggregate principal amount of Second Lien Notes. We issued approximately $99.1 million of Second Lien Notes in connection with our debt exchange offer. We subsequently issued an additional $4.1 million of Second Lien Notes in connection with our private exchange We may add additional lenders
under the second lien credit agreement through the issuance of additional Second Lien Notes as long as the aggregate principal amount of the Second Lien Notes does not exceed $110 million.
The second lien credit agreement and the Second Lien Notes have a maturity date of March 31, 2008. The interest rate with respect to the Second Lien Notes is the six month LIBOR plus 7%, equaling 11.06125% for the first interest period after the closing of the debt exchange offer, payable in cash on January 15th and July 15th of each year, commencing January 15, 2006. The default rate is LIBOR plus 10%.
The Second Lien Notes are redeemable by us at our option, in whole or in part, at any time at a redemption price equal to the following percentage of the principal amount so redeemed, plus accrued and unpaid interest up to the redemption date:
- - if the redemption occurs prior to the first anniversary of the consummation of the debt exchange offer, 102%;
- - if the redemption occurs between the first anniversary and second anniversary of the closing of the debt exchange offer, 101%; and thereafter, 100%.
The second lien credit agreement contains covenants that are substantially the same as the covenants contained in our senior secured credit facility. Under the terms of the second lien credit agreement, to the extent that the lenders under our senior secured credit facility amend or modify the covenants under such facility, the parallel covenants under the second lien credit agreement shall be automatically deemed amended or modified; provided that the lenders under our senior secured credit facility may not amend or modify the covenant limiting the maximum amount of our senior secured credit facility to the difference between (x) $287 million and (y) the aggregate principal amount of Second Lien Notes issued in connection with our debt exchange offer.
The second lien credit agreement allows us, subject to the conditions in our senior secured credit facility, to purchase, prepay or redeem Subordinated Notes at any time after the debt exchange offer; provided that, with respect to 2008 Notes, (1) we must have a minimum level of availability under our senior secured credit facility of at least $4 million after giving effect to any such purchases and (2) the aggregate amount spent by us to purchase 2008 Notes does not exceed $11 million.
Notwithstanding the foregoing, we may spend more than $11 million in the aggregate to purchase 2008 Notes if we meet the foregoing conditions and we optionally prepay or redeem on a ratable basis a cumulative portion of the Second Lien Notes as follows (percentages and amounts assume that we issued $110 million of aggregate principal amount of Second Lien Notes in connection with the debt exchange offer):
Subject to the Intercreditor Agreement described below, if an event of default (other than an event of default resulting from certain events of bankruptcy, insolvency or reorganization) occurs and is continuing, the second lien agent and the holders of at least 66 2/3% in principal amount of Second Lien Notes then outstanding may declare the principal of and accrued but unpaid interest on all of the Second Lien Notes to be due and payable. If an event of default relating to certain events of bankruptcy, insolvency or reorganization occurs and is continuing, the principal of and interest on all of the Second Lien Notes shall automatically become immediately due and payable without notice or demand of any kind.
The Second Lien Notes are our senior secured obligations and rank: (a) senior in right of payment to all of our existing and future subordinated debt, including the Subordinated Notes; and (b) equal in right of payment with all of our other existing and future senior debt, including indebtedness outstanding under our senior secured credit facility.
The Second Lien Notes are secured by a second-priority lien on substantially all of our domestic assets and a pledge of the capital stock of our domestic subsidiaries and certain of our foreign subsidiaries. The Second Lien Notes are also unconditionally guaranteed by each of direct and indirect domestic subsidiaries.
INTERCREDITOR AGREEMENT
The agent and co-agent for our senior secured credit facility, on the one hand, and the second lien agent for our second lien credit agreement entered into an intercreditor agreement dated as of August 26, 2005 which provides that, among other things, any lien on collateral held by or on behalf of the second lien agent or any holder of the Second Lien Notes that secures all or any portion of the Second Lien Notes will in all respects be junior and subordinate to all liens granted to the lenders under our senior secured credit facility. At any time that the agent or co-agent under our senior secured credit facility notifies the second lien agent in writing that an event of default has occurred and is continuing under such facility, then the second lien agent and the holders of the Second Lien Notes will not have any right to exercise any secured creditor remedies (including without limitation, foreclosing or otherwise realizing upon collateral) or take certain other actions (including, without limitation, commencing or causing to be commenced or joining with any creditor in commencing any insolvency proceeding) until the first to occur of (a) payment in full in cash of all obligations under our senior secured credit facility after or concurrently with termination of all commitments to extend credit thereunder, (b) the date upon which the agent or co-agent under our senior secured credit facility shall have waived or acknowledged in writing the termination of such event of default or (c) 270 days following receipt of such notice by the second lien agent (a "standstill period"). Only two standstill periods may be commenced within any 360 day period, and no subsequent standstill period may be commenced within 60 days after the termination of the immediately preceding standstill period.
The intercreditor agreement also substantially limits the rights of the second lien agent and the holders of the Second Lien Notes in an insolvency proceeding. The intercreditor agreement requires the net proceeds from the sale of collateral to be applied first to our obligations under our senior secured credit facility and then to our obligations under the second lien credit agreement.
SENIOR SUBORDINATED NOTES
In addition to borrowings under our senior secured credit facility, we issued $125.0 million of 2005 Notes and $150.0 million of 2008 Notes.
In connection with our debt exchange offer, on August 26, 2005 we accepted for exchange an aggregate of approximately $75.0 million in principal amount of 2005 Notes (approximately 60.0% of the outstanding 2005 Notes) and approximately $90.1 million in principal amount of 2008 Notes (approximately 60.1% of the outstanding 2008 Notes) that were validly tendered in the debt exchange offer. On September 28, 2005, we issued approximately $4.1 million of Senior Lien Notes in exchange for $4.0 million of 2005 Notes.
Interest is payable on the 2005 Notes on June 15th and December 15th of each year. On July 14, 2005, we made the June 15th interest payment due on the 2005 Notes within the thirty-day grace period permitted by the indenture governing the 2005 Notes. Interest is payable on the 2008 Notes on April 15th and October 15th of each year.
In connection with our debt exchange offer, we obtained the consent of the holders of a majority of the outstanding 2005 Notes and a majority of the outstanding 2008 Notes to amend the indentures governing such Subordinated Notes to eliminate substantially all of the substantive covenants (other than these dealing with certain asset sales and the application of proceeds therefrom and changes of control) and certain events of default (other than these dealing with the payment of interest and principal when due) contained in such indentures. We have entered into supplements to the indentures governing the 2005 Notes and 2008 Notes to reflect such amendments.
Our Subordinated Notes are general unsecured obligations and are subordinated to all our current and future senior debt, including all borrowings under our senior secured credit facility and the Second Lien Notes. The Subordinated Notes rank equally with all our other existing and future senior subordinated indebtedness.
Our current and future domestic restricted subsidiaries jointly and severally guarantee our payment obligations under the Subordinated Notes on a senior subordinated basis. The guarantees rank junior to all senior debt of the guarantors (including guarantees under our senior secured credit facility) and equally with all other senior subordinated indebtedness of the guarantors.
OTHER CREDIT FACILITIES
We maintain credit facilities outside of the United States that locally support our foreign subsidiaries operations and working capital requirements. These facilities are at current market rates in those localities and at certain peak periods of the year, are secured by various assets.
SERIES C PREFERRED STOCK
On August 26, 2005, we issued 135, 088 shares of our Series C preferred stock with a total liquidation preference of $13.5 million. Our restated certificate of incorporation authorizes us to issue up to 150,000 shares of Series C preferred stock.
The Series C preferred stock is non-dividend bearing and ranks, as to distribution of assets upon our liquidation, dissolution or winding up, whether voluntary or involuntary, (a) prior to all shares of convertible preferred stock from time to time outstanding, (b) senior, in preference of, and prior to all other classes and series our preferred stock and (c) senior, in preference of, and prior to all of our now or hereafter issued common stock.
Except as required by law or by certain protective provisions in our restated certificate of incorporation, the holders of shares of Series C preferred stock, by virtue of their ownership thereof, have no voting rights.
In the event of our liquidation, dissolution or winding up, whether voluntary or involuntary, holders of the Series C preferred stock will be paid out of our assets available for distribution to our stockholders an amount in cash equal to $100 per share (the "Series C Preferred Liquidation Preference"), before any distribution is made to the holders of our convertible preferred stock, our common stock or any other of our capital stock ranking junior as to liquidation rights to the Series C preferred stock.
In the event of a change of control (as defined in our restated certificate of incorporation), each holder of shares of Series C preferred stock will have the right to require us to redeem such shares at a redemption price equal to the Series C Preferred Liquidation Preference plus an amount equivalent to interest accrued thereon at a rate of 5% per annum compounded annually on each anniversary date of the issuance date for the period from the issuance date through the change of control. The redemption price is payable on a date after a change of control that is 91 days after the earlier of (x) the date on which specified debt (including indebtedness under our senior secured credit facility, the second lien credit agreement, the
indentures under which the Subordinated Notes were issued, and restatements and refinancings of the foregoing) matures and (y) the date on which all such specified debt is repaid in full, in an amount equal to the Series C Preferred Liquidation Preference plus an amount equivalent to interest accrued thereon at a rate of 5% per annum compounded annually on each anniversary date of the issuance date for the period from the issuance date through such change of control payment date. The certificate of designation for the Series C preferred stock provides that, in the event of a change of control, we shall purchase all outstanding shares of Series C preferred stock with respect to which the holder has validly exercised the redemption right before any payment with respect to the redemption of convertible preferred stock upon such change of control.
We may optionally redeem, in whole or in part, the Series C preferred stock at any time at a cash price per share of 100% of the then effective Series C Preferred Liquidation Preference per share. On the fifth anniversary of the issuing date, we will be required to redeem all outstanding shares of Series C preferred stock at a price equal to the Series C Preferred Liquidation Preference per share, payable in cash.
CONVERTIBLE PREFERRED STOCK
On July 28, 1998, we issued $40.0 million of convertible preferred stock in connection with a Stock Purchase Agreement dated July 15, 1998. The convertible preferred stock is non-dividend bearing except if we breach, in any material respect, any of the material obligations in the preferred stock agreement or our restated certificate of incorporation relating to the convertible preferred stock, the holders of the convertible preferred stock are entitled to receive quarterly cash dividends on each share from the date of the breach until it is cured at a rate per annum equal to 12 1/2% of the Liquidation Preference (defined below). The preferred shares are convertible into 3,529,411 shares of our common stock (reflecting an $11.33 per share conversion price). The holders of the convertible preferred stock are entitled to one vote for each share of our common stock that the holder would receive upon conversion of the convertible preferred stock. In connection with the convertible preferred stock issuance, two individuals representing the purchasers of the preferred stock were appointed to serve on our Board of Directors.
In the event of a change in control, each preferred shareholder has the right to require to redeem the shares at a redemption price equal to the Liquidation Preference (defined below) plus interest accrued thereon at a rate of 7% per annum compounded annually each anniversary date from July 28, 1998 through the earlier of the date of such redemption or July 28, 2003.
In the event of a liquidation, dissolution or winding up, whether voluntary or involuntary, holders of the convertible preferred stock are entitled to be paid out of the assets of the Company available for distribution to its stockholders an amount in cash equal to $1,000 per share, plus the amount of any accrued and unpaid dividends thereon (the "Liquidation Preference"), before any distribution is made to the holders of any our common stock or any other of its capital stock ranking junior as to liquidation rights to the convertible preferred stock.
We may optionally convert in whole or in part, the convertible preferred stock at any time on and after July 15, 2003 at a cash price per share of 100% of the then effective Liquidation Preference per share, if the daily closing price per share of our common stock for a specified 20 consecutive trading day period is greater than or equal to 200% of the then current conversion price. On September 15, 2008, we will be required to exchange all outstanding shares of convertible preferred stock at a price equal to the Liquidation Preference per share, payable at the Company's option in cash or shares of our common stock.
NEW ACCOUNTING PRONOUNCEMENTS
In May 2005, the Financial Accounting Standards Board (FASB) issued Statement No. 154, "Accounting Changes and Error Corrections: A Replacement of APB Opinion No. 20 and FASB Statement No. 3." This Statement changes the requirements for the accounting for and reporting of a voluntary change in accounting principle, and also applies to instances when an accounting pronouncement does not include specific transition provisions. This Statement replaces the previous requirement that voluntary changes be recognized by including the cumulative effect of the change in net income of the period of the change. This
Statement requires retrospective application of a new accounting principle to prior periods' financial statements, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. This Statement is effective for changes and corrections made in fiscal years beginning after December 15, 2005. The Company does not expect the adoption of this Statement to have a material effect on its financial condition, results of operations, or cash flows.
In December 2004, the FASB issued Statement No. 153, "Exchanges of Nonmonetary Assets: An Amendment of APB Opinion No. 29." APB Opinion No. 29 provided certain exceptions to the principle that exchanges of nonmonetary assets should be measured based on the fair value of the assets exchanged. This Statement amends the guidance in that Opinion by replacing the exception for nonmonetary exchanges of similar productive assets with a general exception for exchanges of nonmonetary assets that do not have commercial substance. Commercial substance in a nonmonetary exchange exists if the future cash flows of the entity are expected to change significantly as a result of the exchange. This Statement is effective for nonmonetary exchanges occurring in fiscal periods beginning after June 15, 2005. The Company does not expect the adoption of this Statement to have a material effect on its financial condition, results of operations, or cash flows.
In November 2004, the FASB issued Statement No. 151, "Inventory Costs: An Amendment of ARB No. 43, Chapter 4." This Statement clarifies the accounting for abnormal inventory costs, such as idle facility expense, freight, handling costs, and wasted materials, by requiring those items be recognized as current period charges. The provisions of this Statement are effective for inventory costs incurred during fiscal years beginning after June 15, 2005, and should be applied prospectively. The Company will be adopting this Statement for the first quarter of fiscal 2006, beginning July 3, 2005, and does not expect a material impact on its financial condition, results of operations, or cash flows.
In March 2005, the FASB issued FASB Interpretation No. 47, "Accounting for Conditional Asset Retirement Obligations" to clarify certain provisions of FASB Statement No. 143, "Accounting for Asset Retirement Obligations." Interpretation No. 47 specifies that the term "conditional asset retirement obligation" includes an entity's legal obligation to perform an asset retirement activity for which the timing and (or) method of settlement are conditional on a future event that may or may not be in the control of the entity. This Interpretation provides that an entity is required to recognize a liability for a conditional asset retirement obligation if the fair value of the obligation can be reasonably estimated. Interpretation No. 47 is effective no later than the end of fiscal years ending after December 15, 2005. The Company is currently evaluating the impact of this interpretation on its financial statements.
In December 2004, the FASB issued Statement No. 123(R), "Share Based Payment", which replaces Statement No. 123, "Accounting for Stock-Based Compensation," and Accounting Principles Board (APB) Opinion No. 25, "Accounting for Stock Issued to Employees." This Statement requires compensation expense to be measured based on fair value of the stock options, and to be recognized as an expense on the financial statements. This Statement is effective for fiscal periods beginning after June 15, 2005. The Company will be adopting this Statement for the first quarter of fiscal 2006, beginning July 3, 2005. Upon the adoption of SFAS No. 123(R), the Company will be required to expense stock options over the vesting period in its statement of operations. In addition, the Company will need to recognize expense over the remaining vesting period associated with unvested options outstanding as of the beginning of fiscal 2006. For the years ended July 2, 2005, July 3, 2004 and June 28, 2003, total stock-based employee compensation expense, net of related tax effects, determined under this new standard would have been $1.5 million, $1.5 million and $2.0 million, respectively. Based on the Company's analysis of unvested options as of July 3, 2005, the estimated impact of adopting SFAS No. 123(R) will be to add approximately $0.3 million, net of tax benefits, to our annual operating expense. This amount is subject to change should management grant additional stock options.
On October 22, 2004, the American Jobs Creation Act (the "AJCA") was signed into law. The AJCA provides for a deduction of 85% of certain foreign earnings that are repatriated, as defined in the AJCA. The Company has completed its evaluation of the repatriation provision of the AJCA and does not intend to apply this provision to qualifying foreign earnings repatriations. The Company currently has options to
employ lower tax alternatives for potential future foreign earnings repatriations, including accumulated foreign earnings that were previously taxed in the U.S., as well as the use of the Company's U.S. net operating loss carryforward.
DISCUSSION OF CRITICAL ACCOUNTING POLICIES
Our financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America, which require us to make estimates and judgments that significantly affect the reported amounts of assets, liabilities, revenues and expenses and related disclosure of contingent assets and liabilities. We regularly evaluate these estimates, including those related to our allowance for doubtful accounts, reserve for inventory valuation, reserve for returns and allowances, valuation of reporting units with goodwill, valuation of intangible assets having indefinite lives, cooperative advertising accruals, pension benefits and depreciation and amortization. We base these estimates on historical experience and on assumptions that are believed by management to be reasonable under the circumstances. Actual results may differ from these estimates, which may impact the carrying value of assets and liabilities.
The following critical accounting policies required the most significant estimates used in the preparation of our consolidated financial statements:
ALLOWANCE FOR DOUBTFUL ACCOUNTS -- We calculate allowances for estimated losses resulting from the inability of our customers to make required payments. We utilize a number of tools to evaluate and mitigate our customer credit risk. Management evaluates each new customer account using a combination of some or all of the following sources of information: credit bureau reports, industry credit group reports, customer financial statement analysis, customer supplied credit references and bank references. Appropriate credit limits are set in accordance with our credit risk policy and monitored on an on-going basis. Existing customers are monitored and credit limits are adjusted according to changes in their financial condition. Based on the procedures outlined herein, and the fact that no customer accounted for 10.0% or more of the gross accounts receivable at July 2, 2005 and July 3, 2004, we believe there is no concentration of credit risk.
Our exposure to credit loss on our foreign currency forward contracts in the event of non-performance by the counterparties is believed to be remote due to the requirements that the counterparties consist only of major financial institutions that have a long-term credit rating of single-A or better from both Moody's and Standard& Poor's. Additionally, our foreign currency forward contracts generally have a term of one year or less.
INVENTORY VALUATION -- The Company values inventory at the lower of cost or market, and regularly reviews the book value of discontinued product lines and stock keeping units (SKUs) to determine if these items are properly valued. If market value is less than cost, the Company writes down the related inventory to the estimated net realizable value. The Company regularly evaluates the composition of inventory to identify slow-moving and obsolete inventories to determine if additional write-downs are required. The Company's domestic inventories are generally determined by the last-in, first-out (LIFO) method. These inventories account for approximately 50.7% and 53.7% of the Company's inventories as of 2005 and 2004, respectively. All remaining inventory cost is determined on the first-in, first-out basis. See Note 4 "Inventories."
COMMITMENTS AND CONTINGENCIES -- We are subject to lawsuits and other claims related to product and other matters that are being defended and handled in the ordinary course of business. We maintain reserves and or accruals for such costs that may be incurred, which are determined on a case-by-case basis, taking into consideration the likelihood of adverse judgments or outcomes, as well as the potential range of probable loss. The reserves and accruals are monitored on an ongoing basis and are updated for new developments or new information as appropriate.
INTANGIBLE ASSETS -- We record intangible assets through transactions and acquisitions. The cost of acquisitions are allocated to the assets and liabilities acquired, including identifiable intangible assets, with
the remaining amount being classified as goodwill. Under current accounting guidelines that became effective on July 1, 2001, goodwill arising from transactions occurring after July 1, 2001 and any existing goodwill as of June 30, 2002 are not amortized to expense but rather assessed annually for impairment. Other intangible assets that have an indefinite life are also assessed annually for impairment.
The allocation of the acquisition cost to intangible assets and goodwill therefore has a significant impact on our future operating results. The allocation process requires the extensive use of estimates and assumptions, including estimates of future cash flows expected to be generated by the acquired assets. Further, when impairment indicators are identified with respect to previously recorded intangible assets, the values of the assets are determined using a variety of techniques including discounted future cash flows, which are based on estimated future operating results. Significant management judgment is required in the forecasting of future operating results, which are used in the preparation of projected discounted cash flows.
COMMITMENTS AND CONTINGENCIES
To facilitate an understanding of the Company's contractual obligations and commercial commitments, the following data is provided:
(1) Reflects commitments subsequent to July 2, 2005 for debt exchange of senior subordinated notes due 2005 and 2008 for senior second lien notes due 2008. Amounts do not include interest payments.
(2) Includes $0.9 million of loan notes that are fully funded by cash held in escrow. Also, includes $47.6 million of borrowings as of July 2, 2005 under the senior secured revolving credit facility that is classified as current because the agreement includes a subjective acceleration clause and the Company's lockbox account is currently under the exclusive dominion and control of the senior lenders. Additionally, includes $46.0 million Senior Subordinated debt due December 15, 2005.
(1) Includes non-cancelable license agreements. Several of these commitments have the option to be extended at the option of management. Payments beyond the original agreement have not been included above.
(2) Contributions to the Company's defined benefit plans are determined annually based on actuarial valuations. Future period contribution reflect known commitments.
(3) Settlement relating to preferential payments under the U.S. Bankruptcy code.
(4) Agreement with George Foreman for professional appearances associated with the promotion of the George Foreman product line.
(5) Additional consideration to be paid to Sonex International Corporation based on net sales after allowances, commencing after net sales of Sonex products exceed $20.0 million. As of July 2, 2005, the Company will continue to accrue and shall owe up to an additional $2.8 million.
FORWARD LOOKING
We anticipate capital expenditures on an ongoing basis to be at historical levels in relation to net sales.
We believe that (a) future cash flow from operations based on our current level of operations, (b) available borrowings under our senior secured credit facility, second lien credit agreement and other sources of debt funding and (c) funds from the sale or monetization of certain assets will be adequate to meet our anticipated requirements for current capital expenditures, working capital requirements, interest and income tax payments and scheduled debt payments, including the remaining outstanding 2005 Notes, for the next twelve months. Our ability to satisfy our anticipated liquidity requirements, however, is subject to several assumptions, some of which are beyond our control, including: (a) general economic, financial, competitive and other factors; (b) our continued compliance with covenants in our debt instruments; and (c) our ability to repurchase Subordinated Notes in the open market and/or through privately negotiated transactions for cash or other securities (including Second Lien Notes, common stock and/or Series C preferred stock). If we are unable to satisfy our liquidity needs, we could be required to adopt one or more alternatives, such as reducing or delaying capital expenditures, borrowing additional funds, restructuring indebtedness, selling other assets or operations and/or reducing expenditures for new product development, cutting other costs, and some or such actions would require the consent of our senior lenders, holders of Second Lien Notes and/or the holders of our Subordinated Notes. We cannot assure you that any of such actions could be effected, or if so, on terms favorable to us, that such actions would enable us to continue to satisfy our liquidity needs and/or that such actions would be permitted under the terms of our senior secured credit facility, the second lien credit agreement or the indentures governing our Subordinated Notes.
Factors that could affect our liquidity and capital resources are also discussed in Item 1. "Business -- Risk Factors."
UNAUDITED PRO FORMA FINANCIAL INFORMATION
As described in Recent Developments, we completed the debt exchange offer on August 26, 2005 and we completed the sale of our 52.6% interest in AMAP on September 29, 2005.
The unaudited pro forma condensed consolidated financial information shown below is based on audited historical financial statements of the Company. The unaudited pro forma financial information presented reflects the estimated pro forma effect of the debt exchange and the disposition of AMAP (the "Transactions"). In accordance with SFAS No. 15, "Accounting by Debtors and Creditors for Troubled Debt Restructurings," the debt exchange will be treated as a troubled debt restructuring.
The unaudited pro forma condensed consolidated balance sheet of the Company reflects the Transactions as if they occurred on July 2, 2005. The unaudited pro forma condensed consolidated statement of operations for the year ended July 2, 2005 reflects the Transactions as if they had occurred on July 4, 2004. The pro forma adjustments are based on the operating results for AMAP during the period presented, and the reduction and reclassification of debt and gains resulting from the Transactions.
The pro forma financial information is based on presently available information and is not necessarily indicative of the results that would have been reported had the transactions actually occurred on the dates specified. The pro forma gains on the Transactions are based on book values of assets and liabilities, as well as interest rates and exchange rates as of July 2, 2005. The final accounting for the Transactions will be finalized prior to the filing of the Company's Quarterly Report on Form 10-Q for the quarter ended October 1, 2005. The Company's actual recording of the Transactions may differ from the pro forma financial information. The pro forma financial information does not purport to indicate the future consolidated financial position or future consolidated results of operations of the Company.
SALTON, INC.
UNAUDITED PRO FORMA CONDENSED CONSOLIDATED BALANCE SHEET
AS OF JULY 2, 2005 (IN THOUSANDS)
See accompanying notes to unaudited pro forma condensed consolidated balance sheet.
SALTON, INC.
UNAUDITED PRO FORMA CONDENSED CONSOLIDATED BALANCE SHEET (CONTINUED)
AS OF JULY 2, 2005 (IN THOUSANDS)
See accompanying notes to unaudited pro forma condensed consolidated balance sheet.
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(1) Reflects the elimination of costs associated with the exchange offer.
(2) Reflects the income tax effect of the gain on the debt exchange.
(3) Reflects the write-off of unamortized financing fees, prorated for the redeemed 2005 and 2008 bonds.
(4) Reflects the accrual of additional costs associated with the debt exchange.
(5) Reflects the reversal of accrued interest of $2.8 million on the redeemed 2005 and 2008 bonds, which is forgiven under the terms of the debt exchange, and the inclusion of interest due January 15, 2006 of $5.8 million on the new notes.
(6) Reflects the elimination of the extinguished 2005 and 2008 bonds.
(7) Reflects the future cash payments of the new notes, including interest of $22.2 million, as required under the provisions of SFAS No. 15, "Accounting for Debtors and Creditors for Troubled Debt Restructurings."
(8) Reflects the present value of $13.5 million of liquidation value, redeemable in 5 years, based on a discount rate of 10.73%.
(9) Reflects the par value of 2,039,469 shares of common stock issued in connection with the debt exchange
(10) Reflects the market value of 2,039,469 shares of common stock as of July 2, 2005 ($1.13 per share), less par and prorated issuance costs.
(11) Represents the gain, net of income tax of $9.8 million, on the exchange of debt, accounted for in accordance with SFAS No. 15.
(12) Reflects the elimination of AMAP's assets and liabilities.
(13) Reflects the income tax effect of the gain on the disposition of AMAP.
(14) Reflects the amount of debt to be paid using the proceeds from the disposition.
(15) Reflects the elimination of the investment in AMAP.
(16) Represents the gain, net of income tax of $17.1 million, on the disposition of AMAP.
SALTON, INC.
UNAUDITED PRO FORMA CONDENSED CONSOLIDATED STATEMENT OF OPERATIONS YEAR ENDED JULY 2, 2005 (IN THOUSANDS EXCEPT PER SHARE DATA)
See accompanying notes to unaudited pro forma condensed consolidated statement of operations. (1) Reflects the elimination of interest expense associated with exchanged 2005 and 2008 notes, offset with accreted interest on the Series C Preferred Stock.
(2) Reflects the income tax effects of adjustment (1), based on a 37.43% tax rate.
(3) Reflects the issuance of common stock in connection with the debt exchange.
(4) Does not include the anticipated gain before taxes of approximately $24.0 million from early extinguishment of debt to be accounted for in accordance with SFAS No. 15.
(5) Does not include the gain before taxes on the sale of AMAP of approximately $49.0 million.
(6) Includes the elimination of interest expense of $6.2 million related to the Company's debt as a result of the extinguishment of certain of its debt with the proceeds from the disposition.
(7) Includes the income tax effects of adjustment (6), based on a 37.43% tax rate.
ITEM 7a.
ITEM 7a. Quantitative and Qualitative Disclosures about Market Risk
We use derivative financial instruments to manage interest rate and foreign currency risk. Our objectives in managing our exposure to interest rate changes are to limit the impact of interest rate changes on earnings and cash flows and to lower our overall borrowing costs through the use of interest rate swaps. Our objectives in managing our exposure to foreign currency fluctuations is to reduce the impact of changes in foreign exchange rates on consolidated results of operations and future foreign currency denominated cash flows. We do not enter into derivative financial instruments for trading purposes. Our policy is to manage interest rate risk through the use of a combination of fixed and variable rate debt, and hedge foreign currency commitments of future payments and receipts by purchasing foreign currency forward contracts. The following tables provide information about our market sensitive financial instruments and constitutes a "forward-looking statement." Our major risk exposures are changing interest rates in the United States and foreign currency commitments in our foreign subsidiaries. The fair values of our long-term, fixed rate debt and foreign currency forward contracts were estimated based on dealer quotes. The carrying amount of short-term debt and long-term variable-rate debt approximates fair value. All items described in the tables are non-trading.
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(1) The current portion of the long-term fixed rate debt amount consists of Sr. Subordinated Notes due December 15, 2005. This amount does not include $66,031 of extinguished Sr. Subordinated Notes related to the debt exchange subsequent to year end (see Note 20, "Subsequent Events" footnote).
(2) The variable rate amount due fiscal 2008 consists of $100,000 senior secured credit facility and $103,098 of Second Lien Notes (see Note 20, "Subsequent Events" footnote)
(3) The average interest rate on the variable rate debt due fiscal 2008 is the weighted average rate of the senior secured credit facility and the Second Lien Notes. The variable rate senior secured credit facility is set periodically at an established base rate (equivalent to the prime rate of interest) plus an applicable margin or, at our election, a LIBOR rate plus an applicable margin. The variable rate on the Second Lien Credit facility is set at a LIBOR rate plus an applicable margin.
We use foreign currency forward contracts with terms of less than one year, to hedge our exposure to changes in foreign currency exchange rates. In managing our foreign currency exposures, we identify and aggregate naturally occurring offsetting positions and then hedge residual balance sheet exposures. At July 2, 2005, we had forward contracts outstanding for the purchase of $52.8 million over the course of the next twelve months, which had an aggregate fair value of $2.3 million.
ITEM 8.
ITEM 8. Financial Statements and Supplementary Data
The consolidated financial statements of the Company, including the notes to all such statements and other supplementary data are included in this report beginning on page.
ITEM 9.
ITEM 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None
ITEM 9A.
ITEM 9A. Controls and Procedures
DISCLOSURE CONTROLS AND PROCEDURES
Salton carried out an evaluation, under the supervision and with the participation of Salton's management, including Salton's Chief Executive Officer and Senior Financial Officer, of the effectiveness of the design and operation of Salton's disclosure controls and procedures pursuant to Rule 13a-15 under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), as of July 2, 2005. Based upon that evaluation, the Chief Executive Officer and Senior Financial Officer concluded that Salton's disclosure controls and procedures were effective to ensure that information required to be disclosed by the Company (including its consolidated subsidiaries) in the reports the Company files or submits under the Exchange Act, is recorded, processed, summarized and reported within the periods specified in the SEC's rules and forms.
MANAGEMENT'S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
Salton's management is responsible for establishing and maintaining adequate internal control over financial reporting, as defined in Exchange Act Rule 13a-15(f). The Company's management conducted an assessment of the Company's internal control over financial reporting based on the framework established by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control -- Integrated Framework. Based on the assessment, Salton's management has concluded that, as of July 2, 2005, the Company did not maintain effective internal control over financial reporting. This determination resulted from issues related to the preparation and review of its income tax provision and related income tax accounting procedures as described below. Management has determined that this control deficiency constitutes a material weakness as defined by the Public Company Accounting Oversight Board's Auditing Standard No. 2.
In the course of its assessment, management determined that the loss of key personnel late in the year placed additional burden on the Company's resources to complete all year end tax procedures and reviews on a timely basis including reconciliations that are designed to ensure the recording of proper amounts and classifications in the tax accounts. This situation was compounded by several complex domestic and international tax matters including the Company's debt exchange offer and the sale of AMAP, coupled with the need for tax management to quickly retain and manage external resources new to the Company's structure. These conditions resulted in more than a remote likelihood that a material misstatement of the Company's annual or interim financial statements with respect to income taxes would not have been prevented or detected, on a timely basis, by Company employees in the normal course of performing their assigned functions. Specifically, errors were detected by the Company's independent registered public accounting firm, Deloitte & Touche LLP, that resulted in an adjustment to current and deferred income tax expense and accrued income tax balances. These errors were corrected, and the corrections are reflected in the audited consolidated financial statements for the year ended July 2, 2005.
Remediation of the issue began prior to year end with the retention of external resources to supplement the Company's tax personnel, and it continues with their growing knowledge of the Company. With the completion of the Company's debt exchange offer and sale of AMAP, internal resources are less constrained and the Company is in a stronger position financially to attract and hire additional quality personnel, which is underway.
The Company's independent registered public accounting firm, Deloitte & Touche LLP, have issued an attestation report on management's assessment of the Company's internal control over financial reporting, as of July 2, 2005. That report appears below.
CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING
There was no change in internal control over financial reporting that occurred in the fourth quarter of fiscal 2005, that has materially affected or is reasonably likely to materially affect Salton's internal controls over financial reporting.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of Salton, Inc. Lake Forest, Illinois
We have audited management's assessment, included in the accompanying management's report on internal control over financial reporting, that Salton, Inc. and subsidiaries (the "Company") did not maintain effective internal control over financial reporting as of July 2, 2005, because of the effect of the material weakness identified in management's assessment based on criteria established in Internal Control -- Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management's assessment and an opinion on the effectiveness of the Company's internal control over financial reporting based on our audit.
We conducted our audit 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 effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management's assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.
A company's internal control over financial reporting is a process designed by, or under the supervision of, the company's principal executive and principal financial officers, or persons performing similar functions, and effected by the company's board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.
Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
A material weakness is a significant deficiency, or combination of significant deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. The following material weakness has been identified and included in management's assessment:
- - The Company's controls over the calculation of the income tax provision, taxes payable and deferred income tax amounts did not operate effectively as of July 2, 2005. In particular, the Company did not have a sufficient number of personnel with adequate expertise in domestic and foreign income tax accounting matters. Additionally, account reconciliations, which are necessary to detect whether income tax amounts are calculated properly and recorded in the proper period, were not completed and reviewed in time to permit timely reporting of financial results. The ineffective controls resulted in audit adjustments to the provision for income taxes identified by us that were recorded by the Company. Although the recorded adjustments were not material to the consolidated financial statements, we concluded that due to the potential that a material misstatement could occur related to income taxes and due to the absence of mitigating controls, there was more than a remote likelihood that a material misstatement of the interim and annual financial statements would not have been prevented or detected.
This material weakness was considered in determining the nature, timing, and extent of audit tests applied in our audit of the consolidated financial statements and financial statement schedule as of and for the year ended July 2, 2005, of the Company and this report does not affect our report on such financial statements and financial statement schedule.
In our opinion, management's assessment that the Company did not maintain effective internal control over financial reporting as of July 2, 2005, is fairly stated, in all material respects, based on the criteria established in Internal Control -- Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Also in our opinion, because of the effect of the material weakness described above on the achievement of the objectives of the control criteria, the Company has not maintained effective internal control over financial reporting as of July 2, 2005, based on the criteria established in Internal Control -- Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements and financial statement schedule as of and for the year ended July 2, 2005, of the Company and our report dated September 28, 2005 expressed an unqualified opinion on those financial statements and financial statement schedule.
Chicago, Illinois September 28, 2005
PART III
ITEM 10.
ITEM 10. Directors and Executive Officers of the Registrant
The information required by this Item 10 as to the Directors of the Company is incorporated herein by reference to the information set forth under the caption "Election of Directors" in the Company's definitive Proxy Statement for the 2005 Annual Meeting of Stockholders, since such Proxy Statement will be filed with the Securities and Exchange Commission not later than 120 days after the end of our fiscal year pursuant to Regulation 14A. Information required by this Item 10 as to the executive officers of the Company is included in Part I of this Annual Report on Form 10-K.
ITEM 11.
ITEM 11. Executive Compensation
The information required by this Item 11 is incorporated by reference to the information set forth under the caption "Compensation of Directors and Executive Officers" in the Company's definitive Proxy Statement for the 2005 Annual Meeting of Stockholders, since such Proxy Statement will be filed with the
Securities and Exchange Commission not later than 120 days after the end of our fiscal year pursuant to Regulation 14A.
ITEM 12.
ITEM 12. Security Ownership of Certain Beneficial Owners and Management
The information required by this Item 12 is incorporated by reference to the information set forth under the caption "Stock Ownership of Principal Holders and Management" in the Company's definitive Proxy Statement for the 2005 Annual Meeting of Stockholders, since such Proxy Statement will be filed with the Securities and Exchange Commission not later than 120 days after the end of our fiscal year pursuant to Regulation 14A.
EQUITY COMPENSATION PLAN INFORMATION
This table shows information about the securities authorized for issuance under our equity compensation plans as of July 2, 2005.
(1) Includes: 1992 Stock Option Plan, 1995 Stock Option Plan, 1995 Non-Employee Directors Stock Option Plan, 1998 Stock Option Plan, 2002 Stock Option Plan.
(2) Includes our: 1999 Stock Option Plan, 2000 Stock Option Plan, 2001 Stock Option Plan.
ITEM 13.
ITEM 13. Certain Relationships and Related Transactions
The information required by this Item 13 is incorporated by reference to the information set forth under the caption "Certain Transactions" in the Company's definitive Proxy Statement for the 2005 Annual Meeting of Stockholders, since such Proxy Statement will be filed with the Securities and Exchange Commission not later than 120 days after the end of our fiscal year pursuant to Regulation 14A.
ITEM 14.
ITEM 14. Principal Accounting Fees and Services
This information is in the Proxy Statement under the heading "Independent Auditor Information" and is incorporated by reference.
PART IV
ITEM 15.
ITEM 15. Exhibits and Financial Statement Schedules
(A)1 AND 2
An "Index to Financial Statements and Financial Statement Schedules" has been filed as a part of this Report beginning on page hereof.
(A)(3) EXHIBITS:
An "Exhibit Index" has been filed as part of this Report beginning on page E-1 hereof and is incorporated herein by reference.
SIGNATURES
Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, as amended (the "Exchange Act") the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized on the 30 day of September, 2005.
SALTON, INC.
By: /s/ DAVID M. MULDER ------------------------------------ David M. Mulder Executive Vice President, Chief Administrative Officer and Senior Financial Officer
Pursuant to the requirements of the Exchange Act, this report has been signed below by the following persons on behalf of the Registrant and in the capacities indicated on September 30, 2005.
SALTON, INC.
INDEX TO FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES YEAR ENDED JULY 2, 2005
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of Salton, Inc. Lake Forest, Illinois
We have audited the accompanying consolidated balance sheets of Salton, Inc. and subsidiaries (the "Company") as of July 2, 2005 and July 3, 2004, and the related consolidated statements of income, stockholders' equity, and cash flows for each of the three years in the period ended July 2, 2005. Our audits also included the financial statement schedule listed in the Index at Item 15. These financial statements and financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on the financial statements and financial statement schedule based on our audits.
We conducted our audits 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Salton, Inc. and subsidiaries as of July 2, 2005 and July 3, 2004, and the results of their operations and their cash flows for each of the three years in the period ended July 2, 2005, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company's internal control over financial reporting as of July 2, 2005, based on the criteria established in Internal Control -- Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated September 28, 2005 expressed an unqualified opinion on management's assessment of the effectiveness of the Company's internal control over financial reporting and an adverse opinion on the effectiveness of the Company's internal control over financial reporting. Chicago, Illinois September 28, 2005
SALTON, INC.
CONSOLIDATED BALANCE SHEETS
JULY 2, 2005 AND JULY 3, 2004 (IN THOUSANDS EXCEPT SHARE DATA)
See notes to consolidated financial statements.
SALTON, INC.
CONSOLIDATED BALANCE SHEETS (CONTINUED)
JULY 2, 2005 AND JULY 3, 2004 (IN THOUSANDS EXCEPT SHARE DATA)
See notes to consolidated financial statements.
SALTON, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS YEARS ENDED JULY 2, 2005, JULY 3, 2004, AND JUNE 28, 2003 (IN THOUSANDS EXCEPT PER SHARE DATA)
See notes to consolidated financial statements.
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SALTON, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY YEARS ENDED JUNE 28, 2003, JULY 3, 2004 AND JULY 2, 2005 (IN THOUSANDS)
See notes to consolidated financial statements.
See notes to consolidated financial statements.
SALTON, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
YEARS ENDED JULY 2, 2005, JULY 3, 2004 AND JUNE 28, 2003 (IN THOUSANDS)
See notes to consolidated financial statements.
SALTON, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS YEARS ENDED JULY 2, 2005, JULY 3, 2004, AND JUNE 28, 2003 (IN THOUSANDS EXCEPT SHARE DATA)
SUPPLEMENTAL DISCLOSURE OF NONCASH INVESTING AND FINANCING ACTIVITIES:
In the quarter ended July 2, 2005, the Company incurred a capital lease obligation of $580.
In the quarter ended April 2, 2005, the Company incurred a capital lease obligation of $81.
In the quarter ended July 3, 2004, the Company entered into an amended and restated senior secured revolving credit facility ("amended agreement"). Concurrently with the repayment of the terminated credit agreement, the Company recorded $5,925 in financing fees, funded by proceeds from the amended agreement.
In the quarter ended March 27, 2004, the Company issued 146,902 shares of common stock purchase out of treasury in lieu of cash for the final payment to one of the venture participants under the Foreman obligation.
In the quarter ended December 27, 2003, the Company incurred a capital lease obligation of $705.
In the quarter ended September 28, 2002, the Company incurred a capital lease obligation of $418.
In the quarter ended September 28, 2002, the Company authorized the issuance of 184,980 shares of common stock for payment of executive bonuses.
See notes to consolidated financial statements. (Concluded)
SALTON, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED JULY 2, 2005, JULY 3, 2004, AND JUNE 28, 2003
1. SUMMARY OF SIGNIFICANT ACCOUNTING PRINCIPLES
Salton, Inc. (the "Company" or "Salton") is a leading designer, marketer and distributor of branded, high quality small home appliances and electronics for the home, home decor and personal care products. Salton's product mix includes a broad range of kitchen and home appliances, electronics, tabletop products, time products, lighting products, picture frames and personal care and wellness products. Salton sells its products under its portfolio of well recognized brand names such as Salton(R), George Foreman(R), Westinghouse(TM), Toastmaster(R), Melitta(R), Russell Hobbs(R), Farberware(R), Ingraham(R) and Stiffel(R). Salton believes its strong market position results from its well-known brand names, high quality and innovative products, strong relationships with its customer base and the Company's focused outsourcing strategy.
Principles of Consolidation -- The consolidated financial statements include the accounts of all majority-owned subsidiaries. Investments in affiliates, in which the Company has the ability to exercise significant influence, but not control, are accounted for by the equity method. Intercompany balances and transactions are eliminated in consolidation.
Fiscal Year -- The Company's fiscal year ends on the Saturday closest to June 30. Unless otherwise stated, references to years in this report relate to fiscal years rather than calendar years. The effect of the additional week in 2004 had an insignificant impact on results.
Foreign Currency -- Salton's reporting currency is the U.S. Dollar. Salton's foreign subsidiaries functional currencies are their local currencies. Translation adjustments resulting from translating the functional currency financial statements into U.S. Dollars are reported separately in accumulated other comprehensive income in the consolidated statements of stockholders' equity. Gains and losses from foreign currency transactions are recognized in the consolidated statements of operations. The Company recorded net foreign currency transaction gains (losses) of $1.7 million, $(0.6) million and $0.9 million in fiscal 2005, 2004 and 2003, respectively.
Reclassifications -- The consolidated balance sheet as of July 3, 2004 and the consolidated statements of cash flows for the years ended July 3, 2004 and June 28, 2003 have been restated to conform to the current year presentation. Outstanding checks totaling $3.6 million and $3.1 million as of July 3, 2004 and June 28, 2003, respectively, were previously included in accrued expenses and have been reclassified against cash. Additionally, the foreign non-current deferred tax liability of $4.3 million as of July 3, 2004 was segregated from the domestic non-current deferred tax asset. This reclassification effectively increased the non-current deferred tax asset balance by the same amount. An additional $6.1 million was also reclassified from current deferred tax assets to non-current deferred tax assets.
Use of Estimates -- In preparing financial statements in conformity with accounting principles generally accepted in the United States of America, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and revenues and expenses during the reporting period. Actual results could differ from those estimates. Significant estimates include the allowance for doubtful accounts, reserve for inventory valuation, reserve for returns and allowances, valuation of reporting units with goodwill, valuation of intangible assets having indefinite lives, cooperative advertising accruals, pension benefits and estimated lives of fixed assets and intangibles.
Compensating Balances on Deposit -- The Company utilizes a facility with a bank to provide short-term documentary credits to conduct business with its suppliers in certain countries. These arrangements require that funds be held on deposit as security for this facility.
Allowance for Doubtful Accounts -- The Company calculates allowances for estimated losses resulting from the inability of customers to make required payments. The Company utilizes a number of tools to evaluate and mitigate customer credit risk. Management evaluates each new customer account using a combination of some or all of the following sources of information: credit bureau reports, industry credit group reports, customer financial statement analysis, customer supplied credit references and bank references. Appropriate credit limits are set in accordance with company credit risk policy and monitored on an on-going basis. Existing customers are monitored and credit limits are adjusted according to changes in their financial condition. Based on the procedures outlined herein, and the fact that no customer accounted for 10.0% or more of the gross accounts receivable at July 2, 2005 and July 3, 2004, the Company believes there is no concentration of credit risk.
The Company's exposure to credit loss on its foreign currency forward contracts in the event of non-performance by the counterparties is believed to be remote due to the Company's requirement that the counterparties consist only of major financial institutions that have a long-term credit rating of single-A or better from both Moody's and Standard& Poor's. Additionally, its foreign currency forward contracts generally have a term of one year or less.
Inventories -- The Company values inventory at the lower of cost or market, and regularly reviews the book value of discontinued product lines and stock keeping units (SKUs) to determine if these items are properly valued. If market value is less than cost, the Company writes down the related inventory to the estimated net realizable value. The Company regularly evaluates the composition of inventory to identify slow-moving and obsolete inventories to determine if additional write-downs are required. The Company's domestic inventories are generally determined by the last-in, first-out (LIFO) method. These inventories account for approximately 50.7% and 53.7% of the Company's inventories as of 2005 and 2004, respectively. All remaining inventory cost is determined on the first-in, first-out basis. See Note 4 "Inventories."
Property, Plant and Equipment -- Property, plant and equipment are stated at cost. Expenditures for maintenance costs and repairs are charged against income. Depreciation, which includes amortization of assets under capital leases, as well as depreciation for leasehold improvements, is based on the straight-line method over the shorter of the period of the lease or the estimated useful lives of the assets (see table below). For tax purposes, assets are depreciated using accelerated methods.
Depreciation expense charged to operations was $15.9 million in 2005, $18.1 million in 2004 and $13.5 million in 2003.
Patents, Tradenames and Other Identifiable Intangible Assets -- The identifiable intangible assets of the Company are primarily tradenames acquired in transactions and business combinations. Identifiable intangibles with finite lives are amortized and those with indefinite lives are not amortized. The estimated useful life of an identifiable intangible asset to the Company is based upon a number of factors including the effects of demand, competition and the level of maintenance expenditures required to obtain future cash flows.
The Company tests identifiable intangible assets with an indefinite life for impairment, at a minimum on an annual basis, relying on a number of factors including operating results, business plans and projected future cash flows. Identifiable intangible assets that are subject to amortization are evaluated for impairment using a process similar to that used to evaluate other long-lived assets. The impairment test for identifiable intangible assets not subject to amortization consists of a comparison of the fair value of the intangible
asset with its carrying amount. An impairment loss is recognized for the amount by which the carrying value exceeds the fair value of the asset. Currently, the Company does not have material definite-lived intangible assets that are amortized.
Goodwill -- Goodwill is not amortized and is tested for impairment on an annual basis, or earlier when facts and circumstances indicate that there may be a potential impairment. The test for impairment is based upon a number of factors including operating results, business plans and projected future cash flows. As a result of this test, all goodwill was written off in fiscal 2004.
Long-Lived Assets -- Long-lived assets are reviewed for possible impairment whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. If such review indicates that the carrying amount of long-lived assets is not recoverable, the carrying amount of such assets is reduced to the estimated recoverable value.
Revenue Recognition -- The Company principally recognizes revenue at FOB shipping point which corresponds to when title and risks and rewards of ownership transfer to its customers. Fees charged for shipping and handling are included in net sales. Provision is made for the estimated cost of returns, warranties and product liability claims.
Distribution Expenses -- Distribution expenses consist primarily of freight, warehousing, and handling costs of products sold.
Advertising -- The Company sponsors various programs under which it participates in the cost of advertising and other promotional efforts for Company products undertaken by its retail customers. Advertising and promotion costs associated with these programs are expensed in the period in which the advertising or other promotion by the retailer occurs.
The Company's tradenames and, in some instances, specific products, also are promoted from time to time through direct marketing channels, primarily television. Advertising and promotion costs are expensed in the period in which the advertising and promotion occurs. Advertising expense was $84.1 million in 2005, $108.8 million in 2004, and $81.1 million in 2003.
Self-Insurance -- The Company maintains a self-insurance program for health claims and workers' compensation claims for certain covered employees. The Company accrues estimated future costs that will be incurred for existing employee claims. The Company does not provide any post-retirement health care benefits.
Income Taxes -- The Company accounts for income taxes using the asset and liability approach. If necessary, the measurement of deferred tax assets is reduced, based on available evidence, by the amount of any tax benefits that management believes is more likely than not that it will not be realized.
Stock Based Compensation -- The Company has various stock-based compensation plans, which are described more fully in Note 11. The Company accounts for those plans in accordance with APB No. 25, "Accounting for Stock Issued to Employees," and related Interpretations. No stock-based compensation is reflected in net income (loss) as no options granted under those plans had an exercise price less than the market value of the underlying common stock on the date of grant. The following table
illustrates the effect on net income (loss) and earnings (loss) per share if the Company had applied the fair value recognition provisions of SFAS No. 123(R), "Share Based Payment".
Fair Value of Financial Instruments -- The carrying values of financial instruments included in current assets and liabilities approximate fair values due to the short-term maturities of these instruments. The fair value of the Company's long-term, fixed rate debt was estimated based on dealer quotes. As of July 2, 2005, the fair value of the senior subordinated notes was $151.8 million versus a carrying value of $281.4 million. As of July 3, 2004, the fair value of the senior subordinated notes was $225.3 million versus a carrying value of $283.6 million. The carrying amount of other short-term debt and long-term variable-rate debt approximates fair value.
NEW ACCOUNTING PRONOUNCEMENTS
In May 2005, the Financial Accounting Standards Board (FASB) issued Statement No. 154, "Accounting Changes and Error Corrections: A Replacement of APB Opinion No. 20 and FASB Statement No. 3." This Statement changes the requirements for the accounting for and reporting of a voluntary change in accounting principle, and also applies to instances when an accounting pronouncement does not include specific transition provisions. The Statement replaces the previous requirement that voluntary changes be recognized by including the cumulative effect of the change in net income of the period of the change. The Statement requires retrospective application of a new accounting principle to prior periods' financial statements, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. The Statement is effective for changes and corrections made in fiscal years beginning after December 15, 2005. The Company does not expect the adoption of the Statement to have a material effect on its financial condition, results of operations, or cash flows.
In December 2004, the FASB issued Statement No. 153, "Exchanges of Nonmonetary Assets: An Amendment of APB Opinion No. 29." APB Opinion No. 29 provided certain exceptions to the principle that exchanges of nonmonetary assets should be measured based on the fair value of the assets exchanged. The Statement amends the guidance in that Opinion by replacing the exception for nonmonetary exchanges of similar productive assets with a general exception for exchanges of nonmonetary assets that do not have commercial substance. Commercial substance in a nonmonetary exchange exists if the future cash flows of the entity are expected to change significantly as a result of the exchange. The Statement is effective for nonmonetary exchanges occurring in fiscal periods beginning after June 15, 2005. The Company does not expect the adoption of the Statement to have a material effect on its financial condition, results of operations, or cash flows.
In November 2004, the FASB issued Statement No. 151, "Inventory Costs: An Amendment of ARB No. 43, Chapter 4." The Statement clarifies the accounting for abnormal inventory costs, such as idle facility expense, freight, handling costs, and wasted materials, by requiring those items be recognized as
current period charges. The provisions of the Statement are effective for inventory costs incurred during fiscal years beginning after June 15, 2005, and should be applied prospectively. The Company adopted this Statement July 3, 2005, and does not expect a material impact on its financial condition, results of operations, or cash flows.
In March 2005, the FASB issued FASB Interpretation No. 47, "Accounting for Conditional Asset Retirement Obligations" to clarify certain provisions of FASB Statement No. 143, "Accounting for Asset Retirement Obligations." Interpretation No. 47 specifies that the term "conditional asset retirement obligation" includes an entity's legal obligation to perform an asset retirement activity for which the timing and (or) method of settlement are conditional on a future event that may or may not be in the control of the entity. The Interpretation provides that an entity is required to recognize a liability for a conditional asset retirement obligation if the fair value of the obligation can be reasonably estimated. Interpretation No. 47 is effective no later than the end of fiscal years ending after December 15, 2005. The Company is currently evaluating the impact of the interpretation on its financial statements.
In December 2004, the FASB issued Statement No. 123(R), "Share Based Payment" which replaces Statement No. 123, "Accounting for Stock-Based Compensation," and Accounting Principles Board (APB) Opinion No. 25, "Accounting for Stock Issued to Employees." The Statement requires compensation expense to be measured based on fair value of the stock options, and to be recognized as an expense on the financial statements. The Statement is effective for fiscal periods beginning after June 15, 2005. The Company will be adopting the Statement for the first quarter of fiscal 2006, beginning July 3, 2005. Upon the adoption of SFAS No. 123(R), the Company will be required to expense stock options over the vesting period in its statement of operations. In addition, the Company will need to recognize expense over the remaining vesting period associated with unvested options outstanding as of the beginning of fiscal 2006. For the years ended July 2, 2005, July 3, 2004 and June 28, 2003, total stock-based employee compensation expense, net of related tax effects, determined under this new standard would have been $1.5 million, $1.5 million and $2.0 million, respectively. Based on the Company's analysis of unvested options as of July 3, 2005, the estimated impact of adopting SFAS No. 123(R) will be to add approximately $0.3 million, net of tax benefits, to the Company's annual operating expense. This amount is subject to change should management grant additional stock options.
2. GOODWILL AND INTANGIBLE ASSETS
Goodwill and intangible assets that are not amortized are subject to a fair-value based impairment test on an annual basis or more frequently if circumstances indicate a potential impairment. The annual test for impairment of goodwill and other intangible assets is conducted during the fourth quarter of each fiscal year. The company utilizes the services of an independent valuation consultant to prepare the analysis in support of the fair value assessment.
At the end of the third quarter of fiscal 2004, management determined that the combination of the shortfall in meeting projected operating results along with the Company's inability to meet its financial debt covenant requirements for its senior secured credit facility and a downgrade in its debt rating could have an adverse affect on the comparison of fair value to carrying value for goodwill and other intangible assets. An interim impairment test was conducted at that time and the Company determined that the implied fair value of goodwill and the fair value of certain other indefinite lived intangible assets were less than their carrying values. The Company recorded a non-cash impairment charge totaling $34.3 million pre-tax or $29.9 million net of tax, consisting of consolidated goodwill of $28.2 million and certain other indefinite lived intangible assets associated with iCEBOX, of $6.1 million. Upon completion of its annual impairment test at the end of the fourth quarter 2004, the Company determined that an additional charge of $6.5 million was necessary against trademarks impacted by the adoption of its U.S. restructuring plan.
In the fourth quarter of fiscal year 2005, the annual impairment test was again conducted for the indefinite lived intangible assets. Upon completion of the assessment of each of these trademarks, it was determined that a pre-tax impairment charge against trademarks of $3.2 million was necessary to reflect management's decisions regarding certain underperforming product lines.
The following tables summarize the goodwill and intangible asset activity and balances:
Amortization for the existing definite lived assets for fiscal years 2006 through 2008 will be $0.3 million per year. Amortization for existing definite lived assets for fiscal 2009 will be $0.1 million.
3. ACQUISITIONS AND ALLIANCES
AMAP ACQUISITION
On May 16, 2003 the Company increased its 30.8% interest in Amalgamated Appliance Holdings Limited (AMAP) to a 52.6% interest. AMAP is a leading manufacturer and distributor of a wide range of branded consumer electronics and appliances in South Africa. AMAP is a publicly held company, listed on the Johannesburg Stock Exchange, which owns the rights to the Salton brand name in South Africa. This acquisition offers Salton the alliance to enter developing markets on the African continent and introduce them to the Company's brands and product lines. The Chief Executive Officer and the President and Chief Operating Officer of Salton, Inc. are members of the board of directors for AMAP.
The purchase price of the most recent increase in interest was $7.5 million and the cost of the previous 30.8% was $8.2 million. Salton now holds 111,544,628 shares of AMAP stock as of July 2, 2005. The purchase price was based on the market price at the time of the purchase and no premiums were paid. As a result of the business combination, Salton recorded $2.0 million of goodwill.
This step acquisition qualified as a business combination, and therefore the accounts of AMAP have been included in the consolidated financial statements since May 16, 2003. Prior to that date, the Company's investment in AMAP was accounted for on the equity method and was included in other assets.
The following pro forma information presents the results of operations of the Company as if the increased ownership of AMAP had taken place at the beginning of fiscal 2003.
The pro forma results have been prepared for comparative purposes only and do not purport to be indicative of the results of operations that would have occurred had the increase in ownership of AMAP actually occurred at the beginning of fiscal 2003.
Subsequent to fiscal year 2005, the Company completed the sale of its 52.6% interest in AMAP (see Note 20, "Subsequent Events".)
ACQUISITION OF THE GEORGE FOREMAN NAME
In the quarter ended December 25, 1999, Salton acquired effective July 1, 1999, the right to use in perpetuity and worldwide the name George Foreman in connection with the marketing and sale of food preparation and non-alcoholic drink preparation and serving appliances. The aggregate purchase price payable to George Foreman and other participants was $137.5 million, of which $113.8 million was payable in five annual cash installments, and the remaining $23.7 million was paid through the issuance of 779,191 shares of Salton, Inc. common stock issued out of treasury. Salton issued a five-year $113.8 million non-interest bearing subordinated promissory note associated with the annual cash installments. The initial cash installment of $22.8 million was paid during the first half of fiscal year 2000 and the remaining principal of the note of $91.0 was recorded at its present value. Imputed interest expense of $0.0, $0.0, and $1.6 million was recorded in connection with this note in fiscal years 2005, 2004 and 2003, respectively. As of July 2, 2005, all amounts due under the note had been paid.
In September 2000, Salton prepaid the third installment of $20.0 million due July 2001 to George Foreman and paid the second installment of $2.75 million to the other participants by issuing 621,161 shares of common stock (546,075 to Foreman and 75,086 to other participants) at $36.625 per share, which was the market value of the common stock on the date of issuance. In connection with this stock payment, Salton agreed to pay cash or issue additional shares, at Salton's election, if the price of the stock should decline in the next year ("guarantee obligation") based on the average share price in the 90-day period preceding the first anniversary of the payment. The guarantee obligation recorded at June 30, 2001 was approximately $19.37 million.
In July 2001, Salton took back 456,175 of the 546,075 shares of common stock originally issued to George Foreman in September 2000 and paid him $18.0 million. This payment, which represented the original cash installment amount of $20 million less proceeds that Foreman received from the sale on the open market of 89,900 of the 546,075 shares previously issued, terminated the guarantee obligation with respect to the shares issued to him and satisfied the third annual installment due under the note payable.
The guarantee obligation as of June 29, 2002 related to the shares issued to the other participants in September 2000 was $1.4 million. During fiscal 2003, $0.6 million of the guarantee obligation was paid out in cash and the remaining guarantee obligation of $0.8 million was extinguished as the requirements for payment, per the terms of the guarantee obligation, were not met by the other participant.
As of July 1, 2003, Salton settled the final installment to one of the other participants by issuing 146,902 shares of common stock at $9.36 per share, which was the market value of the common stock on the date of issuance. In connection with this stock payment, Salton agrees to pay cash or issue additional shares, at the Company's election, if the price of the stock should decline within a two year period ("new guarantee obligation") based on the average share price during the 90-day period preceding the second anniversary of the agreement. The two year period is defined as that period after the one year anniversary of the date on which the shares were delivered and before the third anniversary of the date on which the shares were delivered. The shares were delivered in February 2004. The new guarantee obligation was $1.2 million and $0.4 million as of July 2, 2005 and July 3, 2004, respectively, recorded in other long-term liabilities.
STRATEGIC ALLIANCES
The Company continued to participate in joint product development relationships with several third parties to develop, market and distribute new products. These strategic alliances enable us to (a) further expand the scope of its product offerings and (b) benefit from the manufacturing expertise and/or strong brand names of the Company's strategic partners. These current alliances involve equity investments by the Company in privately held equity securities or investments with no observable quoted market value and include other contractual arrangements involving expense and profit sharing. The Company's exposure to loss related to its strategic alliances is generally limited to its equity investments and accounts receivable associated with these alliances.
The foregoing strategic alliances provide the opportunity for recurring revenues through the sale of coffee pods and brewing machines. There are arrangements for sharing the profits derived from each of these strategic alliances once all expenses incurred by Salton and/or the other members of the alliance, have been reimbursed from cash flow generated by such alliances. Each of these strategic alliances generally provides for certain license fees and royalties to the strategic partners and contain minimum sales requirements and other obligations that, if not satisfied, may result in termination of the strategic alliance.
4. INVENTORIES
A summary of inventories is as follows:
At July 2, 2005 and July 3, 2004, domestic inventories determined by the last in, first out (LIFO) inventory method amounted to $118.4 million and $136.3 million, respectively. If the first-in, first-out (FIFO) inventory method, which approximates replacement cost had been used to determine cost for 100.0% of the Company's inventories, they would have been $3.1 million and $0.6 million higher at July 2, 2005 and July 3, 2004, respectively, and net loss would have been $50.0 million ($4.39 per share) and $94.7 million ($8.41 per share) for fiscal 2005 and 2004, respectively.
5. ASSETS HELD FOR SALE
The Company classifies certain assets as held for sale in accordance with Statement of Financial Accounting Standards No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets." As of July 2, 2005, the Company had a contract for the sale of a warehouse for $1.8 million. The net book value of the warehouse at July 2, 2005 was $1.0 million and was classified as asset held for sale in the 2005 consolidated balance sheet. The sale was finalized on August 12, 2005.
6. SENIOR SECURED CREDIT FACILITY, LETTERS OF CREDIT AND LONG-TERM DEBT
Senior Secured Credit Facility -- On June 15, 2004, the Company entered into an amended and restated $275.0 million senior secured credit facility, as amended May 11, 2005 ("Credit Facility"), which initially provided for the ability to borrow up to $207.0 million (including $10.0 million for letters of credit). The Credit Facility provided advances based primarily upon percentages of eligible accounts receivable and inventories and had a maturity date of June 15, 2007. As of July 2, 2005, the Company had borrowings of $147.6 million outstanding under this facility and $8.4 million available for future borrowings. Of the amount outstanding, $100.0 million is under a term loan arrangement due in fiscal 2008 and the remaining $47.6 million is under a credit facility. Typically, given the seasonal nature of Salton's business, borrowings and availability tend to be highest in the second fiscal quarter. The Credit Facility is secured by all of the tangible and intangible assets of domestic entities and a pledge of the capital stock of certain of the Company's foreign subsidiaries, including Amalgamated Appliances Holdings, Ltd (AMAP). The Credit Facility is unconditionally guaranteed by each of the Company's direct and indirect domestic subsidiaries. The Credit Facility was further amended on July 8, 2005 and on September 22, 2005 (see Note 20, "Subsequent Events").
At July 2, 2005, the rate plus applicable margin on the Credit Facility was 9.25% for Base (Prime) rate loans. The Company has the option to convert any base rate loan to a LIBOR rate loan, which includes an applicable margin of 5%. LIBOR rate loans are to be no lower than a rate of 7.0%. As of July 2, 2005, the Company had $140.0 million in LIBOR rate loans, at an effective rate of 8.2%.
The Credit Facility contains a number of significant covenants that, among other things, restrict the ability of the Company to dispose of assets, incur additional indebtedness, prepay other indebtedness, pay dividends, repurchase or redeem capital stock, enter into certain investments, enter into sale and lease- back transactions, make certain acquisitions, engage in mergers and consolidations, create liens, or engage in certain transactions with affiliates, and may otherwise restrict corporate and business activities. In addition, under its senior secured credit facility, the Company is required to comply with a minimum EBITDA, consolidated fixed charge coverage ratio and foreign leverage ratio. At July 2, 2005, the Company was in compliance with the covenants described above. As of July 2, 2005 and July 3, 2004 the credit facility of $47.6 million and $32.7 million, respectively, was classified as current because the agreement includes a subjective acceleration clause and the Company is required to deposit all proceeds from collection of accounts receivable and sale of collateral with an account under the exclusive dominion and control of the senior lenders.
Information regarding borrowings under the Credit Agreement is as follows:
Senior Subordinated Notes -- On December 16, 1998, the Company issued $125.0 million of 10 3/4% Senior Subordinated Notes (the "2005 Notes") due December 15, 2005. Proceeds of the 2005 Subordinated Notes were used to repay outstanding indebtedness and for working capital and general corporate purposes. The 2005 Notes contain a number of significant covenants that, among other things, restrict the ability of the Company to dispose of assets, incur additional indebtedness, prepay other indebtedness, pay dividends, repurchase or redeem capital stock, enter into certain investments, enter into sale and lease-back transactions, make certain acquisitions, engage in mergers and consolidations, create
liens, or engage in certain transactions with affiliates, and may otherwise restrict corporate and business activities. At July 2, 2005, the Company was in compliance with all the provisions described above. However, on June 15, 2005, the Company postponed payment of $6.7 million interest due on that date, and therefore was in violation of a covenant. The terms of the indenture governing the notes provides for a 30-day grace period with respect to the payment of the interest. On July 14, 2005, the Company made the defaulted payment and additional interest accrued on the defaulted amount, restoring compliance with the covenants. The Company eliminated substantially all of these covenants in connection with its private debt exchange completed on August 26, 2005 (see Note 20, "Subsequent Events").
On April 23, 2001, the Company issued $150.0 million of 12 1/4% Senior Subordinated notes (the "2008 Notes") due April 15, 2008. Proceeds of the 2008 Notes were used to repay outstanding indebtedness and for the acquisition of Pifco Holdings PLC (Salton Europe). The 2008 Notes contain a number of significant covenants that, among other things, restrict the ability of the Company to dispose of assets, incur additional indebtedness, prepay other indebtedness, pay dividends, repurchase or redeem capital stock, enter into certain investments, enter into sale and lease-back transactions, make certain acquisitions, engage in mergers and consolidations, create liens, or engage in certain transactions with affiliates, and may otherwise restrict corporate and business activities. At July 2, 2005, the Company was in compliance with all the provisions described above. The Company eliminated substantially all of these covenants in connection with its private debt exchange completed on August 26, 2005 (see Note 20, "Subsequent Events").
Subsequent to year end, the Company completed a private debt exchange offer for approximately $75.0 million of the 2005 Notes and $90.1 million of the 2008 Notes (see Note 20, "Subsequent Events"). As a result, the portion of the new debt replacing the 2005 notes was reclassified to long-term as of July 2, 2005.
Subsequent to year end, the Company completed a private exchange transaction for an additional $4.0 million of the 2005 Notes (see Note 20, "Subsequent Events").
Loan Notes -- Approximately $17.7 million of the purchase price of Salton Europe was paid by issuing loan notes (the Loan Notes) in accordance with the purchase offer, with the remainder paid in cash. The Loan Notes have been fully funded by the Company, which is recorded as an escrow asset as of July 2, 2005 and July 3, 2004. The notes bear interest at 1% below LIBOR per annum, payable semi-annually, and are due June 30, 2006. The remaining Loan Notes have been recorded at their net present value, or $0.9 million as of July 2, 2005 and $4.5 million as of July 3, 2004. The Loan Notes may be prepaid, at the option of the holder, after June 30, 2002. As of July 2, 2005, $16.8 million of the Loan Notes were redeemed by shareholders.
As of July 2, 2005, long-term debt matures as follows:
The recorded balance of the 2008 Notes includes the following components:
In addition to the preceding maturity schedules, the Company is required to make additional mandatory payments of 100% of insurance and condemnation proceeds (over $1.0 million with regard to proceeds relating to fixed assets). All such amounts are applied to the reduction of loans under the Credit Agreement.
On September 28, 2004 Salton Europe, Limited ("Salton Europe"), the Company's wholly owned subsidiary, amended its facility (the "Facility Letter") agreement with Hong Kong Shanghai Bank. The amended Facility Letter includes an overdraft facility of up to L8 million ($14.2 million) and a money market borrowing facility of up to L7 million ($12.4 million). In addition, Salton Europe has an invoice finance facility of between L15 and L40 million ($26.6 million and $70.8 million) depending on seasonality and accounts receivable levels. As of July 2, 2005, there was $21.9 million outstanding under the facility, which is included in other current debt.
7. DERIVATIVE FINANCIAL INSTRUMENTS
The Company uses derivative financial instruments to manage interest rate and foreign currency risk. The Company does not enter into derivative financial instruments for trading purposes. Interest rate swap agreements are used as part of the Company's program to manage the fixed and floating interest rate mix of its total debt portfolio and related overall cost of borrowing. The Company uses forward exchange contracts to hedge foreign currency payables for periods consistent with the expected cash flow of the underlying transactions. The contracts generally mature within one year and are designed to limit exposure to exchange rate fluctuations, primarily related to the Australian dollar and the South Africa rand to the American dollar.
When entered into, these financial instruments are designated as hedges of underlying exposures. When a high correlation between the hedging instrument and the underlying exposure being hedged exists, fluctuations in the value of the instruments are offset by changes in the value of the underlying exposures.
The estimated fair values of derivatives used to hedge or modify the Company's risks fluctuate over time. These fair value amounts should not be viewed in isolation, but rather in relation to the fair values of the underlying hedging transactions and investments and to the overall reduction in the Company's exposure to adverse fluctuations in interest rates and foreign exchange rates. The notional amounts of the derivative financial instruments do not necessarily represent amounts exchanged by the parties and, therefore, are not a direct measure of the Company's exposure from its use of derivatives. The amounts exchanged are calculated by reference to the notional amounts and by other terms of the derivatives, such as interest rates or exchange rates.
INTEREST RATE MANAGEMENT -- At June 30, 2001, the Company had an interest rate swap contract to pay a variable-rate interest on $150.0 million notional amount of indebtedness. This contract was terminated in June 2002 resulting in a gain of $8.1 million. At June 29, 2002, the Company had an interest rate swap contract to pay a variable-rate interest on $150.0 million notional amount of indebtedness. This contract was terminated in the first quarter of fiscal 2003 resulting in the receipt of $6.1 million, including a gain of $4.4 million. The Company simultaneously entered into another interest rate swap contract to pay a variable-rate interest on $150.0 million notional amount of indebtedness. This contract was terminated in the second quarter of fiscal 2003, resulting in the receipt of $2.0 million, including a gain of $1.8 million. The gains from early termination of the swap contracts were deferred as adjustments to the carrying amount of
the outstanding debt and are being amortized as an adjustment to interest expense related to the debt over the remaining period originally covered by the terminated swap. The Company did not have any interest rate swap agreements in effect as of July 2, 2005.
FOREIGN CURRENCY MANAGEMENT -- All foreign exchange contracts have been recorded on the balance sheet at fair value of $2.3 million classified as a reduction of accrued expenses. The change in the fair value of contracts that qualify as foreign currency cash flow hedges and are highly effective was $(11.0) million. This amount was recorded in other comprehensive income net of tax. The Company anticipates that all gains and losses in accumulated other comprehensive income related to foreign exchange contracts will be reclassified into earnings during fiscal year 2006. At July 2, 2005, the Company had foreign exchange contracts for the purchase of 52.8 million U.S. dollars.
8. CONVERTIBLE PREFERRED STOCK
On July 28, 1998, the Company issued $40.0 million of convertible preferred stock in connection with a Stock Purchase Agreement dated July 15, 1998. The convertible preferred stock is non-dividend bearing except if the Company breaches, in any material respect, any of the material obligations in the preferred stock agreement or the certificate of incorporation relating to the convertible preferred stock, the holders of the convertible preferred stock are entitled to receive quarterly cash dividends on each share from the date of the breach until it is cured at a rate per annum to 12 1/2% of the Liquidation Preference (defined below). The preferred shares are convertible into 3,529,411 shares of Salton common stock (reflecting a $11.33 per share conversion price). The holders of the convertible preferred stock are entitled to one vote for each share of Salton common stock that the holder would receive upon conversion of the convertible preferred stock. In connection with the convertible preferred stock issuance, two individuals representing the purchasers of the preferred stock were appointed to serve on the Company's Board of Directors.
In the event of a change in control of the Company, each preferred shareholder has the right to require the Company to redeem the shares at a redemption price equal to the Liquidation Preference (defined below) plus interest accrued thereon at a rate of 7% per annum compounded annually each anniversary date from July 28, 1998 through the earlier of the date of such redemption or July 28, 2003.
In the event of a liquidation, dissolution or winding up of the Company, whether voluntary or involuntary, holders of the Convertible Preferred Stock are entitled to be paid out of the assets of the Company available for distribution to its stockholders an amount in cash equal to $1,000 per share, plus the amount of any accrued and unpaid dividends thereon (the Liquidation Preference), before any distribution is made to the holders of any Salton common stock or any other of its capital stock ranking junior as to liquidation rights to the convertible preferred stock.
The Company may optionally convert in whole or in part, the convertible preferred stock at any time on and after July 15, 2003 at a cash price per share of 100% of the then effective Liquidation Preference per share, if the daily closing price per share of the Company common stock for a specified 20 consecutive trading day period is greater than or equal to 200% of the then current Conversion Price. On September 15, 2008, the Company will be required to exchange all outstanding shares of convertible preferred stock at a price equal to the Liquidation Preference per share, payable at the Company's option in cash or shares of Salton common stock.
In accordance with Emerging Issues Task Force Topic No. D-98 "Classification and Measurement of Redeemable Securities", the convertible preferred stock is classified as a separate line item apart from permanent equity on the Company's balance sheet, as redemption thereof in shares of common stock is outside of the Company's control.
9. SHAREHOLDERS' EQUITY AND ACCUMULATED OTHER COMPREHENSIVE INCOME
On June 28, 2004, the Board of Directors of Salton adopted a stockholder rights plan (the "Rights Plan") pursuant to which a dividend consisting of one preferred stock purchase right (a "Right") was
distributed for each share of Common Stock held as of the close of business on July 9, 2004, and is to be distributed to each share of Common Stock issued thereafter until the earlier of (i) the Distribution Date (as defined in the Rights Plan), (ii) the Redemption Date (as defined in the Rights Plan) or (iii) June 28, 2014. The Rights Plan is designed to deter coercive takeover tactics and to prevent an acquirer from gaining control of the Company without offering fair value to its stockholders. The Rights will expire on June 28, 2014, subject to earlier redemption or exchange as provided in the Rights Plan. Each Right entitles the holder thereof to purchase from us one one-thousandth of a share of a new series Series B Junior Participating Preferred Stock at a price of $45.00 per one one-thousandth of a share, subject to adjustment. The Rights are generally exercisable only if a Person (as defined) acquires beneficial ownership of 20 percent or more of the Company's outstanding Common Stock.
Comprehensive income is the change in equity of a company during a period from transactions and events other than investments by and distributions to shareholders. Comprehensive income includes both net income or loss and other comprehensive income or loss. Other comprehensive loss was $1.2 million in 2005 and other comprehensive income was $13.7 million in 2004. Accumulated other comprehensive income is comprised of the following:
10. EARNINGS PER SHARE
(1) Due to the losses in 2005 and 2004, the denominator does not include the effects of convertible preferred stock or stock options as the effect would have been anti-dilutive. Had the Company recognized net income in 2005 and 2004, incremental shares attributable to the assumed conversion of preferred stock and exercise of outstanding options would have increased diluted shares outstanding by 3,935,861 and 3,931,070 shares, respectively.
(2)
Options to purchase 270,000 shares at a price of $29.25 per share were outstanding at June 28, 2003 but were not included in the computation of diluted EPS because the options were contingent upon the Company's share price reaching specified targets for a specified period of time. These stock options were cancelled in June 2004 at management's request.
Options and warrants to purchase 1,288,010 shares of common stock at a price range of $10.44 to $37.00 per share were outstanding at June 28, 2003 but were not included in the computation of diluted EPS because the exercise prices were greater than the average market price of the common shares.
11. EMPLOYEE BENEFIT PLANS
The Company has a 401(k) defined contribution plan that covers eligible domestic employees. The employees are eligible for benefits upon completion of one year of service. Under the terms of the plan, the Company may elect to match a portion of the employee contributions. The Company's discretionary matching contribution is based on a portion of participants' eligible wages, as defined, up to a maximum amount ranging typically from two percent to six percent. The Company's total matching contributions were approximately $0.4 million, $0.5 million, and $0.5 million, in fiscal 2005, 2004 and 2003, respectively.
The Company has two defined benefit plans that cover substantially all of the domestic employees of Toastmaster as of the date the plans were curtailed. Pension benefits are based on length of service, compensation, and, in certain plans, Social Security or other benefits. The Company uses March 31 as the measurement date for the Toastmaster plans for determining pension plan assets and obligations. Effective October 30, 1999, the Company's Board of Directors approved the freezing of benefits under the two Toastmaster defined benefit plans. Beginning October 31, 1999, no further benefits were accrued under the Toastmaster plans.
Salton Europe operates a funded defined benefit pension plan and a defined contribution plan. The assets of the defined benefit plan are held in separate trustee administered funds. The plan is subject to valuation by independent, professionally qualified actuaries. The measurement date of the Salton Europe plan is June 30. The defined benefit plan was closed to new entrants in November 2000. New employees starting after this date can now participate in a defined contribution plan, which is open to all employees. The Company matches employee contributions up to and including 5.0% of gross salary. The total matching contributions were approximately $0.2 million, $0.1 million, and $0.1 million, in fiscal 2005, 2004 and 2003, respectively.
AMAP has defined contribution plans covering substantially all employees. Total matching contributions were approximately $1.3 million and $0.4 million in fiscal 2005 and 2004, respectively.
The Company uses March 31 as the measurement date for the Domestic plans for determining pension plan assets and obligations.
Domestic plan assets will be held in an investment portfolio with an active, strategic asset allocation strategy. This portfolio will be invested exclusively in mutual funds and will be highly liquid. Investments shall be diversified with the intent to minimize the risk of large losses to the Fund. Consequently, the total portfolio will be constructed and maintained to provide prudent diversification with regard to the concentration of holdings in individual issues, corporations, or industries. Over the long-term, the investment objectives for this portfolio shall be to achieve an average total annual rate of return of 9.0% for the aggregate investments.
The investment strategy for the Europe plan is determined by the Trustees of the Pifco (Salton Europe) Group Pension and Life Assurance Plan ("the Plan") in consulting with the Company. The aim of the Trustees of the Plan is to ensure that while the Plan continues to operate on an ongoing basis there are enough assets in the Plan to pay the benefits as they fall due with a stable contribution rate. The overall expected rate of return of 7.0% pa is based on the weighted average of the expected returns on each asset class. The Trustees aim to reduce equity investment and increase debt security investment when they feel the time is right. The target allocation at any point in time is therefore equal to the actual allocation.
Under the requirements of SFAS No. 87, "Employers' Accounting for Pensions," an additional minimum pension liability for all plans, representing the excess of accumulated benefits over the plan assets and accrued pension costs, was recognized at July 2, 2005 and July 3, 2004 with the balance recorded as a separate reduction of stockholders' equity, net of deferred tax effect.
12. STOCK-BASED COMPENSATION
Options to purchase common stock of the Company have been granted to employees under the 1992, 1995, 1998, 1999, 2000, 2001 and 2002 stock option plans at prices equal to the fair market value of the stock on the dates the options were granted. Options have also been granted to non-employee directors of the Company, which are exercisable one year after the date of grant. All options granted expire 10 years from the date of grant, and can vest immediately or up to 3 years from the date of grant.
The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model. The following assumptions were used during the respective years to estimate the fair value of options granted:
A summary of the Company's fixed stock options for the fiscal years ended July 2, 2005, July 3, 2004, and June 28, 2003, is as follows:
The following information summarizes the stock options outstanding at July 2, 2005:
13. COMMITMENTS AND CONTINGENCIES
LEASES -- The Company leases certain facilities and equipment under long-term operating leases. Rental expense under all leases was approximately $10.9 million, $10.8 million and $11.5 million for the fiscal years ended July 2, 2005, July 3, 2004, and June 28, 2003, respectively. Leased equipment meeting certain criteria is capitalized and the present value of the related lease payments is recorded as a liability. Amortization of capitalized leased assets is computed on the straight-line method of the term of the lease.
The future minimum rental commitments as of July 2, 2005 were as follows:
FISCAL YEAR ENDED
Present value of net minimum capital lease obligations:
OTHER COMMITMENTS -- The Company has employment agreements with its four executive officers. Such agreements provide for minimum salary levels as well as for incentive bonuses that are payable if the Company achieves specified target performance goals. The agreements also provide for lump sum severance payments upon termination of employment under certain circumstances.
Salton maintains various licensing and contractual relationships to market and distribute products under specific names and designs. These licensing arrangements generally require certain license fees and royalties. Some of the agreements contain minimum sales requirements that, if not satisfied, may result in the termination of the agreements. Total royalties paid under these agreements, were $7.4 million, $6.1 million and $4.0 million in fiscal 2005, 2004 and 2003, respectively.
The Company has a licensing agreement with Westinghouse Electric Corporation ("Westinghouse") under which minimum royalty payments are required. The minimum royalty payment was $2.8 million for fiscal 2005. After fiscal 2005, the minimum royalty payment increases by 3% each fiscal year. The contract expires on March 31, 2008 with five automatic five-year renewals. Upon prior written notice to Westinghouse, Salton has the option to terminate the agreement at the end of the original contract term or any extension term.
Homeplace of America, a company in liquidation under the United States Bankruptcy Code, brought a lawsuit for recovery of preferential payments made to Salton and its subsidiary, Toastmaster, during the 90 day "preference" period prior to Homeplace filing for bankruptcy. Homeplace's total claimed preferences were approximately $4.0 million. After a trial during November 2004 in the U.S. Bankruptcy Court for the District of Delaware, the Court determined the Company's liability to be approximately $1.6 million. The plaintiff and Salton have agreed that Salton may satisfy this judgment by paying a total of approximately $1.5 million over time as follows: $0.1 million on or before July 1, 2005; $0.1 million on or before August 1, 2005; $0.15 million on or before September 1, 2005; $0.15 million on or before October 3, 2005; $0.5 million on or before November 1, 2005; and $0.5 million on or before December 1, 2005. The Company has accrued $1.4 million as of July 2, 2005 for this settlement. We have made all such required payments as of September 15, 2005
In fiscal 2001, the Company acquired Sonex International Corporation, a designer and distributor of electrically operated toothbrushes, flossers and related products. In connection with that acquisition, the Company agreed to a separate, additional consideration ("Earn-Out Consideration") to commence after net sales of Sonex products exceed $20.0 million. In fiscal 2005, the Company paid $0.2 million under the Earn-Out Consideration and as of July 2, 2005, the Company will continue to accrue and may owe up to an additional $2.8 million.
In fiscal 2003, the Company entered into an agreement with George Foreman for professional appearances associated with the promotion of the George Foreman product line. The contract requires payments in installments over the life of the contract that total $9.0 million. The contract will expire on November 30, 2006. In fiscal 2005, the Company paid $3.0 million under this agreement. As of July 2, 2005, the Company owes an additional $3.8 million.
WARRANTIES AND OTHER CLAIMS -- The Company generally warrants its products against defects for a period of one to three years. Additionally, credits are issued to customers for damages sustained during shipment, claimed shortages, certain returns of undamaged product, and other general allowances. Segregating all allowances granted by discrete category for domestic operations at times require substantial judgment. Accordingly, a single accrual covering all estimated future claims, returns, and account allowances are recorded for domestic operations when products are shipped. Thus, revenue is recognized based upon management's best estimate of future returns and warranty claims considering historical experience. Management also periodically reviews doubtful accounts and makes changes to the allowance
accordingly. The following table summarizes the changes in the Company's aggregate accrual for returns, allowances and doubtful accounts:
The Company's foreign operations maintain a separate warranty reserve. The following table summarizes the changes in these warranty reserves:
14. LEGAL PROCEEDINGS
SECURITIES CLASS ACTION LAWSUITS
In May 2004, two stockholder lawsuits, named Mariss Partners, LLP v. Salton, Inc., Leonhard Dreimann and David M. Mulder, and Warren Beeler v. Salton, Inc., Leonhard Dreimann and David Mulder, were filed in the United States District Court for the Northern District of Illinois against the Company and certain Salton executives. The complaints allege that the defendants violated the federal securities laws, specifically Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 of the Securities and Exchange Commission, by making certain alleged false and misleading statements. The plaintiffs seek unspecified damages on behalf of a purported class of purchasers of the Company's securities during the period from November 11, 2002 through May 11, 2004. The Company believes that these lawsuits are without merit and that it has compelling defenses to the allegations contained in the complaints. Salton intends to vigorously defend itself against these claims. The outcome of the class action lawsuits cannot be predicted with certainty, however, Salton does not believe that this matter will have a material adverse affect on its business, financial condition or results of operations. Therefore, no amounts have been accrued for such claims. The plaintiffs have voluntarily dismissed the Mariss Partners lawsuit on September 3, 2004.
PHILIPS
In June 2003, the Company received a letter from Philips Domestic Appliances and Personal Care B.V. (Philips) accusing Salton of interfering in a contractual relationship between Philips and a manufacturing source for Salton, Electrical and Electronics (E&E), misappropriating trade secrets and infringing other unspecified intellectual property rights in connection with its development and marketing of the One:One single serve coffee maker. On August 14, 2003, Salton filed a complaint in the United States District Court for the Northern District of Illinois seeking a declaratory judgment that the Company had not infringed the alleged trade secret rights of Philips and had not tortuously interfered with the contractual relationship between Philips and E&E.
Philips response was to file a series of lawsuits against Salton in the United States, the UK and Hong Kong claiming patent infringement, misappropriation of trade secrets and copyright violations. Generally, the Philips' suits alleged that E&E misappropriated trade secrets, infringed intellectual property and that E&E breached its contract with Philips in the process of developing and manufacturing the One:One coffee maker for Salton.
On May 2005, Salton, E&E and Philips entered into a settlement agreement which required E&E to make a payment of 1.5 million Euros to Philips. Salton was not required to make any payments to Philips in connection with the settlement.
PRODUCT LIABILITY
On or about October 27, 2004, a lawsuit entitled DiNatale vs. Salton was filed in the New York State Supreme Court against the Company. The plaintiffs, who seek unspecified damages, allege that they were injured by water contaminated with lead taken from a tea kettle sold by the Company under its Russell Hobbs brand. The plaintiffs' attorney had been seeking to convert the lawsuit into a class action suit; no class action suit has been filed to date. The manufacturer of the product and its insurer are defending this lawsuit. The Company's attorneys and its insurers are cooperating in the defense of the lawsuit.
After receiving notice of a lawsuit, the Company voluntarily suspended selling the product. The Company believes that, at substantially the same time, the two retailers who had purchased the kettle from the Company also suspended selling the product. The Company believes that only a limited number of the kettles were sold to consumers.
The Company voluntarily contacted the U.S. Food and Drug Administration ("FDA") and shared its information and test results concerning the product with the agency. The Company issued a recall of the product. The manufacturer has agreed to compensate the Company for its legal costs and out of pocket expenses in connection with the recall and to supply replacement products.
In connection with the tea kettle matter, the Company reviewed other products received from the same manufacturer and subsequently notified the FDA that some manufacturing runs of another coffee maker product might have a lead content above FDA allowed standards. As a result, the FDA requested the Company to recall the product. The Company has done so, the retailer to whom the product was sold has cooperated in returning for credit its unsold units of the product. The manufacturer has agreed to compensate the Company for the costs that it may incur.
The outcome of the foregoing legal matters cannot be predicted with certainty, however Salton does not believe that these actions will have a material adverse affect on its business, financial condition or results of operations. Therefore, no amounts have been accrued for such claims.
ENVIRONMENTAL
The Company has accrued approximately $0.2 million for the anticipated costs of environmental remediation at four of its current and previously owned sites. Although such costs could exceed that amount, Salton believes any such excess will not have a material adverse effect on the financial condition or annual results of operations of the Company.
OTHER
The Company is a party to various other actions and proceedings incident to its normal business operations. The Company believes that the outcome of any such litigation will not have a material adverse effect on its business, financial condition or results of operations. The Company also has product liability and general liability insurance policies in amounts believed to be reasonable given its current level of business. Although historically the Company has not had to pay any material product liability claims, it is conceivable that the Company could incur claims for which we are not insured.
15. OPERATING SEGMENTS
Salton consists of a single operating segment which designs, sources, markets and distributes a diversified product mix for use in the home. The product mix consists of small kitchen and home appliances, electronics for the home, tabletop products, time products, lighting products, picture frames and personal care and wellness products. The Company believes this segmentation is appropriate based upon Management's operating decisions and performance assessment. Nearly all of the Company's products are consumer goods within the housewares market, procured through independent manufacturers, primarily in the Far East. Salton's products are distributed through similar distribution channels and customer base using the marketing efforts of its Global Marketing Team.
PRODUCT INFORMATION -- NET SALES
GEOGRAPHIC INFORMATION -- NET SALES
All revenues are derived from sales to unaffiliated customers. Sales are allocated to geographic areas based on point of shipment. Other Foreign Countries includes shipments directly imported to customers including customers of North America and European Union. In the opinion of management, the three-year financial data for geographic areas may not be indicative of current or future operations.
GEOGRAPHIC INFORMATION -- LONG-LIVED ASSETS
MAJOR CUSTOMERS AND SUPPLIERS -- The Company's net sales in the aggregate to its five largest customers during 2005, 2004 and 2003 were 36.5%, 36.1% and 39.3% of total net sales in these periods, respectively. One customer of AMAP accounted for 12.2% and 10.4% of total net sales in 2005 and 2004, respectively, and less than 10.0% of total net sales in 2003. Another customer accounted for 9.2%, 9.1% and 11.9% of total net sales during 2005, 2004 and 2003, respectively, while an additional customer accounted for 6.2%, 8.1% and 12.5%, for the same respective years.
Although the Company has long-established relationships with many of its customers, it does not have any significant long-term contracts with them. A significant concentration of the Company's business activity is with department stores, mass merchandisers, specialty stores, home shopping networks and warehouse clubs whose ability to meet their obligations to the Company is dependent upon prevailing economic conditions within the retail industry.
During 2005, 2004, and 2003, one supplier located in China accounted for 23.3%, 23.7%, and 33.2% of the Company's product purchases.
16. INCOME TAXES
Income before income taxes is as follows:
Federal, state and foreign taxes were approximately as follows:
Deferred taxes based upon differences between the financial statement and tax bases of assets and liabilities and available tax carryforwards consisted of:
At July 2, 2005, the Company has domestic net operating loss carryforwards of approximately $49.0 million of which $30.3 million will expire in fiscal 2025. The remainder will expire in various periods beginning in fiscal 2009 through fiscal 2024. In addition, the Company has unused foreign tax credits of $6.9 million which expire in fiscal 2009. A valuation allowance has been provided related to these foreign tax credits as it is more likely than not that they may expire unused.
A reconciliation of the statutory federal income tax rate to the effective rate is as follows:
The Company has not provided for U.S. deferred income taxes or foreign withholding taxes on approximately $90.4 million of undistributed earnings of its non-U.S. subsidiaries as of July 2, 2005 as these earnings are intended to be permanently reinvested.
On October 22, 2004, the American Jobs Creation Act (the "AJCA") was signed into law. The AJCA provides for a deduction of 85% of certain foreign earnings that are repatriated, as defined in the AJCA. The Company has completed its evaluation of the repatriation provision of the AJCA and does not intend to apply this provision to qualifying foreign earnings repatriations. The Company currently has options to employ lower tax alternatives for potential future foreign earnings repatriations, including accumulated foreign earnings that were previously taxed in the U.S., as well as the use of the Company's U.S. net operating loss carryforward.
17. QUARTERLY RESULTS OF OPERATIONS (UNAUDITED)
Unaudited quarterly financial data is as follows (amounts in thousands, except per share data).
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(1) The Company has historically experienced higher sales in the August through November months due to holiday sales, which primarily impact the second quarter.
(2) Fiscal 2004 includes the effect of costs related to the U.S. restructuring plan and other items excluded from senior management's assessment of the operating performance of Salton's business which on a combined basis, decreased income before income taxes $38.9 million, $31.0 million after tax ($2.73 per basic share).
(3) Total quarterly earnings per common share may not equal the annual amount because net income per common share is calculated independently for each quarter. Common stock equivalents can change on a quarter-to-quarter basis due to their dilutive impact on the independent quarterly EPS calculation.
18. RESTRUCTURING COSTS
On May 11, 2004, in response to declining domestic sales volumes in 2004, the Company announced a U.S. restructuring plan to better align domestic operating costs with current sales levels. The Company completed the initial phase of this U.S. restructuring plan by reducing salaried headcount in the domestic operations by approximately 25.0% in the fourth quarter of fiscal 2004. Additionally, the Company made decisions to reduce the capacity of its warehousing and distribution network through the rationalization of existing facilities. In connection with the U.S. restructuring plan and subsequent valuation reviews in light of those decisions, the Company recorded certain pretax charges in the fourth quarter of fiscal 2004 totaling $33.9 million.
Of the total costs recorded in fiscal 2004, $20.2 million was associated with the write-down of certain inventory identified for liquidation as part of the Company's decision to rationalize warehouse and distribution facilities and $3.8 million related to the write-off of tooling. These amounts were included in cost of goods sold in the Consolidated Statement of Operations.
The total restructuring costs in fiscal 2004 also included a $1.7 million write-down associated with several marketing programs that were canceled or discontinued, which were included in selling, general and administrative expenses. Included within restructuring costs on the Consolidated Statement of Operations are $1.2 million in consulting and legal costs directly associated with the development and implementation of the U.S. restructuring plan and $0.5 million in termination and severance costs associated with the headcount reduction. Also in connection with the U.S. restructuring plan, the company recorded a
$6.5 million intangible asset impairment charge for trademarks associated with products that will no longer be sold. Such charge is included in impairment loss on goodwill and intangible assets in the Consolidated Statement of Operations.
In fiscal 2005, the Company incurred additional costs related to the U.S. restructuring plan primarily for consulting and legal costs directly associated with the implementation of the plan, severance costs related to the domestic headcount reduction and other expenses related to the warehouse rationalization.
19. SUPPLEMENTAL CONSOLIDATING FINANCIAL INFORMATION
The payment obligations of the Company under the senior secured credit facility and the senior subordinated notes are guaranteed by certain of the Company's wholly-owned domestic subsidiaries (Subsidiary Guarantors). Such guarantees are full, unconditional and joint and several. Separate financial statements of the Subsidiary Guarantors are not presented because the Company's management has determined that they would not be material to investors. The following supplemental financial information sets forth, on a combined basis, balance sheets, statements of income and statements of cash flows for Salton, Inc. (Parent), the Guarantor Subsidiaries, and the Company's Non-Guarantor subsidiaries (Other Subsidiaries).
CONSOLIDATING BALANCE SHEET AS OF JULY 2, 2005 (IN THOUSANDS)
CONSOLIDATING BALANCE SHEET AS OF JULY 3, 2004 (IN THOUSANDS)
CONSOLIDATING STATEMENT OF OPERATIONS FOR THE YEAR ENDED JULY 2, 2005 (IN THOUSANDS)
CONSOLIDATING STATEMENT OF OPERATIONS FOR THE YEAR ENDED JULY 3, 2004 (IN THOUSANDS)
CONSOLIDATING STATEMENT OF OPERATIONS FOR THE YEAR ENDED JUNE 28, 2003 (IN THOUSANDS)
CONSOLIDATING STATEMENT OF CASH FLOWS FOR YEAR ENDED JULY 2, 2005 (IN THOUSANDS)
CONSOLIDATING STATEMENT OF CASH FLOWS FOR YEAR ENDED JULY 3, 2004 (IN THOUSANDS)
CONSOLIDATING STATEMENT OF CASH FLOWS FOR YEAR ENDED JUNE 28, 2003 (IN THOUSANDS)
20. SUBSEQUENT EVENTS
THIRD AMENDMENT TO SENIOR SECURED CREDIT FACILITY -- On July 11, 2005, the Company entered into a third amendment to, and waiver under, the senior secured credit facility (the "Third Amendment") dated as of July 8, 2005.
The Third Amendment permitted the transactions contemplated by the Company's private debt exchange offer, discussed below. The Third Amendment also, among other things: (1) waived the Company's failure to prepare its books and records in accordance with GAAP resulting from the Company's previously announced reclassification of its outstanding preferred stock; (2) amended the maturity date of the Company's senior secured credit facility from June 15, 2007 to December 31, 2007; (3) changed the maximum size of the facility from $275.0 million to the difference between $287.0 million and the principal amount of the new second lien notes, if any, issued in connection with the exchange offer; and (4) revised prepayment provisions triggered by certain future incurrences of debt and sales of assets, which transactions would each require the prior written consent of the lenders under the Company's senior secured credit facility.
DEBT EXCHANGE -- On August 26, 2005, the Company completed a private debt exchange offer for the outstanding 2005 Notes and the outstanding 2008 Notes. The Company accepted for exchange an aggregate of approximately $75.0 million in principal amount of 2005 Notes (approximately 60.0% of the then outstanding 2005 Notes) and approximately $90.1 million in principal amount of 2008 Notes (approximately 60.1% of the outstanding 2008 Notes) that were validly tendered in the debt exchange offer.
Upon closing of the debt exchange offer, the Company issued an aggregate of approximately $99.1 million of senior second lien notes (the "Second Lien Notes"), 2,039,469 shares of its common stock, and 135,088 shares of its Series C preferred stock with a total liquidation preference of $13.5 million. The Second Lien Notes mature on March 31, 2008 and bear interest at LIBOR plus 7%, payable in cash on January 15th and July 15th of each year, with the first payment due on January 15, 2006. The Series C preferred stock is generally non-dividend bearing and is mandatorily redeemable by the Company in cash at the liquidation amount on August 26, 2010. Salton also granted certain registration rights for approximately 1,837,455 shares of its common stock and 121,707 shares of its Series C preferred stock received by certain former holders of Subordinated Notes.
In connection with the debt exchange offer, the Company obtained the consent of the holders of a majority of the outstanding 2005 Notes and a majority of the outstanding 2008 Notes to amend the indentures governing such Subordinated Notes to eliminate substantially all of the restrictive covenants and certain events of default contained in such indentures. The Company has entered into supplements to the indentures governing the 2005 Notes and the 2008 Notes to reflect such amendments.
SALE OF AMAP AND TABLETOP -- On September 29, 2005, the Company completed the sale of its 52.6% ownership interest in AMAP, a leading distributor and marketer of small appliances and other products in South Africa, to a group of investors led by Interactive Capital (Proprietary) Limited. In the first quarter of fiscal 2006, the Company received proceeds, net of expenses, of approximately $80.0 million in connection with the transaction. In the first quarter of fiscal 2006, the Company expects to record a gain of approximately $49.0 million before taxes. The Company expects to license and sell its George Foreman(R), Russell Hobbs(R) and Carmen(R) branded products in South Africa following the transaction.
On September 16, 2005, we completed the sale of certain tabletop assets to Lifetime Brands, Inc. for $14.2 million, which approximates book value, and is subject to post-closing adjustments. In connection with this transaction, we divested our Block(R) and Sasaki(R) brands, licenses to Calvin Klein(R) and Napa Style(TM) tabletop products and distribution of upscale crystal products under the Atlantis(R) brand. In addition, we entered into a new license with Lifetime Brands enabling it to market tabletop products under the Stiffel(R) brand.
Prior to May 15, 2003, the Company's investment in AMAP was accounted for under the equity method. Since May 16, 2003, the date the Company increased its ownership interest from 30.8% to 52.6%, AMAP's financial results have been consolidated in accordance with accounting principles generally accepted in the United States of America ("GAAP") for financial statement presentation. Because management did not have a committed or approved plan to sell either our ownership interest in AMAP as of July 2, 2005, the operating results of these businesses have been included in our consolidated financial statements for 2005.
FOURTH AMENDMENT TO SENIOR SECURED CREDIT FACILITY -- On September 23, 2005, the Company entered into a fourth amendment to the senior secured credit facility (the "Fourth Amendment") dated as of September 22, 2005. Under the terms of the Fourth Amendment, the Company is required to prepay the outstanding principal amount of the original $100.0 million term loan included therein with the proceeds received in connection with the sale of certain of its tabletop assets and the sale of the 52.6% ownership interest in AMAP
Under the terms of the senior secured credit facility, as amended by the Fourth Amendment, the Company is required to request one or more additional term loans on or prior to October 4, 2005; provided that the sum of the outstanding principal amount of the original term loan and these additional term loans must equal $100.0 million. The Company is required by the terms of the senior secured credit facility, as amended by the Fourth Amendment, to: (1) use the first $24.9 million of its borrowings under the additional term loan to prepay the outstanding amount of the revolving line of credit under the senior secured credit facility; and (2) place $50.0 million of such borrowings into an interest-bearing cash collateral account. Salton may use the remaining proceeds of the additional term loan for general corporate purposes.
Subject to certain terms and conditions, including the absence of any default or event of default, the Company may use the $50.0 million cash collateral account to purchase, prepay or redeem the outstanding 2005 Notes. To the extent that Salton issues Second Lien Notes and/or equity in exchange for 2005 Notes prior to the maturity of the 2005 Notes, the Company is permitted to obtain funds from the cash collateral account in an amount equal to the reduction of the principal amount of the 2005 Notes affected by such exchange.
PRIVATE EXCHANGE -- On September 28, 2005, the Company completed a private exchange transaction with FMA CBO Funding III, LTD, in which the Company issued $4.1 million of Second Lien Notes in exchange for $4.0 million of 2005 Notes.
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* These exhibits are management contracts or compensatory plans or arrangements.
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