ITEM 1A - RISK FACTORS
Risks Related to Our Business and Structure
We are a Company with limited history and may not be able to continue to successfully manage our businesses on a combined basis.
We were formed on November 18, 2005 and have conducted operations since May 16, 2006. Although our management team has, collectively, over 90 years of experience in acquiring and managing small and middle market businesses, our failure to continue to develop and maintain effective systems and procedures, including accounting and financial reporting systems, to manage our operations as a consolidated public company, may negatively impact our ability to optimize the performance of our Company, which could adversely affect our ability to pay distributions to our shareholders. In addition, in that case, our consolidated financial statements might not be indicative of our financial condition, business and results of operations.
Our future success is dependent on the employees of our Manager and the management teams of our businesses, the loss of any of whom could materially adversely affect our financial condition, business and results of operations.
Our future success depends, to a significant extent, on the continued services of the employees of our Manager, most of whom have worked together for a number of years. While our Manager will have employment agreements with certain of its employees, including our Chief Financial Officer, these employment agreements may not prevent our Manager’s employees from leaving or from competing with us in the future. Our Manager does not have an employment agreement with our Chief Executive Officer.
The future success of our businesses also depends on their respective management teams because we operate our businesses on a stand-alone basis, primarily relying on existing management teams for management of their day-to-day operations. Consequently, their operational success, as well as the success of our internal growth strategy, will be dependent on the continued efforts of the management teams of the businesses. We provide such persons with equity incentives in their respective businesses and have employment agreements and/or non-competition agreements with certain persons we have identified as key to their businesses. However, these measures may not prevent the departure of these managers. The loss of services of one or more members of our management team or the management team at one of our businesses could materially adversely affect our financial condition, business and results of operations.
We face risks with respect to the evaluation and management of future platform or add-on acquisitions.
A component of our strategy is to continue to acquire additional platform subsidiaries, as well as add-on businesses for our existing businesses. Generally, because such acquisition targets are held privately, we may experience difficulty in evaluating potential target businesses as the information concerning these businesses is not publicly available. In addition, we and our subsidiary companies may have difficulty effectively managing or integrating acquisitions. We may experience greater than expected costs or difficulties relating to such acquisition, in which case, we might not achieve the anticipated returns from any particular acquisition, which may have a material adverse effect on our financial condition, business and results of operations.
We may not be able to successfully fund future acquisitions of new businesses due to the lack of availability of debt or equity financing at the Company level on acceptable terms, which could impede the implementation of our acquisition strategy and materially adversely impact our financial condition, business and results of operations.
In order to make future acquisitions, we intend to raise capital primarily through debt financing at the Company level, additional equity offerings, the sale of stock or assets of our businesses, and by offering equity in the Trust or our businesses to the sellers of target businesses or by undertaking a combination of any of the above. Since the timing and size of acquisitions cannot be readily predicted, we may need to be able to obtain funding on short notice to benefit fully from attractive acquisition opportunities. Such funding may not be available on acceptable terms. In addition, the level of our indebtedness may impact our ability to borrow at the Company level. Another source of capital for us may be the sale of additional shares, subject to market conditions and investor demand for the shares at prices that we consider to be in the interests of our shareholders. These risks may materially adversely affect our ability to pursue our acquisition strategy successfully and materially adversely affect our financial condition, business and results of operations.
While we intend to make regular cash distributions to our shareholders, the Company’s board of directors has full authority and discretion over the distributions of the Company, other than the profit allocation, and it may decide to reduce or eliminate distributions at any time, which may materially adversely affect the market price for our shares.
To date, we have declared and paid quarterly distributions, and although we intend to pursue a policy of paying regular distributions, the Company’s board of directors has full authority and discretion to determine whether or not a distribution by the Company should be declared and paid to the Trust and in turn to our shareholders, as well as the amount and timing of any distribution. In addition, the management fee, profit allocation and put price will be payment obligations of the Company and, as a result, will be paid, along with other Company obligations, prior to the payment of distributions to our shareholders. The Company’s board of directors may, based on their review of our financial condition and results of operations and pending acquisitions, determine to reduce or eliminate distributions, which may have a material adverse effect on the market price of our shares.
We will rely entirely on receipts from our businesses to make distributions to our shareholders.
The Trust’s sole asset is its interest in the Company, which holds controlling interests in our businesses. Therefore, we are dependent upon the ability of our businesses to generate earnings and cash flow and distribute them to us in the form of interest and principal payments on indebtedness and, from time to time, dividends on equity to enable us, first, to satisfy our financial obligations and, second, and to make distributions to our shareholders. This ability may be subject to limitations under laws of the jurisdictions in which they are incorporated or organized. If, as a consequence of these various restrictions, we are unable to generate sufficient receipts from our businesses, we may not be able to declare, or may have to delay or cancel payment of, distributions to our shareholders.
We do not own 100% of our businesses. While the Company is to receive cash payments from our businesses which are in the form of interest payments, debt repayment and dividends and dividends, if any dividends were to be paid by our businesses, they would be shared pro rata with the minority shareholders of our businesses and the amounts of dividends made to minority shareholders would not be available to us for any purpose, including Company debt service or distributions to our shareholders. Any proceeds from the sale of a business will be allocated among us and the minority shareholders of the business that is sold.
The Company’s board of directors has the power to change the terms of our shares in its sole discretion in ways with which you may disagree.
As an owner of our shares, you may disagree with changes made to the terms of our shares, and you may disagree with the Company’s board of directors’ decision that the changes made to the terms of the shares are not materially adverse to you as a shareholder or that they do not alter the characterization of the Trust. Your recourse, if you disagree, will be limited because our Trust Agreement gives broad authority and discretion to our board of directors. However, the Trust Agreement does not relieve the Company’s board of directors from any fiduciary obligation that is imposed on them pursuant to applicable law. In addition, we may change the nature of the shares to be issued to raise additional equity and remain a fixed-investment trust for tax purposes.
Certain provisions of the LLC Agreement of the Company and the Trust Agreement make it difficult for third parties to acquire control of the Trust and the Company and could deprive you of the opportunity to obtain a takeover premium for your shares.
The amended and restated LLC Agreement of the Company, which we refer to as the LLC Agreement, and the amended and restated Trust Agreement of the Trust, which we refer to as the Trust Agreement, contain a number of provisions that could make it more difficult for a third party to acquire, or may discourage a third party from acquiring, control of the Trust and the Company. These provisions include, among others:
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restrictions on the Company’s ability to enter into certain transactions with our major shareholders, with the exception of our Manager, modeled on the limitation contained in Section 203 of the Delaware General Corporation Law, or DGCL;
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allowing only the Company’s board of directors to fill newly created directorships, for those directors who are elected by our shareholders, and allowing only our Manager, as holder of the Allocation Interests, to fill vacancies with respect to the class of directors appointed by our Manager;
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requiring that directors elected by our shareholders be removed, with or without cause, only by a vote of 85% of our shareholders;
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requiring advance notice for nominations of candidates for election to the Company’s board of directors or for proposing matters that can be acted upon by our shareholders at a shareholders’ meeting;
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having a substantial number of additional authorized but unissued shares that may be issued without shareholder action;
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providing the Company’s board of directors with certain authority to amend the LLC Agreement and the Trust Agreement, subject to certain voting and consent rights of the holders of trust interests and Allocation Interests;
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providing for a staggered board of directors of the Company, the effect of which could be to deter a proxy contest for control of the Company’s board of directors or a hostile takeover; and
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limitations regarding calling special meetings and written consents of our shareholders.
These provisions, as well as other provisions in the LLC Agreement and Trust Agreement may delay, defer or prevent a transaction or a change in control that might otherwise result in you obtaining a takeover premium for your shares.
We may have conflicts of interest with the minority shareholders of our businesses.
The boards of directors of our respective businesses have fiduciary duties to all their shareholders, including the Company and minority shareholders. As a result, they may make decisions that are in the best interests of their shareholders generally but which are not necessarily in the best interest of the Company or our shareholders. In dealings with the Company, the directors of our businesses may have conflicts of interest and decisions may have to be made without the participation of directors appointed by the Company, and such decisions may be different from those that we would make.
Our third party credit facility exposes us to additional risks associated with leverage and inhibits our operating flexibility and reduces cash flow available for distributions to our shareholders.
At December 31, 2009, we had approximately $76.0 million outstanding under our Term Loan Facility and $0.5 million outstanding borrowings on our Revolving Credit Facility. We expect to increase our level of debt in the future. The terms of our Revolving Credit Facility contains a number of affirmative and restrictive covenants that, among other things, require us to:
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Maintain a minimum level of cash flow;
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leverage new businesses we acquire to a minimum specified level at the time of acquisition;
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keep our total debt to cash flow at or below a ratio of 3.5 to 1; and
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make acquisitions that satisfy certain specified minimum criteria.
If we violate any of these covenants, our lender may accelerate the maturity of any debt outstanding and we may be prohibited from making any distributions to our shareholders. Such debt is secured by all of our assets, including the stock we own in our businesses and the rights we have under the loan agreements with our businesses. Our ability to meet our debt service obligations may be affected by events beyond our control and will depend primarily upon cash produced by our businesses. Any failure to comply with the terms of our indebtedness could materially adversely affect us.
Changes in interest rates could materially adversely affect us.
Our Credit Agreement bears interest at floating rates which will generally change as interest rates change. We bear the risk that the rates we are charged by our lender will increase faster than the earnings and cash flow of our businesses, which could reduce profitability, adversely affect our ability to service our debt, cause us to breach covenants contained in our Revolving Credit Facility and reduce cash flow available for distribution, any of which could materially adversely affect us.
We may engage in a business transaction with one or more target businesses that have relationships with our officers, our directors, our Manager or CGI, which may create potential conflicts of interest.
We may decide to acquire one or more businesses with which our officers, our directors, our Manager or CGI have a relationship. While we might obtain a fairness opinion from an independent investment banking firm, potential conflicts of interest may still exist with respect to a particular acquisition, and, as a result, the terms of the acquisition of a target business may not be as advantageous to our shareholders as it would have been absent any conflicts of interest.
We are exposed to risks relating to evaluations of controls required by Section 404 of the Sarbanes-Oxley Act of 2002.
We are required to comply with Section 404 of the Sarbanes-Oxley Act of 2002. While we have concluded that at December 31, 2009 we have no material weaknesses in our internal controls over financial reporting we cannot assure you that we will not have a material weakness in the future. A “material weakness” is a control 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. If we fail to maintain a system of internal controls over financial reporting that meets the requirements of Section 404, we might be subject to sanctions or investigation by regulatory authorities such as the SEC or by the NASDAQ Stock Market LLC. Additionally, failure to comply with Section 404 or the report by us of a material weakness may cause investors to lose confidence in our financial statements and our stock price may be adversely affected. If we fail to remedy any material weakness, our financial statements may be inaccurate, we may not have access to the capital markets, and our stock price may be adversely affected
CGI may exercise significant influence over the Company.
CGI, through a wholly owned subsidiary, owns 7,681,000 or approximately 21% of our shares and may have significant influence over the election of directors in the future.
If, in the future, we cease to control and operate our businesses, we may be deemed to be an investment company under the Investment Company Act of 1940, as amended.
Under the terms of the LLC Agreement, we have the latitude to make investments in businesses that we will not operate or control. If we make significant investments in businesses that we do not operate or control or cease to operate and control our businesses, we may be deemed to be an investment company under the Investment Company Act of 1940, as amended, or the Investment Company Act. If we were deemed to be an investment company, we would either have to register as an investment company under the Investment Company Act, obtain exemptive relief from the SEC or modify our investments or organizational structure or our contract rights to fall outside the definition of an investment company. Registering as an investment company could, among other things, materially adversely affect our financial condition, business and results of operations, materially limit our ability to borrow funds or engage in other transactions involving leverage and require us to add directors who are independent of us or our Manager and otherwise will subject us to additional regulation that will be costly and time-consuming.
Risks Relating to Our Manager
Our Chief Executive Officer, directors, Manager and management team may allocate some of their time to other businesses, thereby causing conflicts of interest in their determination as to how much time to devote to our affairs, which may materially adversely affect our operations.
While the members of our management team anticipate devoting a substantial amount of their time to the affairs of the Company, only Mr. James Bottiglieri, our Chief Financial Officer, devotes substantially all of his time to our affairs. Our Chief Executive Officer, directors, Manager and members of our management team may engage in other business activities. This may result in a conflict of interest in allocating their time between our operations and our management and operations of other businesses. Their other business endeavors may be related to CGI, which will continue to own several businesses that were managed by our management team prior to our initial public offering, or affiliates of CGI as well as other parties. Conflicts of interest that arise over the allocation of time may not always be resolved in our favor and may materially adversely affect our operations. See the section entitled “Certain Relationships and Related Party Transactions” for the potential conflicts of interest of which you should be aware.
Our Manager and its affiliates, including members of our management team, may engage in activities that compete with us or our businesses.
While our management team intends to devote a substantial majority of their time to the affairs of the Company, and while our Manager and its affiliates currently do not manage any other businesses that are in similar lines of business as our businesses, and while our Manager must present all opportunities that meet the Company’s acquisition and disposition criteria to the Company’s board of directors, neither our management team nor our Manager is expressly prohibited from investing in or managing other entities, including those that are in the same or similar line of business as our businesses. In this regard, the management services agreement and the obligation to provide management services will not create a mutually exclusive relationship between our Manager and its affiliates, on the one hand, and the Company, on the other.
Our Manager need not present an acquisition or disposition opportunity to us if our Manager determines on its own that such acquisition or disposition opportunity does not meet the Company’s acquisition or disposition criteria.
Our Manager will review any acquisition or disposition opportunity presented to the Manager to determine if it satisfies the Company’s acquisition or disposition criteria, as established by the Company’s board of directors from time to time. If our Manager determines, in its sole discretion, that an opportunity fits our criteria, our Manager will refer the opportunity to the Company’s board of directors for its authorization and approval prior to the consummation thereof; opportunities that our Manager determines do not fit our criteria do not need to be presented to the Company’s board of directors for consideration. If such an opportunity is ultimately profitable, we will have not participated in such opportunity. Upon a determination by the Company’s board of directors not to promptly pursue an opportunity presented to it by our Manager in whole or in part, our Manager will be unrestricted in its ability to pursue such opportunity, or any part that we do not promptly pursue, on its own or refer such opportunity to other entities, including its affiliates.
We cannot remove our Manager solely for poor performance, which could limit our ability to improve our performance and could materially adversely affect the market price of our shares.
Under the terms of the management services agreement, our Manager cannot be removed as a result of underperformance. Instead, the Company’s board of directors can only remove our Manager in certain limited circumstances or upon a vote by the majority of the Company’s board of directors and the majority of our shareholders to terminate the management services agreement. This limitation could materially adversely affect the market price of our shares.
We may have difficulty severing ties with our Chief Executive Officer, Mr. Massoud.
Under the management services agreement, the Company’s board of directors may, after due consultation with our Manager, at any time request that our Manager replace any individual seconded to the Company and our Manager will, as promptly as practicable, replace any such individual. However, because Mr. Massoud is the managing member of our Manager with a significant ownership interest therein, we may have difficulty completely severing ties with Mr. Massoud absent terminating the management services agreement and our relationship with our Manager.
If the management services agreement is terminated, our Manager, as holder of the Allocation Interests in the Company, has the right to cause the Company to purchase such Allocation Interests, which may materially adversely affect our liquidity and ability to grow.
If the management services agreement is terminated at any time other than as a result of our Manager’s resignation or if our Manager resigns on any date that is at least three years after the closing of our initial public offering, our Manager will have the right, but not the obligation, for one year from the date of termination or resignation, as the case may be, to cause the Company to purchase the Allocation Interests for the put price. If our Manager elects to cause the Company to purchase its Allocation Interests, we are obligated to do so and, until we have done so, our ability to conduct our business, including incurring debt, would be restricted and, accordingly, our liquidity and ability to grow may be adversely affected.
Our Manager can resign on 90 days’ notice and we may not be able to find a suitable replacement within that time, resulting in a disruption in our operations that could materially adversely affect our financial condition, business and results of operations as well as the market price of our shares.
Our Manager has the right, under the management services agreement, to resign at any time on 90 days’ written notice, whether we have found a replacement or not. If our Manager resigns, we may not be able to contract with a new manager or hire internal management with similar expertise and ability to provide the same or equivalent services on
acceptable terms within 90 days, or at all, in which case our operations are likely to experience a disruption, our financial condition, business and results of operations as well as our ability to pay distributions are likely to be adversely affected and the market price of our shares may decline. In addition, the coordination of our internal management, acquisition activities and supervision of our businesses is likely to suffer if we are unable to identify and reach an agreement with a single institution or group of executives having the expertise possessed by our Manager and its affiliates. Even if we are able to retain comparable management, whether internal or external, the integration of such management and their lack of familiarity with our businesses may result in additional costs and time delays that could materially adversely affect our financial condition, business and results of operations.
The liability associated with the supplemental put agreement is difficult to estimate and may be subject to substantial period-to-period changes, thereby significantly impacting our future results of operations.
The Company will record the supplemental put agreement at its fair value at each balance sheet date by recording any change in fair value through its income statement. The fair value of the supplemental put agreement is largely related to the value of the profit allocation that our Manager, as holder of Allocation Interests, will receive. The valuation of the supplemental put agreement requires the use of complex financial models, which require sensitive assumptions and estimates. If our assumptions and estimates result in an over-estimation or under-estimation of the fair value of the supplemental put agreement, the resulting fluctuation in related liabilities could cause a material adverse effect on our future results of operations.
We must pay our Manager the management fee regardless of our performance.
Our Manager is entitled to receive a management fee that is based on our adjusted net assets, as defined in the management services agreement, regardless of the performance of our businesses. The calculation of the management fee is unrelated to the Company’s net income. As a result, the management fee may incentivize our Manager to increase the amount of our assets, through, for example, the acquisition of additional assets or the incurrence of third party debt rather than increase the performance of our businesses.
We cannot determine the amount of the management fee that will be paid over time with any certainty.
The management fee paid to CGM for the year ended December 31, 2009, was $12.8 million. The management fee is calculated by reference to the Company’s adjusted net assets, which will be impacted by the acquisition or disposition of businesses, which can be significantly influenced by our Manager, as well as the performance of our businesses and other businesses we may acquire in the future. Changes in adjusted net assets and in the resulting management fee could be significant, resulting in a material adverse effect on the Company’s results of operations. In addition, if the performance of the Company declines, assuming adjusted net assets remains the same, management fees will increase as a percentage of the Company’s net income.
We cannot determine the amount of profit allocation that will be paid over time with any certainty.
We cannot determine the amount of profit allocation that will be paid over time with any certainty. Such determination would be dependent on the potential sale proceeds received for any of our businesses and the performance of the Company and its businesses over a multi-year period of time, among other factors that cannot be predicted with certainty at this time. Such factors may have a significant impact on the amount of any profit allocation to be paid. Likewise, such determination would be dependent on whether certain hurdles were surpassed giving rise to a payment of profit allocation. Any amounts paid in respect of the profit allocation are unrelated to the management fee earned for performance of services under the management services agreement.
The fees to be paid to our Manager pursuant to the management services agreement, the offsetting management services agreements and transaction services agreements and the profit allocation to be paid to our Manager, as holder of the Allocation Interests, pursuant to the LLC Agreement may significantly reduce the amount of cash available for distribution to our shareholders.
Under the management services agreement, the Company will be obligated to pay a management fee to and, subject to certain conditions, reimburse the costs and out-of-pocket expenses of our Manager incurred on behalf of the Company in connection with the provision of services to the Company. Similarly, our businesses will be obligated to pay fees to and reimburse the costs and expenses of our Manager pursuant to any offsetting management services agreements entered into between our Manager and one of our businesses, or any transaction services agreements to which such businesses are a party. In addition, our Manager, as holder of the Allocation Interests, will be entitled to receive profit allocations and may be entitled to receive the put price. While it is difficult to quantify with any certainty the actual
amount of any such payments in the future, we do expect that such amounts could be substantial. See the section entitled “Certain Relationships and Related Party Transactions” for more information about these payment obligations of the Company. The management fee, profit allocation and put price will be payment obligations of the Company and, as a result, will be paid, along with other Company obligations, prior to the payment of distributions to shareholders. As a result, the payment of these amounts may significantly reduce the amount of cash flow available for distribution to our shareholders.
Our Manager’s influence on conducting our operations, including on our conducting of transactions, gives it the ability to increase its fees and compensation to our Chief Executive Officer, which may reduce the amount of cash flow available for distribution to our shareholders.
Under the terms of the management services agreement, our Manager is paid a management fee calculated as a percentage of the Company’s adjusted net assets for certain items and is unrelated to net income or any other performance base or measure. Our Manager, which Mr. Massoud, our Chief Executive Officer, controls, may advise us to consummate transactions, incur third party debt or conduct our operations in a manner that, in our Manager’s reasonable discretion, are necessary to the future growth of our businesses and are in the best interests of our shareholders. These transactions, however, may increase the amount of fees paid to our Manager. In addition, Mr. Massoud’s compensation is paid by our Manager from the management fee it receives from the Company. Our Manager’s ability to increase its fees, through the influence it has over our operations, may increase the compensation paid by our Manager to Mr. Massoud. Our Manager’s ability to influence the management fee paid to it by us could reduce the amount of cash flow available for distribution to our shareholders.
Fees paid by the Company and our businesses pursuant to transaction services agreements do not offset fees payable under the management services agreement and will be in addition to the management fee payable by the Company under the management services agreement.
The management services agreement provides that our businesses may enter into transaction services agreements with our Manager pursuant to which our businesses will pay fees to our Manager. See the section entitled “Certain Relationships and Related Party Transactions” for more information about these agreements. Unlike fees paid under the offsetting management services agreements, fees that are paid pursuant to such transaction services agreements will not reduce the management fee payable by the Company. Therefore, such fees will be in excess of the management fee payable by the Company.
The fees to be paid to our Manager pursuant to these transaction service agreements will be paid prior to any principal, interest or dividend payments to be paid to the Company by our businesses, which will reduce the amount of cash flow available for distributions to shareholders.
Our Manager’s profit allocation may induce it to make suboptimal decisions regarding our operations.
Our Manager, as holder of 100% of the Allocation Interests in the Company, will receive a profit allocation based on ongoing cash flows and capital gains in excess of a hurdle rate. In this respect, a calculation and payment of profit allocation may be triggered upon the sale of one of our businesses. As a result, our Manager may be incentivized to recommend the sale of one or more of our businesses to the Company’s board of directors at a time that may not optimal for our shareholders.
The obligations to pay the management fee and profit allocation, including the put price, may cause the Company to liquidate assets or incur debt.
If we do not have sufficient liquid assets to pay the management fee and profit allocation, including the put price, when such payments are due, we may be required to liquidate assets or incur debt in order to make such payments. This circumstance could materially adversely affect our liquidity and ability to make distributions to our shareholders.
Risks Related to Taxation
Our shareholders will be subject to tax on their share of the Company’s taxable income, which taxes or taxable income could exceed the cash distributions they receive from the Trust.
For so long as the Company or the Trust (if it is treated as a tax partnership) would not be required to register as an investment company under the Investment Company Act of 1940 and at least 90% of our gross income for each taxable year constitutes “qualifying income” within the meaning of Section 7704(d) of the Internal Revenue Code of 1986, as
amended (the “Code”), on a continuing basis, we will be treated, for U.S. federal income tax purposes, as a partnership and not as an association or a publicly traded partnership taxable as a corporation. In that case our shareholders will be subject to U.S. federal income tax and, possibly, state, local and foreign income tax, on their share of the Company’s taxable income, which taxes or taxable income could exceed the cash distributions they receive from the Trust. There is, accordingly, a risk that our shareholders may not receive cash distributions equal to their portion of our taxable income or sufficient in amount even to satisfy their personal tax liability those results from that income. This may result from gains on the sale or exchange of stock or debt of subsidiaries that will be allocated to shareholders who hold (or are deemed to hold) shares on the day such gains were realized if there is no corresponding distribution of the proceeds from such sales, or where a shareholder disposes of shares after an allocation of gain but before proceeds (if any) are distributed by the Company. Shareholders may also realize income in excess of distributions due to the Company’s use of cash from operations or sales proceeds for uses other than to make distributions to shareholders, including funding acquisitions, satisfying short- and long-term working capital needs of our businesses, or satisfying known or unknown liabilities. In addition, certain financial covenants with the Company’s lenders may limit or prohibit the distribution of cash to shareholders. The Company’s board of directors is also free to change the Company’s distribution policy. The Company is under no obligation to make distributions to shareholders equal to or in excess of their portion of our taxable income or sufficient in amount even to satisfy the tax liability that results from that income.
All of the Company’s income could be subject to an entity-level tax in the United States, which could result in a material reduction in cash flow available for distribution to holders of shares of the Trust and thus could result in a substantial reduction in the value of the shares.
We do not expect the Company to be characterized as a corporation so long as it would not be required to register as an investment company under the Investment Company Act of 1940 and 90% or more of its gross income for each taxable year constitutes “qualifying income.” The Company expects to receive more than 90% of its gross income each year from dividends, interest and gains on sales of stock or debt instruments, including principally from or with respect to stock or debt of corporations in which the Company holds a majority interest. The Company intends to treat all such dividends, interest and gains as “qualifying income.”
If the Company fails to satisfy this “qualifying income” exception, the Company will be treated as a corporation for U.S. federal (and certain state and local) income tax purposes, and would be required to pay income tax at regular corporate rates on its income. Taxation of the Company as a corporation could result in a material reduction in distributions to our shareholders and after-tax return and, thus, could likely result in a reduction in the value of, or materially adversely affect the market price of, the shares of the Trust.
A shareholder may recognize a greater taxable gain (or a smaller tax loss) on a disposition of shares than expected because of the treatment of debt under the partnership tax accounting rules.
We may incur debt for a variety of reasons, including for acquisitions as well as other purposes. Under partnership tax accounting principles (which apply to the Company), debt of the Company generally will be allocable to our shareholders, who will realize the benefit of including their allocable share of the debt in the tax basis of their investment in shares. At the time a shareholder later sells shares, the selling shareholder’s amount realized on the sale will include not only the sales price of the shares but also the shareholder’s portion of the Company’s debt allocable to his shares (which is treated as proceeds from the sale of those shares). Depending on the nature of the Company’s activities after having incurred the debt, and the utilization of the borrowed funds, a later sale of shares could result in a larger taxable gain (or a smaller tax loss) than anticipated.
Our structure involves complex provisions of U.S. federal income tax law for which no clear precedent or authority may be available. Our structure also is subject to potential legislative, judicial or administrative change and differing interpretations, possibly on a retroactive basis.
The U.S. federal income tax treatment of holders of the Shares depends in some instances on determinations of fact and interpretations of complex provisions of U.S. federal income tax law for which no clear precedent or authority may be available. You should be aware that the U.S. federal income tax rules are constantly under review by persons involved in the legislative process, the IRS, and the U.S. Treasury Department, frequently resulting in revised interpretations of established concepts, statutory changes, revisions to regulations and other modifications and interpretations. The IRS pays close attention to the proper application of tax laws to partnerships. The present U.S. federal income tax treatment of an investment in the Shares may be modified by administrative, legislative or judicial interpretation at any time, and any such action may affect investments and commitments previously made. For example, changes to the U.S. federal tax laws and interpretations thereof could make it more difficult or impossible to meet the qualifying income exception for us to be treated as a partnership for U.S. federal income tax purposes that is not taxable as a corporation, affect or cause
us to change our investments and commitments, affect the tax considerations of an investment in us and adversely affect an investment in our Shares. Our organizational documents and agreements permit the Board of Directors to modify our operating agreement from time to time, without the consent of the holders of Shares, in order to address certain changes in U.S. federal income tax regulations, legislation or interpretation. In some circumstances, such revisions could have a material adverse impact on some or all of the holders of our Shares. Moreover, we will apply certain assumptions and conventions in an attempt to comply with applicable rules and to report income, gain, deduction, loss and credit to holders in a manner that reflects such holders’ beneficial ownership of partnership items, taking into account variation in ownership interests during each taxable year because of trading activity. However, these assumptions and conventions may not be in compliance with all aspects of applicable tax requirements. It is possible that the IRS will assert successfully that the conventions and assumptions used by us do not satisfy the technical requirements of the Code and/or Treasury regulations and could require that items of income, gain, deductions, loss or credit, including interest deductions, be adjusted, reallocated, or disallowed, in a manner that adversely affects holders of the Shares.
Risks Relating Generally to Our Businesses
The recent disruption in the overall economy and the financial markets will adversely impact our business.
Many industries, including our businesses, have been affected by current economic factors, including the significant deterioration of global economic conditions, declines in employment levels, and shifts in consumer spending patterns. The recent disruptions in the overall economy and volatility in the financial markets have greatly reduced, and may continue to reduce, consumer confidence in the economy, negatively affecting consumer spending, which could be harmful to our financial position. Disruptions in the overall economy may also lead to a lower collection rate on billings as consumers or businesses are unable to pay their bills in a timely fashion. Decreased cash flow generated from our products may adversely affect our financial position and our ability to fund our operations. In addition, macro economic disruptions, as well as the restructuring of various commercial and investment banking organizations, could adversely affect our ability to access the credit markets. The disruption in the credit markets may also adversely affect the availability of financing to support our strategy for growth through future acquisitions. There is a risk that government responses to the disruptions in the financial markets will not restore consumer confidence, stabilize the markets, or increase liquidity and the availability of credit.
Impairment of our intangible assets could result in significant charges that would adversely impact our future operating results.
We have significant intangible assets, including goodwill with an indefinite life, which are susceptible to valuation adjustments as a result of changes in various factors or conditions. The most significant intangible assets on our balance sheet are goodwill, technologies, customer relationships and trademarks we acquired when we acquired our businesses and Staffmark. Customer relationships are amortized on a straight line basis based upon the pattern in which the economic benefits of customer relationships are being utilized. Other identifiable intangible assets are amortized on a straight-line basis over their estimated useful lives. We assess the potential impairment of goodwill and indefinite lived intangible assets on an annual basis, as well as whenever events or changes in circumstances indicate that the carrying value may not be recoverable. We assess definite lived intangible assets whenever events or changes in circumstances indicate that the carrying value may not be recoverable.
Factors that could trigger impairment include the following:
•
significant underperformance relative to historical or projected future operating results;
•
significant changes in the manner of or use of the acquired assets or the strategy for our overall business;
•
significant negative industry or economic trends;
•
significant decline in our stock price for a sustained period;
•
changes in our organization or management reporting structure could result in additional reporting units, which may require alternative methods of estimating fair values or greater desegregation or aggregation in our analysis by reporting unit; and
•
a decline in our market capitalization below net book value.
As of December 31, 2009, we had identified indefinite lived intangible assets with a carrying value in our financial statements of $216.4 million, and goodwill of $288.0 million.
During the year ended December 31, 2009 we wrote off $50.0 million of goodwill associated with Staffmark. We also wrote off $9.8 million in intangible assets associated with the rebranding of the CBS Personnel name to Staffmark in 2009.
Further adverse changes in the operations of our businesses or other unforeseeable factors could result in an impairment charge in future periods that would impact our results of operations and financial position in that period.
Our businesses are subject to unplanned business interruptions which may adversely affect our performance.
Operational interruptions and unplanned events at one or more of our production facilities, such as explosions, fires, inclement weather, natural disasters, accidents, transportation interruptions and supply could cause substantial losses in our production capacity. Furthermore, because customers may be dependent on planned deliveries from us, customers that have to reschedule their own operations due to our delivery delays may be able to pursue financial claims against us, and we may incur costs to correct such problems in addition to any liability resulting from such claims. Such interruptions may also harm our reputation among actual and potential customers, potentially resulting in a loss of business. To the extent these losses are not covered by insurance, our financial position, results of operations and cash flows may be adversely affected by such events.
Our businesses rely and may rely on their intellectual property and licenses to use others’ intellectual property, for competitive advantage. If our businesses are unable to protect their intellectual property, are unable to obtain or retain licenses to use other’s intellectual property, or if they infringe upon or are alleged to have infringed upon others’ intellectual property, it could have a material adverse affect on their financial condition, business and results of operations.
Each businesses’ success depends in part on their, or licenses to use others’, brand names, proprietary technology and manufacturing techniques. These businesses rely on a combination of patents, trademarks, copyrights, trade secrets, confidentiality procedures and contractual provisions to protect their intellectual property rights. The steps they have taken to protect their intellectual property rights may not prevent third parties from using their intellectual property and other proprietary information without their authorization or independently developing intellectual property and other proprietary information that is similar. In addition, the laws of foreign countries may not protect our businesses’ intellectual property rights effectively or to the same extent as the laws of the United States. Stopping unauthorized use of their proprietary information and intellectual property, and defending claims that they have made unauthorized use of others’ proprietary information or intellectual property, may be difficult, time-consuming and costly. The use of their intellectual property and other proprietary information by others, and the use by others of their intellectual property and proprietary information, could reduce or eliminate any competitive advantage they have developed, cause them to lose sales or otherwise harm their business.
Our businesses may become involved in legal proceedings and claims in the future either to protect their intellectual property or to defend allegations that they have infringed upon others’ intellectual property rights. These claims and any resulting litigation could subject them to significant liability for damages and invalidate their property rights. In addition, these lawsuits, regardless of their merits, could be time consuming and expensive to resolve and could divert management’s time and attention. The costs associated with any of these actions could be substantial and could have a material adverse affect on their financial condition, business and results of operations.
The operations and research and development of some of our businesses’ services and technology depend on the collective experience of their technical employees. If these employees were to leave our businesses and take this knowledge, our businesses’ operations and their ability to compete effectively could be materially adversely impacted.
The future success of some of our businesses depends upon the continued service of their technical personnel who have developed and continue to develop their technology and products. If any of these employees leave our businesses, the loss of their technical knowledge and experience may materially adversely affect the operations and research and development of current and future services. We may also be unable to attract technical individuals with comparable experience because competition for such technical personnel is intense. If our businesses are not able to replace their technical personnel with new employees or attract additional technical individuals, their operations may suffer as they
may be unable to keep up with innovations in their respective industries. As a result, their ability to continue to compete effectively and their operations may be materially adversely affected.
If our businesses are unable to continue the technological innovation and successful commercial introduction of new products and services, their financial condition, business and results of operations could be materially adversely affected.
The industries in which our businesses operate, or may operate, experience periodic technological changes and ongoing product improvements. Their results of operations depend significantly on the development of commercially viable new products, product grades and applications, as well as production technologies and their ability to integrate new technologies. Our future growth will depend on their ability to gauge the direction of the commercial and technological progress in all key end-use markets and upon their ability to successfully develop, manufacture and market products in such changing end-use markets. In this regard, they must make ongoing capital investments.
In addition, their customers may introduce new generations of their own products, which may require new or increased technological and performance specifications, requiring our businesses to develop customized products. Our businesses may not be successful in developing new products and technology that satisfy their customers’ demand and their customers may not accept any of their new products. If our businesses fail to keep pace with evolving technological innovations or fail to modify their products in response to their customers’ needs in a timely manner, then their financial condition, business and results of operations could be materially adversely affected as a result of reduced sales of their products and sunk developmental costs. These developments may require our personnel staffing business to seek better educated and trained workers, who may not be available in sufficient numbers.
Our businesses could experience fluctuations in the costs of raw materials as a result of inflation and other economic conditions, which fluctuations could have a material adverse effect on their financial condition, business and results of operations.
Changes in inflation could materially adversely affect the costs and availability of raw materials used in our manufacturing businesses, and changes in fuel costs likely will affect the costs of transporting materials from our suppliers and shipping goods to our customers, as well as the effective areas from which we can recruit temporary staffing personnel. For example, for Advanced Circuits, the principal raw materials consist of copper and glass and represent approximately 16.9% of net sales in 2009. Prices for these key raw materials may fluctuate during periods of high demand. The ability by these businesses to offset the effect of increases in raw material prices by increasing their prices is uncertain. If these businesses are unable to cover price increases of these raw materials, their financial condition, business and results of operations could be materially adversely affected.
Our businesses do not have and may not have long-term contracts with their customers and clients and the loss of customers and clients could materially adversely affect their financial condition, business and results of operations.
Our businesses are and may be, based primarily upon individual orders and sales with their customers and clients. Our businesses historically have not entered into long-term supply contracts with their customers and clients. As such, their customers and clients could cease using their services or buying their products from them at any time and for any reason. The fact that they do not enter into long-term contracts with their customers and clients means that they have no recourse in the event a customer or client no longer wants to use their services or purchase products from them. If a significant number of their customers or clients elect not to use their services or purchase their products, it could materially adversely affect their financial condition, business and results of operations.
Our businesses are and may be subject to federal, state and foreign environmental laws and regulations that expose them to potential financial liability. Complying with applicable environmental laws requires significant resources, and if our businesses fail to comply, they could be subject to substantial liability.
Some of the facilities and operations of our businesses are and may be subject to a variety of federal, state and foreign environmental laws and regulations including laws and regulations pertaining to the handling, storage and transportation of raw materials, products and wastes, which require and will continue to require significant expenditures to remain in compliance with such laws and regulations currently in place and in the future. Compliance with current and future environmental laws is a major consideration for our businesses as any material violations of these laws can lead to substantial liability, revocations of discharge permits, fines or penalties. Because some of our businesses use hazardous materials and generate hazardous wastes in their operations, they may be subject to potential financial liability for costs associated with the investigation and remediation of their own sites, or sites at which they have arranged for the disposal of hazardous wastes, if such sites become contaminated. Even if they fully comply with applicable environmental laws
and are not directly at fault for the contamination, our businesses may still be liable. Costs associated with these risks could have a material adverse effect on our financial condition, business and results of operations.
Defects in the products provided by our companies could result in financial or other damages to those customers, which could result in reduced demand for our companies’ products and/or liability claims against our companies.
Some of the products our businesses produce could potentially result in product liability suits against them. Some of our companies manufacture products to customer specifications that are highly complex and critical to customer operations. Defects in products could result in customer dissatisfaction or a reduction in or cancellation of future purchases or liability claims against our companies. If these defects occur frequently, our reputation may be impaired. Defects in products could also result in financial or other damages to customers, for which our companies may be asked or required to compensate their customers. Any of these outcomes could negatively impact our financial condition, business and results of operations.
Some of our businesses are subject to certain risks associated with the movement of businesses offshore.
Some of our businesses are potentially at risk of losing business to competitors operating in lower cost countries. An additional risk is the movement offshore of some of our businesses’ customers, leading them to procure products or services from more closely located companies. Either of these factors could negatively impact our financial condition, business and results of operations.
Loss of key customers of some of our businesses could negatively impact financial condition.
Some of our businesses have significant exposure to certain key customers, the loss of which could negatively impact our financial condition, business and results of operations.
Our businesses are subject to certain risks associated with their foreign operations or business they conduct in foreign jurisdictions.
Some of our businesses have and may have operations or conduct business outside the United States. Certain risks are inherent in operating or conducting business in foreign jurisdictions, including exposure to local economic conditions; difficulties in enforcing agreements and collecting receivables through certain foreign legal systems; longer payment cycles for foreign customers; adverse currency exchange controls; exposure to risks associated with changes in foreign exchange rates; potential adverse changes in political environments; withholding taxes and restrictions on the withdrawal of foreign investments and earnings; export and import restrictions; difficulties in enforcing intellectual property rights; and required compliance with a variety of foreign laws and regulations. These risks individually and collectively have the potential to negatively impact our financial condition, business and results of operations.
Risks Related to Advanced Circuits
Unless Advanced Circuits is able to respond to technological change at least as quickly as its competitors, its services could be rendered obsolete, which could materially adversely affect its financial condition, business and results of operations.
The market for Advanced Circuits’ services is characterized by rapidly changing technology and continuing process development. The future success of its business will depend in large part upon its ability to maintain and enhance its technological capabilities, retain qualified engineering and technical personnel, develop and market services that meet evolving customer needs and successfully anticipate and respond to technological changes on a cost-effective and timely basis. Advanced Circuits’ core manufacturing capabilities are for 2 to 12 layer printed circuit boards. Trends towards miniaturization and increased performance of electronic products are dictating the use of printed circuit boards with increased layer counts. If this trend continues Advanced Circuits may not be able to effectively respond to the technological requirements of the changing market. If it determines that new technologies and equipment are required to remain competitive, the development, acquisition and implementation of these technologies may require significant capital investments. It may be unable to obtain capital for these purposes in the future, and investments in new technologies may not result in commercially viable technological processes. Any failure to anticipate and adapt to its customers’ changing technological needs and requirements or retain qualified engineering and technical personnel could materially adversely affect its financial condition, business and results of operations.
Advanced Circuits’ customers operate in industries that experience rapid technological change resulting in short product life cycles and as a result, if the product life cycles of its customers slow materially, and research and development expenditures are reduced, its financial condition, business and results of operations will be materially adversely affected.
Advanced Circuits’ customers compete in markets that are characterized by rapidly changing technology, evolving industry standards and continuous improvement in products and services. These conditions frequently result in short product life cycles. As professionals operating in research and development departments represent the majority of Advanced Circuits’ net sales, the rapid development of electronic products is a key driver of Advanced Circuits’ sales and operating performance. Any decline in the development and introduction of new electronic products could slow the demand for Advanced Circuits’ services and could have a material adverse effect on its financial condition, business and results of operations.
Electronics manufacturing services corporations are increasingly acting as intermediaries, positioning themselves between PCB manufacturers and OEMS, which could reduce operating margins.
Advanced Circuits’ OEM customers are increasingly outsourcing the assembly of equipment to third party manufacturers. These third party manufacturers typically assemble products for multiple customers and often purchase circuit boards from Advanced Circuits in larger quantities than OEM manufacturers. The ability of Advanced Circuits to sell products to these customers at margins comparable to historical averages is uncertain. Any material erosion in margins could have a material adverse effect on Advanced Circuits’ financial condition, business and results of operations.
Risks Related to American Furniture Manufacturing
Competition from larger furniture manufacturers may adversely affect American Furniture Manufacturing’s business and operating results.
The residential upholstered furniture industry is highly competitive. Certain of American Furniture Manufacturing’s competitors are larger, have broader product lines and offer widely-advertised, well-known, branded products. If such larger competitors introduce additional products in the promotional segment of the upholstered furniture market, the segment in which American Furniture Manufacturing primarily participates, it may negatively impact American Furniture Manufacturing’s market share and financial performance.
Risks Related to Anodyne
Certain of Anodyne’s products are subject to regulation by the FDA.
Certain of Anodyne’s mattress products are Class II devices within Section 201(h) of the Federal FDCA (21 USC §321(h), and, as such, are subject to the requirements of the FDCA and certain rules and regulations of the FDA. Prior to our acquisition of Anodyne, one of its subsidiaries received a warning letter from the FDA in connection with certain deficiencies identified during a regular FDA audit, including noncompliance with certain design control requirements, certain of the good manufacturing practice regulations defined in 21 C.F.R. 820 and certain record keeping requirements. Anodyne’s subsidiary has undertaken corrective measures to address the deficiencies and continues to fully cooperate with the FDA. Anodyne is vulnerable to actions that may be taken by the FDA which have a material adverse effect on Anodyne and/or its business. The FDA has the authority to inspect without notice, and to take any disciplinary action that it sees fit.
A change in Medicare Reimbursement Guidelines may reduce demand for Anodyne’s products.
Certain changes in Medicare Reimbursement Guidelines may reduce demand for medical support surfaces and have a material effect on Anodyne’s operating performance.
Two of Anodyne’s largest customers represented approximately 50% of its gross sales in 2009.
Anodyne has significant exposure to two key customers. The loss of either customer could negatively impact Anodyne’s financial condition, business and results of operations.
Risks Related to Fox
Growth in popularity of alternative recreational activities may reduce demand for mountain bikes and off road products which would reduce demand for Fox’s products.
Mountain biking and other off-road sports compete against numerous recreational activities for share of time and spend of enthusiasts. Any growth in popularity of other outdoor activities at the expense of mountain biking and off-road sports could lead to a decrease in demand for the company’s product’s and could materially adversely affect Fox’s financial condition, business and results of operations.
Risks Related to HALO
Increases in the portion of existing customers and potential customers buying directly from manufacturers or exclusively over the internet could have a material adverse affect on the business of HALO.
The promotional products industry supply chain is comprised of multiple levels. As a distributor, HALO does not manufacturer or decorate the promotional products it sells. Additionally, in recent years there have been a number of suppliers and distributors who have attempted to sell directly to customers over the internet with varying levels of success. Though management believes distributors and account executives play crucial roles in the industry supply chain, increases in the portion of end customers buying directly from manufacturers or exclusively through the internet could have a material adverse affect on the business of HALO.
The loss of a significant number of account executives could adversely affect the business of HALO.
HALO relies on its large staff of account executives to develop and maintain relationships with end customers. HALO’s sales force is comprised of both full time employees and sub-contractors. These professionals have relationships with customers of varying sizes and profitability. Though management believes its compensation structure and support of its sales forces is comparable or better than many industry participants, there can be no assurances that HALO will be able to retain their continuing services. The loss of a significant number of account executives could adversely affect the business of HALO.
HALO relies on suppliers for the timely delivery of products to end customers. Delays in the delivery of promotional products to customers could adversely affect HALO’s results of operations.
HALO often relies on many of its suppliers to ship directly to its end customers (“drop-shipments”). Delays in the shipment of products or supply shortages in promotional products in high demand could affect HALO’s standing with its end customers and adversely affect HALO’s results of operations.
Risks Related to Staffmark
Staffmark’s business depends on its ability to attract and retain qualified staffing personnel that possess the skills demanded by its clients.
As a provider of temporary staffing services, the success of Staffmark’s business depends on its ability to attract and retain qualified staffing personnel who possess the skills and experience necessary to meet the requirements of its clients or to successfully bid for new client projects. Staffmark must continually evaluate and upgrade its base of available qualified personnel through recruiting and training programs to keep pace with changing client needs and emerging technologies. Staffmark’s ability to attract and retain qualified staffing personnel could be impaired by rapid improvement in economic conditions resulting in lower unemployment, increases in compensation or increased competition. During periods of economic growth, Staffmark faces increasing competition for retaining and recruiting qualified staffing personnel, which in turn leads to greater advertising and recruiting costs and increased salary expenses. If Staffmark cannot attract and retain qualified staffing personnel, the quality of its services may deteriorate and its financial condition, business and results of operations may be materially adversely affected.
Customer relocation of positions filled by Staffmark may materially adversely affect Staffmark’s financial condition, business and results of operations
Many companies have built offshore operations, moved their operations to offshore sites that have lower employment costs or outsourced certain functions. If Staffmark’s customers relocate positions filled by Staffmark, this would have a material adverse effect on the financial condition, business and results of operations of Staffmark.
Staffmark assumes the obligation to make wage, tax and regulatory payments for its employees, and as a result, it is exposed to client credit risks.
Staffmark generally assumes responsibility for and manages the risks associated with its employees’ payroll obligations, including liability for payment of salaries and wages (including payroll taxes), as well as group health and retirement benefits for its leased employees. These obligations are fixed, whether or not its clients make payments required by services agreements, which exposes Staffmark to credit risks of its clients, primarily relating to uncollateralized accounts receivables. If Staffmark fails to successfully manage its credit risk, its financial condition, business and results of operations may be materially adversely affected.
Staffmark is exposed to employment-related claims and costs and periodic litigation that could materially adversely affect its financial condition, business and results of operations.
The temporary services business entails employing individuals and placing such individuals in clients’ workplaces. Staffmark’s ability to control the workplace environment of its clients is limited. As the employer of record of its temporary employees, it incurs a risk of liability to its temporary employees and clients for various workplace events, including claims of misconduct or negligence on the part of its employees; discrimination or harassment claims against its employees, or claims by its employees of discrimination or harassment by its clients; immigration-related claims; claims relating to violations of wage, hour and other workplace regulations; claims relating to employee benefits, entitlements to employee benefits, or errors in the calculation or administration of such benefits; and possible claims relating to misuse of customer confidential information, misappropriation of assets or other similar claims. Staffmark may incur fines and other losses and negative publicity with respect to any of these situations. Some the claims may result in litigation, which is expensive and distracts management’s attention from the operations of Staffmark’s business. Furthermore, while Staffmark maintains insurance with respect to many of these items, it, may not be able to continue to obtain insurance at a cost that does not have a material adverse effect upon it. As a result, such claims (whether by reason of it not having insurance or by reason of such claims being outside the scope of its insurance) may have a material adverse effect on Staffmark’s financial condition, business and results of operations.
Staffmark’s workers’ compensation loss reserves may be inadequate to cover its ultimate liability for workers’ compensation costs.
Staffmark self-insures its workers’ compensation exposure for certain employees. The calculation of the workers’ compensation reserves involves the use of certain actuarial assumptions and estimates. Accordingly, reserves do not represent an exact calculation of liability. Reserves can be affected by both internal and external events, such as adverse developments on existing claims or changes in medical costs, claims handling procedures, administrative costs, inflation, and legal trends and legislative changes. As a result, reserves may not be adequate.
If reserves are insufficient to cover the actual losses, Staffmark would have to increase its reserves and incur charges to its earnings that could be material.
Any significant economic downturn could result in our clients using fewer temporary and contract workers or becoming unable to pay us for our services on a timely basis or at all, which would materially adversely affect our business.
Because demand for recruitment services is sensitive to changes in the level of economic activity, our business may suffer during economic downturns. As economic activity begins to slow down, companies tend to reduce their use of temporary and contract workers before undertaking layoffs of their regular employees, resulting in decreased demand for temporary and contract workers. Significant declines in demand, and thus in revenues, can result in expense de-leveraging, which would result in lower profit levels.
In addition, during economic downturns companies may slow the rate at which they pay their vendors or become unable to pay their debts as they become due. If any of our significant clients does not pay amounts owed to us in a timely manner or becomes unable to pay such amounts to us at a time when we have substantial amounts receivable from such client, our cash flow and profitability may suffer.
State unemployment insurance expense is a direct cost of doing business in the Staffing Industry. State unemployment tax rates are established based on a company’s specific experience rate of unemployment claims and a state’s required funding
for total claims. Economic downturns may result in a higher occurrence of unemployment claims resulting in higher state unemployment tax rates. Additionally, as states are paying more in total prolonged claims during an economic downturn, states may increase unemployment tax rates to employers, regardless of the employer’s specific experience. This would result in higher direct costs to Staffmark.
ITEM 1B.
ITEM 1B. UNRESOLVED STAFF COMMENTS
NONE
ITEM 2.
ITEM 2. - PROPERTIES
Advanced Circuits
Advanced Circuits operations are located in a 61,058 square foot building in Aurora, Colorado. This facility is leased and comprises both the factory and office space. The lease term is for 15 years with a renewal option for an additional 10 years.
American Furniture
American Furniture operates primarily from a manufacturing and warehousing facility located in Ecru, MS, of which approximately 750,000 square feet was refurbished in 2008 as a result of damage caused by a fire in 2008. This 1.1 million square foot facility includes 350,000 square feet of manufacturing space, 750,000 square feet of warehouse space and 82 shipping docks. AFM can add additional manufacturing lines within its existing footprint to accommodate demand during peak times. In addition to AFM’s primary manufacturing facility, AFM leases approximately 300,000 square feet of warehouse and small manufacturing space within the vicinity of its primary Ecru facility. AFM also leases showroom space in High Point, North Carolina and Tupelo Mississippi, allowing it to showcase its products to buyers and during trade shows held in the area.
Anodyne
Anodyne leases a 33,000 square foot facility in Coral Springs, Florida, which houses its manufacturing and distribution operations for the east coast. It also leases an 81,000 square foot facility in Corona, California, which houses the manufacturing and distribution facilities for the west coast.
Fox
Fox’s corporate headquarters and main manufacturing facilities are located in an 86,000 square foot facility located in Watsonville California. In addition, Fox leases five other smaller facilities totaling approximately 50,000 square feet in the surrounding Watsonville area.
HALO
HALO distributes its products through a leased 40,000 square foot office facility and a 57,000 square foot fulfillment warehouse, both of which are located in Sterling, IL. Due to its high percentage of drop shipments, HALO is able to operate from a much smaller warehouse than a similar size company with a traditional inventory-based business model. HALO also maintains a small IT department in Oak Brook, IL and an office for its CEO in Chicago.
The following table shows the number of offices located in each state and the function of each office as of December 31, 2009.
Staffmark
Staffmark’s principal executive offices are located in Cincinnati, Ohio where it leases 38,867 square feet of office space. Staffmark provides staffing services through 208 branch offices located in 29 states which include branch offices and locations for its recent Staffmark acquisition. Lease terms for the branch offices typically run from 3 to 5 years.
Our corporate offices are located in Westport, Connecticut, where we lease approximately 1,500 square feet from our Manager.
We believe that our properties at each of our businesses are sufficient to meet our present needs and we do not anticipate any difficulty in securing additional space, as needed, on acceptable terms.
ITEM 3.
ITEM 3. - LEGAL PROCEEDINGS
In the normal course of business, we are involved in various claims and legal proceedings. While the ultimate resolution of these matters has yet to be determined, we do not believe that their outcome will have a material adverse effect on our financial position or results of operations.
ITEM 4.
ITEM 4. - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
RESERVED
Part II
Item 5.
Item 5. - Market for Registrants’ Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Market Information
Our Trust stock trades on the NASDAQ Global Select Market under the symbol “CODI.” The following table sets forth the high and low closing prices per share as reported by the NASDAQ Global Select Market during the periods indicated. The highest and lowest prices per share of Trust stock were $6.89 and $15.58, respectively, for the periods presented below:
COMPARATIVE PERFORMANCE OF SHARES OF TRUST STOCK
The performance graph shown below compares the change in cumulative total shareholder return on shares of Trust stock with the NASDAQ Stock Market Index (US) and the NASDAQ Other Finance Index (US) from May 16, 2006, when we completed our initial public offering, through the quarter ended December 31, 2009. The graph sets the beginning value of shares of Trust stock and the indices at $100, and assumes that all quarterly dividends were reinvested at the time of payment. This graph does not forecast future performance of shares of Trust stock.
Shareholders
As of February 26, 2010 we had 36,625,000 shares of Trust stock outstanding that were held by twelve holders of record; however, we believe the number of beneficial owners of our shares is over 9,000.
Distributions
For the years 2008 and 2009 we have declared and paid quarterly cash distributions to holders of record as follows:
We currently intend to continue to declare and pay regular quarterly cash distributions on all outstanding shares through fiscal 2010. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources” in Part II, Item 7.
ITEM 7. -
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
This item 7 contains forward-looking statements. Forward-looking statements in this Annual Report on Form 10-K are subject to a number of risks and uncertainties, some of which are beyond our control. Our actual results, performance, prospects or opportunities could differ materially from those expressed in or implied by the forward-looking statements. Additional risks of which we are not currently aware or which we currently deem immaterial could also cause our actual results to differ, including those discussed in the sections entitled “Forward-Looking Statements” and “Risk Factors” included elsewhere in this Annual Report.
Overview
Compass Diversified Holdings, a Delaware statutory trust, was incorporated in Delaware on November 18, 2005. Compass Group Diversified Holdings, LLC, a Delaware limited liability Company, was also formed on November 18, 2005. In accordance with the Trust Agreement, the Trust is sole owner of 100% of the Trust Interests (as defined in the LLC Agreement) of the Company and, pursuant to the LLC Agreement, the Company has outstanding, the identical number of Trust Interests as the number of outstanding shares of the Trust. The Manager is the sole owner of the Allocation Interests of the Company. The Company is the operating entity with a board of directors and other corporate governance responsibilities, similar to that of a Delaware corporation.
The Trust and the Company were formed to acquire and manage a group of small and middle-market businesses headquartered in North America. We characterize small and middle market businesses as those that generate annual cash flows of up to $60 million. We focus on companies of this size because we believe that these companies are more able to achieve growth rates above those of their relevant industries and are also frequently more susceptible to efforts to improve earnings and cash flow.
In pursuing new acquisitions, we seek businesses with the following characteristics:
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North American base of operations;
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stable and growing earnings and cash flow;
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maintains a significant market share in defensible industry niche (i.e., has a “reason to exist”);
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solid and proven management team with meaningful incentives;
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low technological and/or product obsolescence risk; and
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a diversified customer and supplier base.
Our management team’s strategy for our subsidiaries involves:
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utilizing structured incentive compensation programs tailored to each business in order to attract, recruit and retain talented managers to operate our businesses;
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regularly monitoring financial and operational performance, instilling consistent financial discipline, and supporting management in the development and implementation of information systems to effectively achieve these goals;
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assisting management in their analysis and pursuit of prudent organic cash flow growth strategies (both revenue and cost related);
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identifying and working with management to execute attractive external growth and acquisition opportunities; and
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forming strong subsidiary level boards of directors to supplement management in their development and implementation of strategic goals and objectives.
Based on the experience of our management team and its ability to identify and negotiate acquisitions, we believe we are well positioned to acquire additional attractive businesses. Our management team has a large network of over 2,000 deal
intermediaries to whom it actively markets and who we expect to expose us to potential acquisitions. Through this network, as well as our management team’s active proprietary transaction sourcing efforts, we typically have a substantial pipeline of potential acquisition targets. In consummating transactions, our management team has, in the past, been able to successfully navigate complex situations surrounding acquisitions, including corporate spin-offs, transitions of family-owned businesses, management buy-outs and reorganizations. We believe the flexibility, creativity, experience and expertise of our management team in structuring transactions provides us with a strategic advantage by allowing us to consider non-traditional and complex transactions tailored to fit a specific acquisition target.
In addition, because we intend to fund acquisitions through the utilization of our Revolving Credit Facility, we do not expect to be subject to delays in or conditions by closing acquisitions that would be typically associated with transaction specific financing, as is typically the case in such acquisitions. We believe this advantage is a powerful one and is highly unusual in the marketplace for acquisitions in which we operate.
Initial public offering and Company formation
On May 16, 2006, we completed our initial public offering of 13,500,000 shares of the Trust at an offering price of $15.00 per share (the “IPO”). Total net proceeds from the IPO, after deducting the underwriters’ discounts, commissions and financial advisory fee, were approximately $188.3 million. On May 16, 2006, we also completed the private placement of 5,733,333 shares to CGI for approximately $86.0 million and completed the private placement of 266,667 shares to Pharos I LLC, an entity controlled by Mr. Massoud, the Chief Executive Officer of the Company, and owned by our management team, for approximately $4.0 million. CGI also purchased 666,667 shares for $10.0 million through the IPO.
Subsequent to the IPO the Company’s board of directors engaged the Manager to externally manage the day-to-day operations and affairs of the Company, oversee the management and operations of the businesses and to perform those services customarily performed by executive officers of a public company.
From May 16, 2006 through December 31, 2009, we purchased nine businesses (each of our businesses is treated as a separate business segment) and disposed of three, as follows:
Acquisitions
We did not acquire any new businesses during the year ended 2009. The acquisition market picked up considerably during the fourth quarter of 2009 where we began seeing more quality acquisition candidates.
Dispositions
We are dependent on the earnings of, and cash receipts from, the businesses that we own in order to meet our corporate overhead and management fee expenses and to pay distributions. These earnings and distributions, net of any noncontrolling interest in these businesses, are available to:
•
meet capital expenditure requirements, management fees and corporate overhead charges;
•
fund distributions from the businesses to the Company; and
•
be distributed by the Trust to shareholders.
2009 Highlights
Term Loan Facility pay down
On February 18, 2009, the Company reduced its debt and repaid at par, from cash on its balance sheet, $75.0 million of long term debt under its Term Loan Facility due in December of 2013.
Equity offering
On June 9, 2009 we successfully completed a public offering of 5.1 million Trust shares at $8.85 per share raising $45.1 million in gross proceeds. The net proceeds to the Company, after deducting underwriter’s discount and offering costs totaled approximately $42.1 million.
2009 Distributions
We increased our quarterly distribution to $0.34 per share during the third quarter of 2008. For the 2009 fiscal year we declared distributions to our shareholders totaling $1.36 per share.
Areas for focus in 2010
The areas of focus for 2010, which are generally applicable to each of our businesses, include:
•
Taking advantage, where possible, of the current economic downturn by growing market share in each of our market niche leading companies at the expense of less well capitalized competitors;
•
Achieving sales growth, technological excellence and manufacturing capability through global expansion;
•
Continuing to grow through disciplined, strategic acquisitions and rigorous integration processes;
•
Continue to pursue expense reduction and cost savings through contraction in discretionary spending, and reductions in workforce and production levels in response to lower production volume;
•
Driving free cash flow through increased net income and effective working capital management enabling continued investment in our businesses, strategic acquisitions, and enabling us to return value to our shareholders; and
Results of Operations
We were formed on November 18, 2005 and acquired our existing businesses (segments) as follows:
Fiscal 2009, 2008 and 2007 represents a full year of operating results included in our consolidated results of operations for only three of our businesses. The remaining three businesses were acquired during fiscal 2007 and 2008 (see table above). As a result, we cannot provide a meaningful comparison of our historical consolidated results of operations for the year ended December 31, 2009 with the two prior years. In the following results of operations, we provide (i) our consolidated results of operations for the years ended December 31, 2009, 2008 and 2007, which includes the historical results of operations of our businesses (segments) from the date of acquisition and (ii) comparative historical results of operations for each of our businesses on a stand-alone basis, for each of the years ended December 31, 2009, 2008 and 2007, together with relevant pro-forma adjustments.
Consolidated Results of Operations - Compass Diversified Holdings
Net sales
On a consolidated basis net sales decreased approximately $289.7 million in the year ended December 31, 2009 compared to 2008. This decrease in net sales in 2009 is due principally to decreased revenues at our Staffmark, Advanced Circuits, Anodyne, Fox and Halo operating segments offset in part by increased net sales at American Furniture. Revenues at Staffmark decreased $261.0 million during the year ended December 31, 2009 compared with the same period in 2008. On a consolidated basis net sales increased approximately $696.7 million in the year ended December 31, 2008 compared to 2007. The increase is primarily attributable to increased revenues at Staffmark resulting from the acquisition of Staffmark LLC on January 23, 2008 ($436.5 million) and net sales attributable to our majority owned subsidiary, Fox, also acquired in January 2008 ($131.7 million). Refer to “Results of Operations - Our Businesses” for a more detailed analysis of net sales and revenues by operating segment.
We do not generate any revenues apart from those generated by the businesses we own. We may generate interest income on the investment of available funds, but expect such earnings to be minimal. Our investment in our businesses is typically in the form of loans from the Company to such businesses, as well as equity interests in those companies. Cash flows coming to the Trust and the Company are the result of interest payments on those loans, amortization of those loans and, dividends on our equity ownership. However, on a consolidated basis these items are eliminated.
Cost of sales
On a consolidated basis cost of sales decreased approximately $219.2 million in the year ended December 31, 2009 compared to 2008 and increased approximately $560.2 million in the year ended December 31, 2008 compared to 2007. These charges are due almost entirely to the corresponding decrease/increase in net sales referred to above. Refer to “Results of Operations - Our Businesses” for a more detailed analysis of cost of sales expense by operating segment.
Staffing, selling, general and administrative expense
On a consolidated basis, staffing, selling, general and administrative expense decreased approximately $48.0 million in the year ended December 31, 2009 compared to 2008. The 2009 vs. 2008 year over year decrease is due principally to cost
cutting measures enacted at the operating segment level in response to the softening economy and its negative impact on sales and operating income in 2009. Additionally, costs directly tied to sales, such as commission expense, declined as a direct result of the decrease in net sales. On a consolidated basis staffing, selling, general and administrative costs increased approximately $117.6 million in the year ended December 31, 2008 compared to the same period in 2007. The 2008 vs. 2007 year over year increase is due principally to our 2008 acquisitions and full year results of our 2007 acquisitions. At the corporate level general and administrative costs decreased approximately $1.3 million for the year ended December 31, 2009 compared to the same period in 2008 due principally to lower costs for professional fees being incurred in 2009 in connection with Sarbanes Oxley compliance. For the year ended December 31 2008 costs at the corporate level increased approximately $2.0 million compared to the comparable period in 2007 due principally to increased salaries and wages and professional fees. - Please refer to “Results of Operations - Our Businesses” for a more detailed analysis of staffing, selling, general and administrative expense by operating segment.
Management fees
Pursuant to the Management Services Agreement, we pay CGM a quarterly management fee equal to 0.5% (2.0% annualized) of our adjusted net assets, which is defined in the Management Services Agreement (see Related Party Transactions). For the years ended December 31, 2009, 2008 and 2007 we incurred approximately $12.8 million, $14.7 million and $10.1 million, respectively, in expense for these fees. The decrease in Management fees in 2009 compared to 2008 is due principally to the decrease in consolidated adjusted net assets at December 31, 2009 resulting from the $75.0 million pay down of our Term Loan Facility with available cash in February 2009 and the $59.8 million impairment charge in 2009. The increase in Management fees in 2008 compared to 2007 is principally due to the increase in consolidated adjusted net assets in 2008 as a result of LLC’s acquisition of Staffmark in January 2008 and our acquisition of Fox in January 2008, offset in part by the sale of Aeroglide and Silvue in June 2008. Staffmark paid approximately $0.3 million and $0.5 million during the year ended December 31, 2009 and 2008, respectively, to the predecessor owner of Staffmark. - Please refer to “Related Party Transactions and Certain Transactions Involving our Businesses for more information about the Management Services Agreement.
Supplemental put expense
In 2006 we entered into a Supplemental Put Agreement with our Manager pursuant to which our Manager has the right to cause us to purchase the Allocation Interests then owned by them upon termination of the Management Services Agreement. The Company accrued approximately $6.4 million and $7.4 million in expense during the years ended December 31, 2008 and 2007, respectively, and reversed approximately $1.3 million in charges in 2009 in connection with this agreement. This expense represents that portion of the estimated increase in the fair value of our businesses over our original basis in those businesses that our Manager is entitled to if the Management Services Agreement were terminated or those businesses were sold - Please refer to “Related Party Transactions and Certain Transactions Involving our Businesses for more information about the Supplemental Put Agreement.
Impairment expense
Based on the results of our annual impairment tests performed as of March 31, 2009 an indication of impairment existed at the Staffmark reporting unit. In each of our other businesses (reporting units) the result of the annual goodwill impairment test indicated that the fair value of the business exceeded its carrying value. Based on the results of the second step of the impairment test at Staffmark, we estimated that the carrying value of Staffmark goodwill exceeded its fair value by approximately $50.0 million. As a result of this shortfall, we recorded a $50.0 million pretax goodwill impairment charge for 2009. The results of the annual impairment tests performed as of April 30, 2008 and 2007 indicated that the fair values of the reporting units (businesses) exceeded their carrying values and, therefore, goodwill was not impaired. Accordingly, there were no charges for goodwill impairment in 2008 or 2007.
In connection with the annual goodwill impairment we tested other indefinite-lived intangible assets at our Staffmark reporting unit. As a result of this analysis we determined that the carrying value exceeded the fair value of the CBS Personnel trade name, based principally on the discontinuance of the use of the CBS Personnel trade name and rebranding of the reporting units business to Staffmark beginning in February 2009. During 2009, we recorded an asset impairment charge of approximately $9.8 million at the corporate level to decrease the carrying value of the CBS personnel trade name to its fair value.
Results of Operations - Our Businesses
As previously discussed, we acquired our businesses on various acquisition dates beginning May 16, 2006 (see table above). As a result, our consolidated operating results only include the results of operations since the acquisition date associated with each of our businesses. The following discussion reflects a comparison of the historical results of operations for each of our initial businesses (segments), for the complete fiscal years ending December 31, 2009, 2008 and 2007. In addition, the historical results of operations for Staffmark include the results of Staffmark (acquired on January 21, 2008) as if CBS acquired Staffmark as of January 1, 2007. For the 2008 acquisitions and 2007 acquisitions the
following discussion reflects comparative historical results of operations for the entire fiscal years ending December 31, 2009, 2008 and 2007 as if we had acquired the businesses on January 1, 2007. When appropriate, relevant pro-forma adjustments are reflected in the historical operating results. Adjustments to depreciation and amortization resulting from purchase allocations that were not “pushed down” to a business are not included as a component of operating results. We believe this presentation enhances the discussion and provides a more meaningful comparison of operating results. The following operating results of our businesses are not necessarily indicative of the results to be expected for a full year, going forward.
Advanced Circuits
Overview
Advanced Circuits is a provider of prototype, quick-turn and volume production PCBs to customers throughout the United States. Collectively, prototype and quick-turn PCBs represent approximately 66.0% of Advanced Circuits’ gross revenues. Prototype and quick-turn PCBs typically command higher margins than volume production PCB’s given that customers require high levels of responsiveness, technical support and timely delivery of prototype and quick-turn PCBs and are willing to pay a premium for them. Advanced Circuits is able to meet its customers’ demands by manufacturing custom PCBs in as little as 24 hours, while maintaining over 98.0% error-free production rates and real-time customer service and product tracking 24 hours per day.
While global demand for PCBs has remained strong in recent years, industry wide domestic production has declined over 50% since 2000. In contrast, Advanced Circuits’ revenues increased steadily through 2008 as its customers’ prototype and quick-turn PCB requirements, such as small quantity orders and rapid turnaround, are less able to be met by low cost volume manufacturers in Asia and elsewhere. Advanced Circuits’ management anticipates that demand for its prototype and quick-turn printed circuit boards will remain strong and anticipates that demand will be impacted less by current economic conditions than by its longer lead time production business, which is driven more by consumer purchasing patterns and capital investments by businesses.
We purchased a controlling interest in Advanced Circuits on May 16, 2006.
Results of Operations
The table below summarizes the statement of operations for Advanced Circuits for the fiscal years ending December 31, 2009, 2008 and 2007.
Fiscal Year Ended December 31, 2009 Compared to Fiscal Year Ended December 31, 2008
Net sales
Net sales for the year ended December 31, 2009 were approximately $46.5 million compared to approximately $55.4 million for the year ended December 31, 2008, a decrease of approximately $8.9 million or 16.1%. The decrease in net sales is due to decreased sales in quick-turn ($2.1 million) and prototype ($3.4 million) production PCBs. In addition long-lead and sub-contract sales decreased approximately $4.7 million. These decreases were offset in part by an increase in assembly sales of $1.1 million. Quick-turn production PCBs represented approximately 36.3% of gross sales for the year ended December 31, 2009 compared to approximately 34.4% for the fiscal year ended December 31, 2008. Prototype production represented approximately 30.6% of gross sales for the year ended December 31, 2009 compared to
approximately 31.6% for the same period in 2008. Long-lead production and sub-contract sales as a percentage of gross sales decreased to approximately 28.3% of gross sales for the fiscal year 2009 compared to approximately 31.7% for fiscal 2008. Assembly sales represented approximately 4.8% of gross sales in 2009 compared to approximately 2.3% in 2008.
The decline in net sales in each of the PCB categories in 2009 when compared to 2008 is attributable to the economic slowdown in 2009 and the adverse impact it had on our customers during the year. Based on fourth quarter 2009 orders and 2010 orders to date we currently anticipate modest sales increases in 2010 in each of these product sectors.
Cost of sales
Cost of sales for the fiscal year ended December 31, 2009 was approximately $20.0 million compared to approximately $23.8 million for the year ended December 31, 2008, a decrease of approximately $3.8 million or 16.1%. The decrease in cost of sales was largely due to the decrease in net sales. Gross profit as a percent of net sales in each of the years ended December 31, 2009 and 2008 was approximately 57.1%.
Selling, general and administrative expenses
Selling, general and administrative expenses decreased approximately $3.5 million during the year ended December 31, 2009 compared to the corresponding period in 2008. Approximately $2.2 million of the decrease is attributable to reduced loan forgiveness charges in 2009, compared to 2008, which include a reversal of prior year charges totaling approximately $1.6 million. The remaining decrease of approximately $1.3 million is principally due to decreases in personnel, salaries and wages and associated benefits due principally to lower net sales in 2009. ACI will not incur any charges related to the officer loan forgiveness in 2010. See Significant Related Party Transactions - Advanced Circuits.
Income from operations
Income from operations for the year ended December 31, 2009 was $16.3 million compared to $17.7 million for the year ended December 31, 2008, a decrease of $1.4 million. This decrease primarily was the result of decreased net sales and other factors described above.
Fiscal Year Ended December 31, 2008 Compared to Fiscal Year Ended December 31, 2007
Net sales
Net sales for the year ended December 31, 2008 was approximately $55.4 million compared to approximately $52.3 million for the year ended December 31, 2007, an increase of approximately $3.2 million or 6.0%. The increase in net sales was largely due to increased sales in quick-turn and prototype production PCBs, which increased by approximately $0.8 million and $2.1 million, respectively. Quick-turn production PCBs represented approximately 34.4% of gross sales for the year ended December 31, 2008 compared to approximately 33.0% for the fiscal year ended December 31, 2007. Prototype production represented approximately 31.6% of gross sales for the year ended December 31, 2008 compared to approximately 32.2% for the same period in 2007. Long-lead production and other sales as a percentage of gross sales increased to approximately 31.7% of gross sales for the fiscal year 2008 compared to approximately 32.1% for the fiscal 2007, as this segment of the company’s business is typically driven more by economic conditions than either quick-turn or prototype production.
Cost of sales
Cost of sales for the fiscal year ended December 31, 2008 was approximately $23.8 million compared to approximately $23.1 million for the year ended December 31, 2007, an increase of approximately $0.6 million or 2.8%. The increase in cost of sales was largely due to the increase in net sales. Gross profit as a percent of net sales increased by approximately 1.3% to approximately 57.1% for the year ended December 31, 2008 compared to approximately 55.8% for the year ended December 31, 2007, largely as a result of increased production efficiencies, due to increased volume, offset in part by slight increases in raw material costs.
Selling, general and administrative expenses
Selling, general and administrative expenses increased $2.0 million during the year ended December 31, 2008 compared to the corresponding period in 2007. In 2008, Advanced Circuits incurred non-cash charges aggregating approximately $1.6 million reflecting loan forgiveness arrangements provided to Advanced Circuits’s senior management associated with CGI’s initial acquisition of Advanced Circuits, compared to $0.3 million in 2007. The 2007 loan forgiveness charge was only $0.3 million due to an over accrual of the charge in 2006. The remaining increase of approximately $0.7 million is principally due to increases in personnel, salaries and wages and associated benefits.
Income from operations
Income from operations for the year ended December 31, 2008 was $17.7 million compared to $17.1 million for the year ended December 31, 2007, an increase of $0.6 million. This increase primarily was the result of increased net sales and other factors described above.
American Furniture
Overview
Founded in 1998 and headquartered in Ecru, Mississippi, American Furniture is a leading U.S. manufacturer of upholstered furniture, focused exclusively on the promotional segment of the furniture industry. American Furniture offers a broad product line of stationary and motion furniture, including sofas, loveseats, sectionals, recliners and complementary products, sold primarily at retail price points ranging between $199 and $999. American Furniture is a low-cost manufacturer and is able to ship any product in its line to its approximately 750 customers, within 48 hours of receiving an order.
On February, 12, 2008, American Furniture’s 1.1 million square foot corporate office and manufacturing facility in Ecru, MS was partially destroyed in a fire. Approximately 750 thousand square feet of the facility was impacted by the fire. The executive offices were fundamentally unaffected. The recliner and motion plant, although largely unaffected, suffered some smoke damage but resumed operations on February 21, 2008. There were no injuries related to the fire.
The Company temporarily moved its stationary production lines into other facilities. In addition to its 45 thousand square foot ‘flex’ facility, management secured 320 thousand square feet of additional manufacturing and warehouse space in the surrounding Pontotoc area. These temporary stationary production facilities provided the company with approximately 90% of the pre-fire stationary production capabilities for the months of April, through November. Orders for motion and recliner products were addressed by the production facilities that were largely unaffected by the fire at the Ecru, MS facility. On November 7, 2008 the damaged manufacturing facility was fully restored and operating.
American Furniture’s products are adapted from established designs in the following categories: (i) motion and recliner; (ii) stationary; (iii) occasional chair and; (iv) accent tables and rugs. American Furniture’s products are manufactured from common components and offer proven select fabric options, providing manufacturing efficiency and resulting in limited design risk or inventory obsolescence.
Results of Operations
The table below summarizes the results of operations for American Furniture for the fiscal year ending December 31, 2009 and 2008 and the pro-forma results of operations for the year ended December 31, 2007. We purchased a controlling interest in American Furniture on August 31, 2007. The following operating results are reported as if we acquired American Furniture on January 1, 2007.
Prior period results of operations of American Furniture for the year ended December 31, 2007 include the following pro-forma adjustments:
(a)
Selling, general and administrative expenses were reduced by $2.8 million, representing one-time transaction costs incurred by the seller.
(b)
A reduction in charges to amortization of intangible assets totaling $0.7 million, as a result of, and derived from, the purchase price allocation in connection with our acquisition of American Furniture in August 2007.
Fiscal Year Ended December 31, 2009 Compared to Fiscal Year Ended December 31, 2008
Net sales
Net sales for the year ended December 31, 2009 were $142.0 million compared to $130.9 million for the same period in 2008, an increase of $11.0 million or 8.4%. Stationary product sales increased approximately $16.7 million for the year ended December 31, 2009 compared to the same period in 2008. Motion and Recliner product sales decreased approximately $4.5 million, while Table and Occasional sales decreased $1.0 million for the year ended December 31, 2009 compared to the same period in 2008. The increase in net sales of stationary product was principally due to the inability to ship product in 2008 as a result of the lack of product resulting from the fire that destroyed the finished goods warehouse and most of the manufacturing facilities in February 2008. The decrease in net sales of motion product in 2009 is the result of the continuing soft retail environment in the more expensive retail categories and a larger presence of Asian import product in the motion category in 2009. We expect this trend to continue through the first fiscal quarter of 2010, which historically represents AFM’s strongest fiscal quarter. Stationary product represented 70% of net sales in 2009 compared to 63.5% in 2008.
Cost of sales
Cost of sales increased approximately $9.8 million for the year ended December 31, 2009 compared to the same period of 2008 and is due principally to the corresponding increase in sales. Gross profit as a percent of sales was 19.5% for the year ended December 31, 2009 compared to 20.2% in the corresponding period in 2008. The decrease in gross profit as a percent of sales of 0.7% for the year ended December 31, 2009 compared to the same period in 2008 is attributable to an increase in third-party shipping cost (2.0%) and raw material costs (0.8%) offset in part by labor efficiencies achieved due to the increased volume and a greater use of imported cut and sew kits (1.9%). During the year ended December 31, 2009 management estimates that it utilized third-party carriers for approximately 70% of its customer shipments compared to approximately 50% during 2008. Historically, American Furniture has charged third-party shipping costs to cost of sales and in-house shipping costs to selling expense. (See below for offsetting variance in in-house shipping costs).
Selling, general and administrative expenses
Selling, general and administrative expenses for the year ended December 31, 2009 increased approximately $0.2 million over the corresponding period in 2008. This increase is largely a product of the business interruption insurance proceeds recorded during 2008 totaling approximately $3.1 million (none was recorded in selling, general and administrative expense in 2009), increases in sales commissions and insurance expense totaling $0.8 million in 2009 offset by a reduction in in-house shipping costs totaling $3.7 million in 2009.
Income from operations
Income from operations increased approximately $1.4 million for the year ended December 31, 2009 over the corresponding period in 2008, primarily due to the increase in net sales, and other factors as described above.
Fiscal Year Ended December 31, 2008 Compared to Pro-forma Fiscal Year Ended December 31, 2007
Net sales
Net sales for the year ended December 31, 2008 were $130.9 million compared to $156.6 million for the same period in 2007, a decrease of $25.7 million or 16.4%. Stationary product sales decreased approximately $19.0 million for the year ended December 31, 2008 compared to the same period in 2007. Motion and Recliner product sales decreased approximately $5.8 million, while Table and Occasional sales decreased $0.3 million for the year ended December 31, 2008 compared to the same period in 2007. These decreases in sales are due principally to the fire that destroyed the finished goods warehouse and a large part of the manufacturing facility in February 2008. Management believes that the softer economy in 2008 is also responsible, although to a lesser extent, for the decrease in sales volume.
Cost of sales
Cost of sales decreased approximately $16.2 million for the year ended December 31, 2008 compared to the same period of 2007 and is due principally to the corresponding decrease in sales. Gross profit as a percent of sales was 20.2% for the year ended December 31, 2008 compared to 22.9% in the corresponding period in 2007. This decrease in margin is attributable to raw material price increases in 2008, particularly foam and steel, and to a lesser extent labor inefficiencies incurred in the manufacturing recovery process due to multiple temporary production facilities being utilized for much of the year and associated overtime costs incurred, resulting from the fire in February 2008. As of November 7, 2008, we have rebuilt our primary production facility destroyed in the fire, and as such do not expect to incur additional labor inefficiency costs in the future
Selling, general and administrative expenses
Selling, general and administrative expenses for the year ended December 31, 2008 decreased approximately $2.8 million over the corresponding period in 2007. This decrease is primarily due to the business interruption insurance proceeds recorded during the period of approximately $3.1 million. Also contributing to the decrease was a reduction of $0.5 million in commissions paid and $0.4 million in insurance expense during the period due to significant reduction in net sales caused by the fire. These decreases were offset in part by increases in fuel costs of $0.5 million and increases in property taxes and legal costs of $0.7 million during the year ended December 31, 2008 compared to 2007.
Income from operations
Income from operations decreased approximately $6.7 million for the year ended December 31, 2008 over the corresponding period in 2007, primarily due to the decrease in net sales, related gross profit margins and other factors as described above.
Anodyne
Overview
Anodyne, with operations headquartered in Coral Springs, Florida, is a leading designer and manufacturer of powered and non-powered medical therapeutic support surfaces and patient positioning devices serving the acute care, long-term care and home health care markets. The Anodyne group of companies provides its customers with the opportunity to source all therapeutic surface technologies from a single fully integrated supplier.
Anodyne develops products both independently and in partnership with large distribution intermediaries. Medical distribution companies then sell or rent the Anodyne portfolio of products to one of three end markets: (i) acute care, (ii) long term care and (iii) home healthcare . The level of sophistication largely varies for each product, as some patients require simple foam surfaces (“non-powered”) while others may require electronically controlled, low air loss, lateral rotation, pulmonary therapy or alternating pressure surfaces (“powered”). The design, engineering and manufacturing of all products are completed in-house (with the exception of PrimaTech products, which are manufactured in Taiwan) and are Food and Drug Administration (“FDA”) compliant. We purchased a controlling interest in Anodyne from CGI on July 31, 2006.
Results of Operations
The table below summarizes the results of operations for Anodyne for the fiscal years ending December 31, 2009, 2008 and 2007.
Fiscal Year Ended December 31, 2009 Compared to Fiscal Year Ended December 31, 2008
Net sales
Net sales for the year ended December 31, 2009 were approximately $54.1 million compared to approximately $54.2 million for the same period in 2008, a decrease of $0.1 million. Sales of non-powered products (including patient positioning devices) totaled $42.6 million during the year ended December 31, 2009 representing an increase of $6.8 million compared to the same period in 2008. Non-powered product sales attributable to new product offerings were $1.4 million in the year ended December 31, 2009. The remaining increase in sales of non-powered products in 2009 is principally attributable to sales of a modified 2008 product release to a key existing customer’s new national account. Non-powered sales represented approximately 78.7% of net sales in 2009 compared to 66.1% in 2008. Sales of powered products totaled $11.4 million during the year ended December 31, 2009, a $6.9 million decrease when compared to the same period in 2008. The significant decrease in powered sales in 2009 reflects substantial cutbacks in healthcare institutional spending experienced during the period, particularly in the higher priced, more capital intensive products such as our powered product offerings. We believe that these purchasing levels have stabilized and current indications suggest a potential for modest increases in powered product sales in 2010 compared to 2009. Powered sales represented approximately 21.3% of net sales in 2009 compared to 33.9% in 2008.
Cost of sales
Cost of sales decreased approximately $2.7 million for the year ended December 31, 2009 compared to the same period in 2008. Gross profit as a percentage of sales was 29.8% for the year ended December 31, 2009 compared to 24.9% in the corresponding period in 2008. The decrease in cost of sales together with the significant increase in gross profit as a percentage of sales of 4.9% in 2009 is principally due to (i) lower raw material costs (3.7%) (ii) labor and material manufacturing efficiencies realized in 2009 (4.2%), particularly as it related to a portion of new product sales in 2008 and (ii) other reductions in manufacturing overhead offset in part by an unfavorable sales mix in 2009 (3.0%), as powered products carry a higher margin than non-powered.
Selling, general and administrative expenses
Selling, general and administrative expenses for the year ended December 31, 2009 decreased approximately $0.5 million compared to the same period in 2008. This decrease is principally due to a reduction in costs attributable to Hollywood Capital, a former management group that was comprised of the previous CEO and CFO. The Hollywood Capital management services agreement was terminated in October 2008.
Income from operations
Income from operations increased approximately $3.2 million to $7.4 million for the year ended December 31, 2009 compared to the same period in 2008, principally as a result of the significant increase in gross profit margins, the reduction in overhead cost and other factors described above.
Fiscal Year Ended December 31, 2008 Compared to Fiscal Year Ended December 31, 2007
Net sales
Net sales for the year ended December 31, 2008 were approximately $54.2 million compared to approximately $44.2 million for the same period in 2007, an increase of $10.0 million or 22.7%. Sales reflecting new product introductions to new customers, year over year growth to existing customers and price increases totaled approximately $9.0 million. Sales associated with PrimaTech, which was purchased in June 2007, accounted for $1.0 million of this increase. During the fourth quarter of 2008, the general economic slowdown in the United States showed significant signs of contraction in health care capital budgets.
Cost of sales
Cost of sales increased approximately $7.6 million for the year ended December 31, 2008 compared to the same period in 2007 and is principally due to the corresponding increases in sales, raw material costs and manufacturing infrastructure costs. Gross profit as a percent of sales decreased slightly to approximately 24.9% for the year ended December 31, 2008 compared to 25.2% in the same period of 2007. This decrease is due to increases in manufacturing infrastructure costs, raw materials and the timing between cost increases and sales price increases. Raw materials, particularly polyurethane foam and fabric generally represent approximately 50% of cost of sales.
Selling, general and administrative expenses
Selling, general and administrative expenses for the year ended December 31, 2008 increased approximately $1.0 million compared to the same period in 2007. This increase is largely the result of increased costs associated with the acquisition of PrimaTech totaling $0.4 million and $0.7 million of increased costs related to administrative staff and associated costs necessary to support the increase in sales, and new product development. These increases were offset in part by a reduction in costs totaling $0.1 million, attributable to Hollywood Capital, a former management group that was comprised of the former CEO and CFO. The Hollywood Capital management services agreement was terminated in October 2008. We
expect annual savings of approximately $0.7 million going forward as a result of terminating the Hollywood Capital arrangement.
Amortization expense
Amortization expense increased approximately $0.2 million in the year ended December 31, 2008 compared to the corresponding period in 2007, due principally to the full year impact of amortization in fiscal 2008 in connection with the intangible assets realized as part of the add-on acquisition of PrimaTech in June 2007.
Income from operations
Income from operations increased approximately $1.3 million to $4.2 million for the year ended December 31, 2008 compared to the same period in 2007, principally as a result of the significant increase in net sales offset in part by higher infrastructure costs necessary to support the increase in sales volume and other factors described above.
Fox
Overview
Fox, headquartered in Watsonville, California, is a branded action sports company that designs, manufactures and markets high-performance suspension products for mountain bikes and power sports, which include; snowmobiles, motorcycles, all-terrain vehicles ATVs, and other off-road vehicles.
Fox’s products are recognized by manufacturers and consumers as being among the most technically advanced suspension products currently available in the marketplace. Fox’s technical success is demonstrated by its dominance of award winning performances by professional athletes across its suspension products. As a result, Fox’s suspension components are incorporated by OEM customers on their high-performance models at the top of their product lines in the mountain bike and power sports sector. OEMs capitalize on the strength of Fox’s brand to maintain and expand their own sales and margins. In the Aftermarket segment, customers seeking higher performance select Fox’s suspension components to enhance their existing equipment.
Fox sells to more than 200 OEM and 7,600 Aftermarket customers across its market segments. In each of the years 2009, 2008 and 2007, approximately 76%, 76% and 75% of net sales were to OEM customers. The remaining net sales were to Aftermarket customers. Sales of suspension components to the mountain bike sector represent a significant majority of both OE and Aftermarket sales in each of the years ended December 31, 2009, 2008 and 2007.
Results of Operations
The table below summarizes the results of operations for Fox for the fiscal years ending December 31, 2009, 2008 and the pro-forma results of operations for the year ended December 31, 2007. We purchased a controlling interest in Fox on January 4, 2008. The following operating results are reported as if we acquired Fox on January 1, 2007.
Prior period results of operations of Fox for the year ended December 31, 2007 include the following pro-forma adjustments:
(a)
An increase in cost of sales totaling $0.3 million, reflecting additional depreciation expense as a result of, and derived from, the purchase price allocation in connection with our acquisition of Fox in January 2008.
(b)
An increase in selling, general and administrative expense totaling $0.1 million reflecting additional depreciation expense as a result of, and derived from, the purchase price allocation in connection with our acquisition of Fox in January 2008.
(c)
An increase in management fees totaling $0.5 million reflecting quarterly fees that would have been due to our Manager in connection with our Management Services Agreement.
(d)
An increase in amortization of intangible assets totaling $5.2 million reflecting amortization expense as a result of, and derived from, the purchase price allocation in connection with our acquisition of Fox in January 2008.
Fiscal Year Ended December 31, 2009 Compared to Fiscal Year Ended December 31, 2008
Net sales
Net sales for the year ended December 31, 2009 decreased $10.2 million, or 7.8%, versus the corresponding period in 2008. OEM sales declined $7.8 million to $92.5 million for the year ended December 31, 2009 compared to $100.3 million for the same period in 2008. The decrease in net sales is attributable to a decrease in sales in the mountain biking sector totaling $12.7 million, offset in part by increases in sales to the powered vehicles sector totaling approximately $4.9 million. The decrease in sales in the mountain biking sector during the year ended December 31, 2009 is due to the impact of the global economic recession experienced in 2009 which created excess capacity in the industry, particularly in the first half of the year. The increase in sales to the powered vehicle sector during 2009 is the result of sales of new suspension components to Ford Motor Company for use in its Raptor Off-road pickup and increases in sales of suspension components to the ATV market. Aftermarket sales declined $2.4 million to $29.0 million for the year ended December 31, 2009 compared to $31.4 million in the same period in 2008. This decrease is largely attributable to decreases in net sales in the mountain bike sector due to the negative impact of the global recession.
International OEM and After market sales were $84.0 million in 2009 compared to $92.5 million in 2008 a decrease of $8.5 million or 9.2%. This decrease is due to the global economic recession experienced in 2009 resulting in a temporary oversupply issue in the industry.
Cost of sales
Cost of sales for the year ended December 31, 2009 decreased approximately $8.8 million, or 9.2%, compared to the corresponding period in 2008. The decrease in cost of sales is primarily attributable to the decrease in net sales for the same period. Gross profit as a percentage of sales increased to 28.4% at December 31, 2009 from 27.2% at December 31, 2008, largely due to reduced overhead costs, lower freight costs as supply chain improvements reduced the necessity to air ship product, lower product warranty costs as high quality products continue to reduce these costs, and lower material and component costs in 2009 all as compared to 2008.
Selling, general and administrative expenses
Selling, general and administrative expenses for the year ended December 31, 2009 decreased approximately $1.0 million over the corresponding period in 2008. This decrease is the result of decreases in 2009 in (i) marketing costs ($0.5 million), (ii) a decline in bad debt expense ($0.25 million), and decreases in other administrative costs compared to 2008.
Income from operations
Income from operations for the year ended December 31, 2009 decreased less than $0.1 million compared to the corresponding period in 2008, based principally on the decline in net sales, offset by the cost savings described above.
Fiscal Year Ended December 31, 2008 Compared to Pro-forma Fiscal Year Ended December 31, 2007
Net sales
Net sales for the year ended December 31, 2008 increased $26.0 million, or 24.6%, over the corresponding period in 2007. Sales growth was driven largely by OEM sales in mountain biking and power sports which totaled approximately $100.3 million for the year ended December 31, 2008 compared to $79.0 million in the same period of 2007. This represents an increase of $21.3 million, or 27.0%. Aftermarket sales totaled approximately $31.4 million in 2008 compared to $26.7 million in 2007, an increase of $4.7 million, or 17.6%. These OEM and Aftermarket sales increases are principally the result of well received new model year products, particularly in mountain biking. International OEM and After market sales were $92.5 million in 2008 compared to $70.5 million in 2007 an increase of $22.0 million or 31.2%. In addition, there was a temporary plant shutdown in fiscal 2007 which also contributed, although to a much lesser extent, to the increase in 2008 sales compared to 2007.
Cost of sales
Cost of sales for the year ended December 31, 2008 increased approximately $14.1 million, or 17.2%, over the corresponding period in 2007. The increase in cost of sales is primarily attributable to the increase in net sales for the same period. Gross profit as a percentage of sales increased to 27.2% at December 31, 2008 from 22.7% at December 31, 2007, largely due to improved manufacturing efficiencies associated with the overall increase in sales and lower freight costs as supply chain improvements reduced the necessity to air ship product, offset in part by increased raw material costs.
Selling, general and administrative expenses
Selling, general and administrative expenses for the year ended December 31, 2008 increased $3.4 million over the corresponding period in 2007. This increase is the result of increases in administrative, engineering, sales and marketing costs to drive and support the significant sales growth. Marketing costs increased $1.6 million and research and development costs increased $0.6 million in 2008 compared to 2007.
Income from operations
Income from operations for the year ended December 31, 2008 increased approximately $8.3 million over the corresponding period in 2007 based principally on the significant increase in sales and related gross profit and other factors, described above.
HALO
Overview
Operating under the brand names of HALO and Lee Wayne, headquartered in Sterling, IL, HALO is an independent provider of customized drop-ship promotional products in the U.S. Through an extensive group of dedicated sales professionals, HALO serves as a one-stop shop for approximately 38,000 customers throughout the U.S. HALO is involved in the design, sourcing, management and fulfillment of promotional products across several product categories, including apparel, calendars, writing instruments, drink ware and office accessories. HALO’s sales professionals work with customers and vendors to develop the most effective means of communicating a logo or marketing message to a target audience. Approximately 95% of products sold are drop shipped, resulting in minimal inventory risk. HALO has established itself as a leader in the promotional products and marketing industry through its focus on service through its approximately 700 account executives.
HALO acquired Goldman Promotions, a promotional products distributor, in April 2008, the promotional products distributor division of Eskco, Inc., in November 2008 and the promotional products distributor AdNov in March 2009.
Distribution of promotional products is seasonal. Typically, HALO expects to realize approximately 45% of its sales and 70% of its operating income in the months of September through December, due principally to calendar sales and corporate holiday promotions.
Results of Operations
The table below summarizes the results of operations for HALO for the fiscal year ending December 31, 2009 and 2008 and the pro-forma results of operations for the year ended December 31, 2007. We purchased a controlling interest in HALO on February 28, 2007. The following operating results are reported as if we acquired HALO on January 1, 2007.
Prior period results of operations of HALO for the year ended December 31, 2007 includes the following pro-forma adjustments:
(a)
An increase in selling, general and administrative expense totaling $0.3 million reflecting additional depreciation expense as a result of, and derived from, the purchase price allocation in connection with our acquisition of HALO in February 2007.
(b)
An increase in management fees totaling $0.1 million, reflecting additional quarterly fees that would have been due to our Manager in connection with our Management Services Agreement.
(c)
An increase in amortization of intangible assets totaling $0.3 million reflecting additional amortization expense as a result of, and derived from, the purchase price allocation in connection with our acquisition of HALO in February 2007.
Fiscal Year Ended December 31, 2009 Compared to Fiscal Year Ended December 31, 2008
Net sales
Net sales for the year ended December 31, 2009 were $139.3 million, compared to $159.8 million for the same period in 2008, a decrease of $20.5 million or 12.8%. Sales increases attributable to accounts acquired in 2008 and 2009 accounted for approximately $9.4 million of increased sales in 2009, offset by a decrease in sales to existing customers totaling approximately $29.9 million in 2009 compared to 2008. This decrease in sales to existing customers is attributable to decreases in sales order volume as customers of all sizes have cut back on merchandising expenditures in response to the economic recession which began in the latter half of 2008 and continued through 2009. In 2009 and 2008, Halo’s top ten customers represented 11.8% and 14.9% of gross sales, respectively.
Cost of sales
Cost of sales for the year ended December 31, 2009 decreased approximately $14.0 million compared to the same period in 2008. The decrease in cost of sales is primarily attributable to the decrease in net sales for the same period. Gross profit as a percentage of net sales totaled approximately 39.1% and 38.1% of net sales in each of the years ended December 31, 2009 and 2008, respectively. The increase in gross profit as a percent of sales is due to (i) a favorable sales mix in 2009 compared to 2008, (ii) efficiencies realized in shipping and increased supplier rebates during 2009, and (iii) the procurement of more favorable pricing from calendar suppliers.
Selling, general and administrative expenses
Selling, general and administrative expenses for the year ended December 31, 2009, decreased approximately $4.1 million compared to the same period in 2008. This decrease is largely the result of decreases in the year ended December 31, 2009 compared to the same period in 2008 for sales commission expense and salaries and wages attributable to the decline in net sales and cost cutting measures ($4.3 million) and other overhead costs ($0.6 million), offset in part by increases in 2009 for health insurance costs ($0.5 million) and bad debt expense ($0.3 million).
Amortization expense
Amortization expense for the year ended December 31, 2009 increased approximately $0.1 million compared to the same period in 2008. This increase is principally due to the amortization expense of intangible assets recognized in connection with a March 2009 acquisition.
Income from operations
Income from operations decreased approximately $2.4 million for the year ended December 31, 2009 compared to the same period in 2008 due principally to the decrease in net sales to existing customers offset in part by lower selling, general and administrative costs, as described above.
Fiscal Year Ended December 31, 2008 Compared to Pro-forma Fiscal Year Ended December 31, 2007
Net sales
Net sales for the year ended December 31, 2008 were $159.8 million, compared to $144.3 million for the same period in 2007, an increase of $15.5 million or 10.7%. Sales increases to accounts from acquisitions made in 2008 and 2007 accounted for approximately $22.8 million of increased sales offset by a decrease in sales to existing customers totaling approximately $7.3 million. This decrease in sales to existing customers is attributable to decreases in sales order volume as customers have cut back on merchandising expenditures in response to the economic slowdown and worsening global economic conditions. We expect that current unfavorable economic conditions will continue and may result in lower volume orders from existing customers in 2009 as advertising budgets are continuing to be pared in response to the current economic climate.
Cost of sales
Cost of sales for the year ended December 31, 2008 increased approximately $9.9 million compared to the same period in 2007. The increase in cost of sales is primarily attributable to the increase in net sales for the same period. Gross profit as a percentage of net sales totaled approximately 38.1% and 38.4% of net sales in each of the years ended December 31, 2008 and 2007, respectively. The slight decrease in gross profit as a percent of sales is due to unfavorable product mix.
Selling, general and administrative expenses
Selling, general and administrative expenses for the year ended December 31, 2008, increased approximately $5.7 million compared to the same period in 2007. This increase is largely the result of increased direct commission expense attributable to the increase in net sales, totaling approximately $2.5 million, increased administrative and personnel costs incurred as a result of the increase in the number of independent sales representatives in 2007, totaling $2.5 million, and one-time integration costs of our 2008 acquisitions, totaling approximately $0.9 million. In response to the severe economic slowdown, HALO plans to reduce overhead costs in 2009 and curtail discretionary spending by approximately $2.0 million in order to more appropriately align its cost structure with anticipated reductions in net sales.
Amortization expense
Amortization expense for the year ended December 31, 2008 increased approximately $0.2 million compared to the same period in 2007. This increase is principally due to the amortization expense of intangible assets recognized in connection with the two acquisitions in 2008.
Income from operations
Income from operations decreased approximately $0.4 million for the year ended December 31, 2008 compared to the same period in 2007 due principally to the decrease in sales to existing customers and the increase in integration costs and other administrative costs associated with the acquisitions made in 2008, offset in part by the increase in gross profit contributions from sales associated with the acquisitions.
Staffmark
Overview
Staffmark a provider of temporary staffing services in the United States, provides a wide range of human resource services, including temporary staffing services, employee leasing services, and permanent staffing and temporary-to-hire placement services. Staffmark serves over 6,400 corporate and small business clients and during an average week places over 34,000 employees in a broad range of industries, including manufacturing, transportation, retail, distribution, warehousing, automotive supply, construction, industrial, healthcare and financial sectors.
Staffmark’s business strategy includes maximizing production in existing offices, increasing the number of offices within a market when conditions warrant, and expanding organically into contiguous markets where it can benefit from shared management and administrative expenses. Staffmark typically enters new markets through acquisition. In keeping with these strategies, on January 21, 2008, CBS Personnel Holdings, Inc. acquired Staffmark Investment LLC and its subsidiaries. The acquisition essentially doubled the revenues of Staffmark. This acquisition gave CBS Personnel a presence in Arkansas, Tennessee, Colorado, Oklahoma, and Arizona, while significantly increasing its presence in California, Texas, the Carolinas, New York and the New England area. While no specific acquisitions are currently contemplated at this time, Staffmark continues to view acquisitions as an attractive means to enter new geographic markets.
Fiscal 2008 and 2009 were extremely challenging years for the temporary staffing industry. The already-weak economic conditions and employment trends in the U.S., present during the first half of fiscal 2008 continued to worsen as the year progressed and continued through the first three quarters of 2009 before showing signs of improvement during the fourth quarter of 2009.
According to a U.S. Bureau of Labor Statistics report dated January 2010, since the recession began in December of 2007; 7.6 million jobs have been lost. From October 2009 through December 2009, job losses averaged 69,000 per month, compared with losses averaging 645,000 per month from November 2008 to April 2009 and 307,000 per month from May 2009 through September 2009. Temporary help services employment has risen by 166,000 since reaching a low point in July 2009, and in December 2009 added 47,000 jobs.
Results of Operations
The table below summarizes the income from operations for Staffmark for the year ended December 31, 2009 and pro-forma results of operations for each of the fiscal years ended December 31, 2008 and 2007. We purchased a controlling
interest in CBS Personnel Holdings, Inc. on May 16, 2006. The following operating results were prepared as if Staffmark was acquired on January 1, 2007.
Fiscal Year Ended December 31, 2009 compared to Pro-forma Fiscal Year Ended December 31, 2008
Service revenues
Revenues for the year ended December 31, 2009 decreased approximately $292.1 million, or 28.2%, compared to the same period in 2008. The reduction in revenues reflects reduced demand for temporary staffing services (primarily clerical and light industrial) as a result of the downturn in the economy. Approximately $7.5 million of the decrease is related to reduced revenues for permanent staffing services as clients were affected by weaker economic conditions. In the fourth quarter of 2009 and to date in 2010 we have witnessed modest temporary staffing job creation which may signal a strengthening global ecconomy, although significant uncertainty remains. Permanent staffing revenues have historically lagged rebounds in temporary staffing revenues.
Cost of services
Cost of services for the year ended December 31, 2009 decreased approximately $226.2 million compared to the same period in 2008. This decrease is principally the direct result of the decrease in service revenues. Gross margin was approximately 15.1% and 17.2% of revenues for the years ended December 31, 2009 and December 31, 2008, respectively. The decrease in margins is primarily the result of (i) reduced permanent staffing services, which carries a significantly higher profit margin, (ii) downward pricing pressure experienced from our temporary staffing services clients, and (iii) increases in workers’ compensation and unemployment insurance costs. The significant reduction in permanent staffing services is responsible for approximately 1.0% of the 2.1% margin decrease.
Staffing, selling, general and administrative expenses
Staffing, selling, general and administrative expenses for the year ended December 31, 2009 decreased approximately $43.1 million compared to the same period in 2008. Management has taken measures to reduce overhead costs, consolidate facilities and close unprofitable branches in order to mitigate the negative impact that the current weak economic environment has had on our top-line revenues. We incurred approximately $2.0 million in one-time cost for non-recurring expenses related to the integration of the Staffmark and CBS Personnel and one-time non-recurring restructuring costs associated with the reduction in overhead costs during the year ended December 31, 2009. For the year ended December 31, 2008 costs associated with the Staffmark integration totaled approximately $7.4 million.
Management fees
Management fees are based on a formula of gross revenues. The decrease in management fees in 2009 compared to 2008 is principally the result of the significant decrease in revenues in 2009 compared to 2008.
Impairment expense
Based on the results of our annual goodwill impairment test performed as of March 31, 2009, an indication of goodwill impairment existed. Based on the results of the second step of the goodwill impairment test, we calculated that the carrying amount of goodwill exceeded its fair value by approximately $50.0 million. Therefore, we recorded a $50.0 million pretax goodwill impairment charge during the year ended December 31, 2009. The carrying amount of goodwill exceeded the fair value due to the recent and projected significant decrease in revenue and operating profit at Staffmark resulting from the negative impact on temporary staffing and permanent placement revenues due to the depressed macroeconomic conditions and downward employment trends. We do not expect to incur any additional impairment charges at this reporting unit during 2010.
Income (loss) from operations
The weakened economy significantly affected our operating results in fiscal 2009. For the year ended December 31, 2009, income from operations decreased approximately $71.7 million to a loss of approximately $55.6 million compared to the same period in 2008 principally as a result of the impairment charge and the significant decline in revenues.
Pro-forma Fiscal Year Ended December 31, 2008 compared to Pro-forma Fiscal Year Ended December 31, 2007
Service revenues
Revenues for the year ended December 31, 2008 decreased approximately $115.7 million, or 10.0%, compared to the same period in 2007. The reduction in revenues reflects reduced demand for temporary staffing services (primarily clerical and light industrial) as a result of the downturn in the economy. Approximately $3.2 million of the decrease is related to reduced revenues for permanent staffing services as clients were affected by weaker economic conditions.
Cost of services
Cost of services for the year ended December 31, 2008 decreased approximately $92.2 million compared to the same period in 2007. This decrease is principally the direct result of the decrease in service revenues. Gross margin was approximately 17.2% and 17.5% of revenues for the years ended December 31, 2008 and December 31, 2007, respectively. The decrease in margins is primarily the result of reduced permanent staffing services, which carries a higher profit margin.
Staffing, selling, general and administrative expenses
Staffing, selling, general and administrative expenses for the year ended December 31, 2008 decreased approximately $7.7 million compared to the same period in 2007. Comparative year over year staffing, selling, general and administrative costs decreased approximately $15.1 million principally due to achievement of synergies from the Staffmark acquisition and cost reduction efforts in response to the economic downturn. This decrease was offset by approximately $7.4 million in one-time integration costs associated with the integration of the Staffmark operations during 2008. We have taken measures beginning in the fourth quarter of 2008 to reduce overhead costs, consolidate facilities and close unprofitable branches in order to mitigate the negative impact of the current economic environment. This cost reduction program continued through fiscal 2009. These cost savings wiere offset in part by additional Staffmark integration and one-time costs of approximately $1.3 million in 2009
Management fees
Management fees are based on a formula of net revenues. The decrease in management fees in 2008 compared to 2007 is a direct result of the decrease in revenues in 2008 compared to 2007. The decrease was offset by an additional $0.5 million paid to a separate manager of Staffmark, unrelated to CGM.
Income from operations
The weakened economy significantly affected our operating results in fiscal 2008. For the year ended December 31, 2008, income from operations decreased approximately $15.5 million to approximately $16.1 million compared to the same period in 2007. Based on the impact that the current economic deterioration has had and will continue to have on the employment markets and temporary staffing industry, and other factors described above, we expect income from operations to decline significantly in 2009.
Liquidity and Capital Resources
At December 31, 2009, on a consolidated basis, cash flows provided by operating activities totaled approximately $20.2 million, which reflects the results of operations of all six of our businesses for the year ended December 31, 2009. Consolidated net loss in 2009 totaling $39.6 million coupled with $13.7 million in negative cash flow attributable to working capital was more than offset by non-cash charges included in the consolidated net loss for the year. Cash flows provided by operations in 2008 totaled approximately $40.5 million. The $20.3 million decrease in operating cash flow is attributable to a decline in net sales and operating profits at our businesses due principally to the depressed economic environment experienced during the year.
Cash flows used in investing activities totaled approximately $5.0 million for the year ended December 31, 2009, which reflects approximately $3.6 million in capital expenditures and $1.4 million in add-on acquisition costs at Advanced Circuits and Halo. We expect to use considerably more cash in investing activities in 2010 for planned acquisitions and greater capital expenditures at each of our businesses.
Cash flows used in financing activities totaled approximately $81.2 million for the year ended December 31, 2009, principally reflecting: (i) distributions paid to shareholders during the year totaling approximately $46.3 million; (ii) scheduled amortization of our Term Loan Facility of $2.0 million; and (iii) repayment of our Term Loan Facility of $75.0 million together with $2.5 million in cancellation fees paid for terminating that portion of an interest rate swap connected to the Term Loan Facility repaid. These cash outflows were offset in part by net proceeds from our June 2009 stock offering totaling $42.1 million and net proceeds received from non-controlling shareholders totaling $2.5 million during 2009.
At December 31, 2009 we had approximately $31.5 million of cash and cash equivalents on hand. The majority of our cash is invested in short-term U.S. government securities and corporate debt securities and is maintained in accordance with the Company’s investment policy, which identifies allowable investments and specifies credit quality standards. The primary objective of our investment activities is the preservation of principal and minimizing risk. We do not hold any investments for trading purposes.
At December 31, 2009 we had the following outstanding loans due from each of our businesses:
Each loan has a scheduled maturity and each business is entitled to repay all or a portion of the principal amount of the outstanding loans, without penalty, prior to maturity. At December 31, 2009, all of our businesses were in compliance with their financial covenants with us.
In May 2009 we amended the Staffmark inter-company credit agreement which, among other things, recapitalized a portion of Staffmark’s long-term debt by exchanging $35.0 million of unsecured debt for common stock in Staffmark. A noncontrolling shareholder participated in this exchange. As a result of this transaction we currently own 76.2% of the outstanding common stock of Staffmark on a primary basis and 69.4% on a fully diluted basis.
Our primary source of cash is from the receipt of interest and principal on our outstanding loans to our businesses. Accordingly, we are dependent upon the earnings and cash flow of these businesses, which are available for (i) operating expenses; (ii) payment of principal and interest under our Credit Agreement; (iii) payments to CGM due or potentially due pursuant to the Management Services Agreement, the LLC Agreement, and the Supplemental Put Agreement; (iv) cash distributions to our shareholders and (v) investments in future acquisitions. Payments made under (iii) above are required to be paid before distributions to shareholders and may be significant and exceed the funds held by us, which may require us to dispose of assets or incur debt to fund such expenditures. A liability of approximately $12.1 million is reflected in our consolidated balance sheet, which represents our estimated liability for potential obligation to CGM at December 31, 2009.
On June 9, 2009, we completed a secondary offering of 5,100,000 Trust shares at an offering price of $8.85 per share. Our net proceeds after deducting underwriter’s discount and offering costs, totaled approximately $42.1 million.
We believe that we currently have sufficient liquidity and capital resources, which include amounts available under our Revolving Credit Facility, to meet our existing obligations, including quarterly distributions to our shareholders, as approved by our Board of Directors, over the next twelve months.
On December 7, 2007 we amended our existing $250 million credit facility with a group of lenders led by Madison Capital, LLC. The current Credit Agreement provides for a Revolving Credit Facility totaling $340 million which matures in December 2012 and a Term Loan Facility totaling $76.0 million. The Term Loan Facility requires quarterly payments of $0.5 million that commenced March 31, 2008 with a final payment of the outstanding principal balance due on December 7, 2013.
The Revolving Credit Facility allows for loans at either base rate the London Interbank Offer Rate, or LIBOR. Base rate loans bear interest at a fluctuating rate per annum equal to the greater of (i) the prime rate of interest published by the Wall Street Journal and (ii) the sum of the Federal Funds Rate plus 0.5% for the relevant period, plus a margin ranging from 1.50% to 2.50% based upon the ratio of total debt to adjusted consolidated earnings before interest expense, tax expense, and depreciation and amortization expenses for such period (the “Total Debt to EBITDA Ratio”). LIBOR loans bear interest at a fluctuating rate per annum equal to for the relevant period plus a margin ranging from 2.50% to 3.50% based on the Total Debt to EBITDA Ratio. We are required to pay commitment fees ranging between 0.75% and 1.25% per annum on the unused portion of the Revolving Credit Facility. At December 31, 2009 we had $0.5 million in borrowings outstanding under our Revolving Credit Facility and $136.8 million available.
The Term Loan Facility bears interest at either base rate or LIBOR. Base rate loans bear interest at a fluctuating rate per annum equal to the greater of (i) the prime rate of interest published by the Wall Street Journal and (ii) the sum of the Federal Funds Rate plus 0.5% for the relevant period plus a margin of 3.0%. LIBOR loans bear interest at a fluctuating rate per annum equal to the LIBOR, for the relevant period plus a margin of 4.0%. At December 31, 2009 we had $76.0 million in borrowings outstanding under our Term Loan Facility.
The following table reflects required and actual financial ratios as of December 31, 2009 included as part of the affirmative covenants in our Credit Agreement:
On January 22, 2008 we entered into a three-year interest rate swap agreement with our bank lenders, fixing the rate of $140 million at 7.35% on a like amount of variable rate Term Loan Facility borrowings. The interest rate swap is intended to mitigate the impact of fluctuations in interest rates and effectively converts $140 million of our floating-rate Term Loan Facility to a fixed rate basis for a period of three years. On February 18, 2009, we terminated $70.0 million of our outstanding interest rate swap in connection with the repayment of $75.0 million of our Term Loan Facility. Termination fees totaled $2.5 million, which represented the fair value of the terminated portion of the swap as of February 18, 2009.
Our Term Loan Facility received a B1 rating from Moody’s Investors Service (“Moody’s”), and a BB- rating from Standard and Poor’s Rating Services and our Revolving Credit Facility received a Ba1 rating from Moody’s, reflective of our strong cash flow relative to debt, and industry diversification of our businesses.
We intend to use the availability under our Revolving Credit Facility to pursue acquisitions of additional platform and add-on businesses in 2010 and beyond, to the extent permitted under our Credit Agreement, and to provide for working capital needs.
We completed our annual goodwill impairment testing as of March 31, 2009. At each of our reporting units, the units’ fair value exceeded carrying value with the exception of Staffmark. The carrying amount of Staffmark exceeded its fair value due primarily to the significant decrease in revenue and operating profit at Staffmark resulting from the negative impact on temporary staffing and permanent placement revenues due to macroeconomic conditions and downward employment trends experienced in 2008 and 2009. As a result, we performed the second step of the goodwill impairment test in order to determine the amount of impairment loss. The second step of the goodwill impairment test involved comparing the implied fair value of Staffmark’s goodwill with the carrying value of that goodwill. This comparison resulted in a goodwill impairment charge of $50.0 million, which was recorded in impairment expense on the consolidated statement of operations.
At March 31, 2009, our last annual impairment test date, the fair value of two of our reporting units, not including Staffmark, exceeded the carrying value of the reporting unit by less than ten percent. The goodwill allocated to each of these reporting units at December 31, 2009 is as follows:
We perform our annual impairment test on March 31 of each fiscal year. Estimating the fair value of reporting units involves the use of estimates and significant judgments that are based on a number of factors including actual operating results. If current conditions change from those expected, it is reasonably possible that the judgments and estimates described above could change in future periods. Due to the minimal amount that these reporting units’ fair value exceeded their carrying value at March 31, 2009 it is possible that on March 31, 2010, our next annual impairment test date, if conditions change adversely from what we currently expect we could experience a goodwill impairment charge.
The table below details cash receipts and payments that are not reflected on our income statement in order to provide an additional measure of management’s estimate of cash flow available for distribution (“CAD”). CAD is a non-GAAP measure that we believe provides additional information to our shareholders in order to enable them to evaluate our ability to make anticipated quarterly distributions. Because other entities do not necessarily calculate CAD the same way we do, our presentation of CAD may not be comparable to similarly titled measures provided by other entities. We believe that our historic and future CAD, together with our cash balances and access to cash via our debt facilities, will be sufficient to meet our anticipated distributions over the next twelve months. The table below reconciles CAD to net income and to cash flow provided by operating activities, which we consider to be the most directly comparable financial measure calculated and presented in accordance with GAAP.
(1)
Represents the commitment fee on the unused portion of our Revolving Credit Facility.
(2)
Represents interest income on loans to Advanced Circuit’s management (see related parties).
(3)
Represents maintenance capital expenditures that were funded from operating cash flow and excludes approximately $3.5 million of growth capital expenditures for the year ended December 31, 2008.
Cash flows of certain of our businesses are seasonal in nature. Cash flows from American Furniture are typically highest in the months of January through April of each year, coinciding with homeowners’ tax refunds. Cash flows from Staffmark are typically lower in the first quarter of each year than in other quarters due to reduced seasonal demand for temporary staffing services and to lower gross margins during that period associated with the front-end loading of certain taxes and other payments associated with payroll paid to our employees. Cash flows from HALO are typically highest in the months of September through December of each year primarily as the result of calendar sales and holiday promotions. HALO generates approximately two-thirds of its operating income in the months of September through December
Related Party Transactions and Certain Transactions Involving our Businesses
We have entered into the following related party transactions with our Manager, CGM:
Management Services Agreement
We entered into a management services agreement (“Management Services Agreement”) with CGM effective May 16, 2006. The Management Services Agreement provides for, among other things, CGM to perform services for us in exchange for a management fee paid quarterly and equal to 0.5% of our adjusted net assets. We amended the Management Services Agreement on November 8, 2006, to clarify that adjusted net assets are not reduced by non-cash charges associated with the Supplemental Put Agreement. The management fee is required to be paid prior to the payment of any distributions to shareholders. For the year ended December 31, 2009, 2008 and 2007, we incurred $12.8 million, $14.7 million and $10.1 million, respectively, in management fees to CGM.
Staffmark paid management fees of approximately $0.3 million and $0.7million for the years ended December 31, 2009 and 2008, respectively to a separate manager of Staffmark, unrelated to CGM.
LLC Agreement
As distinguished from its provision of providing management services to us, pursuant to the Management Services Agreement, CGM is the owner of 100% of the Allocation Interests in us. CGM paid $0.1 million for these Allocation Interests and has the right to cause us to purchase the Allocation Interests it owns. The Allocation Interests give CGM the right to distributions pursuant to a profit allocation formula upon the occurrence of certain events. Certain events include, but are not limited to, the dispositions of subsidiaries. In connection with the dispositions of Silvue and Aeroglide in 2008 we paid CGM a profit allocation of $14.9 million. In connection with the disposition of Crosman in 2006, we paid CGM a profit allocation of $7.9 million. No profit allocations were paid to CGM in 2009.
Supplemental Put Agreement
Concurrent with the IPO, we and CGM entered into a Supplemental Put Agreement, which may require us to acquire the Allocation Interests, described above, upon termination of the Management Services Agreement. Essentially, the put rights granted to CGM require us to acquire CGM’s Allocation Interests in us at a price based on a percentage of the increase in fair value in our businesses over our basis in those businesses. Each fiscal quarter we estimate the fair value of our businesses for the purpose of determining our potential liability associated with the Supplemental Put Agreement. Any change in the potential liability is accrued currently as a non-cash adjustment to earnings. For the years ended December 31, 2008 and 2007, we recognized approximately $6.4 million and $7.4 million in expense related to the Supplemental Put Agreement. For the year ended December 31, 2009 we reversed approximately $1.3 million in expenses related to this agreement.
Cost Reimbursement and Fees
We reimbursed our Manager, CGM, approximately $2.6 million, $2.6 million and $01.8 million, principally for occupancy and staffing costs incurred by CGM on our behalf during the years ended December 31, 2009, 2008 and 2007, respectively.
CGM acted as an advisor for each of the 2008 acquisitions (Fox and Staffmark) for which it received transaction service and expense payments in an aggregate amount of approximately $2.0 million. CGM acted as an advisor for each of the 2007 acquisitions (Aeroglide, HALO and American Furniture) for which it received transaction service and expense payments in an aggregate amount of approximately $2.1 million. No advisor fees were paid to CGM in 2009.
We have entered into the following significant related party transactions with our businesses:
Anodyne
On August 8, 2008 we exchanged a note due August 15, 2008, totaling approximately $6.9 million (including accrued interest) due from Mark Bidner, the former CEO of Anodyne in exchange for shares of stock of Anodyne held by the CEO. In addition, Mr. Bidner was granted an option to purchase approximately 10% of the outstanding shares of Anodyne, at a strike price exceeding the exchange price, from us in the future for which Mr. Bidner exchanged Anodyne stock valued at $0.2 million (the fair value of the option at the date of grant) as consideration.
On August 5, 2008 we exchanged $1.5 million in term debt due from Anodyne for 15,500 shares of common stock and 13,950 shares of convertible preferred stock of Anodyne.
Advanced Circuits
In connection with the acquisition of Advanced Circuits by CGI in September 2005, Advanced Circuits loaned certain officers and members of management of Advanced Circuits $3.4 million for the purchase of 136,364 shares of Advanced Circuit’s common stock. On January 1, 2006, Advanced Circuits loaned certain officers and members of management of Advanced Circuits $4.8 million for the purchase of an additional 193,366 shares of Advanced Circuit’s common stock. The notes bared interest at 6% and interest is added to the notes. The notes were due in September 2010 and December 2010 and are subject to mandatory prepayment provisions if certain conditions are met.
In connection with the issuance of the notes as described above, Advanced Circuits implemented a performance incentive program whereby the notes could either be partially or completely forgiven based upon the achievement of certain pre-defined financial performance targets. The measurement date for determination of any potential loan forgiveness is based on the financial performance of Advanced Circuits for the fiscal year ended December 31, 2010. During each of the fiscal years 2008, 2007 and 2006, ACI accrued approximately $1.6 million for this loan forgiveness. This expense has been classified as a component of general and administrative expense
On January 12, 2010 the promissory notes and loan forgiveness arrangements referred to above were amended as follows: (i) $5.8 million of the outstanding loans and interest were forgiven with the remaining balance, $4.7 million repaid in Class A common stock valued at $47.50 per share, (ii) 0.1million stock options were granted at an exercise price of $89.27 per share. The options are outstanding for ten years and vested at the grant date. The effect of this amendment was reflected as of December 31, 2009.
On October 10, 2007, we entered into an amendment to our inter-company loan agreement (the “Amendment”) with ACI dated as of May 16, 2006, between us and ACI (the “Loan Agreement”). The Loan Agreement was amended to (i) provide for additional term loan borrowings of $47.0 million and to permit the proceeds thereof to fund cash distributions totaling $47.0 million by ACI to Compass AC Holdings, Inc. (“ACH”), ACI’s sole shareholder, and by ACH to its shareholders, including us, (ii) extend the maturity dates of the loans under the Loan Agreement, and (iii) modify certain financial covenants of ACI under the Loan Agreement. Our share of the cash distribution was approximately $33.0 million with approximately $14.0 million being distributed to ACH’s other shareholders. All other material terms and conditions of the Loan Agreement were unchanged.
American Furniture
AFM’s largest supplier, Independent Furniture Supply (“Independent”), is 50% owned by Mike Thomas, AFM’s CEO. AFM purchases polyfoam from Independent on an arms-length basis and AFM performs regular audits to verify market pricing. AFM does not have any long-term supply contracts with Independent. Total purchases from Independent during 2009 and 2008 totaled approximately $19.4 and $18.4 million, respectively. From August 31, 2007 (acquisition date) to December 31, 2007, purchases from Independent totaled approximately $8.4 million.
Fox
Fox leases its principal manufacturing and office facilities in Watsonville, California from Robert Fox, a founder, Chief Engineering Officer and noncontrolling shareholder of Fox. The term of the lease is through July of 2018 and the rental payments can be adjusted annually for a cost-of-living increase based upon the consumer price index. Fox is responsible for all real estate taxes, insurance and maintenance related to this property. The leased facilities are 86,000 square feet and Fox paid rent under this lease of approximately $1.1 million and $1.0 million for each of the years ended December 31, 2009 and 2008, respectively.
Staffmark
In April 2009, we amended the Staffmark intercompany credit agreement which, among other things, recapitalized a portion of Staffmark’s long-term debt by exchanging $35.0 million of debt for Staffmark common stock. As a result of this transaction, the Company’s ownership percentage of the outstanding stock of Staffmark increased. In addition, as a result of
the exchange the Company received cash from a noncontrolling shareholder and recorded an increase to noncontrolling interest of $4.9 million.
Contractual Obligations and Off-Balance Sheet Arrangements
We have no special purpose entities or off balance sheet arrangements, other than operating leases entered into in the ordinary course of business.
Long-term contractual obligations, except for our long-term debt obligations, are generally not recognized in our consolidated balance sheet. Non-cancelable purchase obligations are obligations we incur during the normal course of business, based on projected needs.
The table below summarizes the payment schedule of our contractual obligations at December 31, 2009 (in thousands).
(a)
Reflects commitment fees and letter of credit fees under our Revolving Credit Facility and amounts due, together with interest on our Term Loan Facility.
(b)
Reflects various operating leases for office space, manufacturing facilities and equipment from third parties.
(c)
Reflects non-cancelable commitments as of December 31, 2009, including: (i) shareholder distributions of $49.8 million, (ii) management fees of $13.5 million per year over the next five years and; (iii) other obligations, including amounts due under employment agreements. Distributions to our shareholders are approved by our Board of Directors each fiscal quarter. The amount approved for future quarters may differ from the amount included in this schedule.
(d)
The supplemental put obligation represents the long-term portion of an estimated liability accrued as if our Management Services Agreement with CGM had been terminated. This agreement has not been terminated and there is no basis upon which to determine a date in the future, if any, that this amount will be paid.
The table does not include the long-term portion of the actuarially developed reserve for workers compensation, which does not provide for annual estimated payments beyond one year. This liability, totaling approximately $38.9 million at December 31, 2009, is included in our consolidated balance sheet as a component of workers’ compensation liability.
Critical Accounting Estimates
The following discussion relates to critical accounting policies for the Company, the Trust and each of our businesses.
The preparation of our financial statements in conformity with GAAP will require management to adopt accounting policies and make estimates and judgments that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from these estimates under different assumptions and judgments and uncertainties, and potentially could result in materially different results under different conditions. Our critical accounting estimates are discussed below. These critical accounting estimates are reviewed by our independent auditors and the audit committee of our board of directors.
Supplemental Put Agreement
In connection with our Management Services Agreement, we entered into a supplemental put agreement with our Manager pursuant to which our Manager has the right to cause the Company to purchase the Allocation Interests then owned by our Manager upon termination of the management services agreement for a price to be determined in accordance with the supplemental put agreement. We adjust the supplemental put agreement to its fair value quarterly by recording any change in value through the income statement. The fair value of the supplemental put agreement is largely related to the value of the profit allocation that our Manager, as holder of Allocation Interests, will receive. The valuation of the supplemental put agreement requires the use of complex models, which require highly sensitive assumptions and estimates. Annually, we confer with outside experts as to the reasonableness of our assumptions and estimates. The impact of over-estimating or
under-estimating the value of the supplemental put agreement could have a material effect on operating results. In addition, the value of the supplemental put agreement is subject to the volatility of our operations which may result in significant fluctuation in the value assigned to this supplemental put agreement.
Revenue Recognition
We recognize revenue when it is realized or realizable and earned. We consider revenue realized or realizable and earned when it has persuasive evidence of an arrangement, the product has been shipped or the services have been provided to the customer, the sales price is fixed or determinable and collectibility is reasonably assured. Provisions for customer returns and other allowances based on historical experience are recognized at the time the related sale is recognized.
Staffmark recognizes revenue for temporary staffing services at the time services are provided by Staffmark employees and reports revenue based on gross billings to customers. Revenue from Staffmark employee leasing services is recorded at the time services are provided. Such revenue is reported on a net basis (gross billings to clients less worksite employee salaries, wages and payroll-related taxes). We believe that net revenue accounting for leasing services more closely depicts the transactions with its leasing customers and is consistent with guidelines outlined in authoritative guidance. The effect of using this method of accounting is to report lower revenue than would be otherwise reported.
Business Combinations
The acquisitions of our businesses are accounted for under the purchase method of accounting. The amounts assigned to the identifiable assets acquired and liabilities assumed in connection with acquisitions are based on estimated fair values as of the date of the acquisition, with the remainder, if any, to be recorded as identifiable intangibles or goodwill. The fair values are determined by our management team, taking into consideration information supplied by the management of the acquired entities and other relevant information. Such information typically includes valuations supplied by independent appraisal experts for significant business combinations. The valuations are generally based upon future cash flow projections for the acquired assets, discounted to present value. The determination of fair values requires significant judgment both by our management team and by outside experts engaged to assist in this process. This judgment could result in either a higher or lower value assigned to amortizable or depreciable assets. The impact could result in either higher or lower amortization and/or depreciation expense.
Goodwill and Intangible Assets
Goodwill represents the excess of the purchase price over the fair value of the assets acquired. We are required to perform impairment reviews at least annually and more frequently in certain circumstances.
The goodwill impairment test is a two-step process, which requires management to make judgments in determining certain assumptions used in the calculation. The first step of the process consists of estimating the fair value of each of our reporting units based on a discounted cash flow model using revenue and profit forecast and a market approach which compares peer data and multiples. We then compare those estimated fair values with the carrying values, which include allocated goodwill. If the estimated fair value is less than the carrying value, a second step is performed to compute the amount of the impairment by determining an “implied fair value” of goodwill. The determination of a reporting unit’s “implied fair value” of goodwill requires the allocation of the estimated fair value of the reporting unit to the assets and liabilities of the reporting unit. Any unallocated fair value represents the “implied fair value” of goodwill, which is then compared to its corresponding carrying value. We cannot predict the occurrence of certain future events that might adversely affect the reported value of goodwill and/or intangible assets. Such events include, but are not limited to, strategic decisions made in response to economic and competitive conditions, the impact of the economic environment on our customer base, and material adverse effects in relationships with significant customers.
The “implied fair value” of reporting units is determined by management and generally is based upon future cash flow projections for the reporting unit, discounted to present value and market comparison to comparable peer companies. We use outside valuation experts to assist us in determining and evaluating the fair value of our reporting units.
We completed our annual goodwill impairment testing as of March 31, 2009. At each of our reporting units, the units’ fair value exceeded carrying value with the exception of Staffmark. The carrying amount of Staffmark exceeded its fair value due primarily to the significant decrease in revenue and operating profit at Staffmark resulting from the negative impact on temporary staffing and permanent placement revenues due to macroeconomic conditions and downward employment trends experienced in 2008 and 2009. As a result, we performed the second step of the goodwill impairment test in order to determine the amount of impairment loss. The second step of the goodwill impairment test involved comparing the implied fair value of Staffmark’s goodwill with the carrying value of that goodwill. This comparison resulted in a goodwill
impairment charge of $50.0 million, which was recorded in impairment expense on the consolidated statement of operations.
In connection with the annual goodwill impairment testing, we tested other indefinite-lived intangible assets at our Staffmark reporting unit. As a result of this analysis we determined that the carrying value exceeded the fair value of the CBS Personnel trade name (an indefinite-lived asset), based principally on the discontinuance of the CBS Personnel trade name and rebranding of the reporting unit to Staffmark in February 2009. The fair value of the CBS Personnel trade name was determined by applying the relief from royalty technique to forecasted revenues at the Staffmark reporting unit. The result of this analysis indicated that the carrying value of the trade name ($10.6 million) exceeded its fair value ($0.8 million) by $9.8 million. Therefore, an impairment charge of $9.8 million is recorded in impairment expense on the consolidated statement of operations for the year ended December 31, 2009. The remaining balance ($0.8 million) of the CBS Personnel trade name is being amortized over 2.75 years. (See footnote I to our Consolidated Financial Statements).
Long-lived intangible assets subject to amortization, including customer relationships, non-compete agreements and technology are amortized using the straight-line method over the estimated useful lives of the intangible assets, which we determine based on the consideration of several factors including the period of time the asset is expected to remain in service. We evaluate the carrying value and remaining useful lives of intangible assets subject to amortization whenever indications of impairment are present.
The determination of fair values and estimated useful lives requires significant judgment both by our management team and by outside experts engaged to assist in this process. This judgment could result in either a higher or lower value assigned to our reporting units and intangible assets. The impact could result in either higher or lower amortization and/or the incurrence of an impairment charge
Allowance for Doubtful Accounts
The Company records an allowance for doubtful accounts on an entity-by-entity basis with consideration for historical loss experience, customer payment patterns and current economic trends. The Company reviews the adequacy of the allowance for doubtful accounts on a periodic basis and adjusts the balance, if necessary. The determination of the adequacy of the allowance for doubtful accounts requires significant judgment by management. The impact of either over or under estimating the allowance could have a material effect on future operating results.
Workers’ Compensation Liability
Staffmark is an employer with both self-insurance and large deductible plans for its worker’s compensation exposure. Staffmark establishes reserves based upon its experience and expectations as to its ultimate liability for those claims using developmental factors based upon historical claim experience. Staffmark continually evaluates the potential for change in loss estimates with the support of qualified actuaries. As of December 31, 2009, Staffmark had approximately $61.0 million in workers’ compensation liability related to claims, reserves and settlements. The ultimate settlement of this liability could differ materially from the assumptions used to calculate this liability, which could have a material adverse effect on future operating results.
Deferred Tax Assets
Several of our majority owned subsidiaries have deferred tax assets recorded at December 31, 2009 which in total amount to approximately $22.7 million. These deferred tax assets are comprised primarily of reserves not currently deductible for tax purposes. The temporary differences that have resulted in the recording of these tax assets may be used to offset taxable income in future periods, reducing the amount of taxes we might otherwise be required to pay. Realization of the deferred tax assets is dependent on generating sufficient future taxable income. Based upon the expected future results of operations, we believe it is more likely than not that we will generate sufficient future taxable income to realize the benefit of existing temporary differences, although there can be no assurance of this. The impact of not realizing these deferred tax assets would result in an increase in income tax expense for such period when the determination was made that the assets are not realizable. (See Note M - “Income taxes in the Notes to Consolidated Financial Statements”)
Recent Accounting Pronouncements
Refer to footnote B to our consolidated financial statements.
ITEM 7A.
ITEM 7A. - Quantitative and Qualitative Disclosures about Market Risk
Interest Rate Sensitivity
At December 31, 2009, we were exposed to interest rate risk primarily through borrowings under our Credit Agreement because borrowings under this agreement are subject to variable interest rates. We had outstanding $76.0 million under the Term Loan Facility and $0.5 million outstanding under the Revolving Credit Facility portions of our Credit Agreement at December 31, 2009. We fixed $70.0 million of the Term Loan Facility borrowings with a “floating-to-fixed” interest rate swap with a bank. This swap effectively fixes the interest rate on the last $70.0 million of our Term Debt at 7.35% through 2010. Our exposure to fluctuation in variable interest on the remaining $6.0 million in Term Debt and $0.5 million in Revolving Debt is not deemed to be material to our financial condition or results of operations.
We expect to borrow under our Revolving Credit Facility in the future in order to finance our short term working capital needs and future acquisitions.
Exchange Rate Sensitivity
At December 31, 2009, we were not exposed to significant foreign currency exchange rate risks that could have a material effect on our financial condition or results of operations.
Credit Risk
We are exposed to credit risk associated with cash equivalents, investments, and trade receivables. We do not believe that our cash equivalents or investments present significant credit risks because the counterparties to the instruments consist of major financial institutions and we manage the notional amount of contracts entered into with any one counterparty. Our cash and cash equivalents at December 31, 2009 consists principally of (i) treasury and Government backed securities money market funds, (ii)insured prime money market funds, (iii) FDIC insured Certificates of Deposit, (iv) Commercial Paper and, cash balances in several non-interest bearing checking accounts. Substantially all trade receivable balances of our businesses are unsecured. The concentration of credit risk with respect to trade receivables is limited by the large number of customers in our customer base and their dispersion across various industries and geographic areas. Although we have a large number of customers who are dispersed across different industries and geographic areas, a prolonged economic downturn could increase our exposure to credit risk on our trade receivables. We perform ongoing credit evaluations of our customers and maintain an allowance for potential credit losses.
ITEM 8.
ITEM 8. - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The consolidated financial statements and financial statement schedules referred to in the index contained on page of this report are incorporated herein by reference.
ITEM 9.
ITEM 9. - CHANGES AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
NONE
ITEM 9A
ITEM 9A - CONTROLS AND PROCEDURES
Disclosure Controls and Procedures
(a) Management’s Evaluation of Disclosure Controls and Procedures. The Company’s management, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company’s disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end of the period covered by this report. Based on such evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that, as of December 31, 2009, the Company’s disclosure controls and procedures are effective in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act and in ensuring that information required to be disclosed by the Company in such reports is accumulated and communicated to the Company’s management, including the Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely discussions regarding require disclosure.
(b) Information with respect to Report of Management on Internal Control over Financial Reporting is contained on page F- 2 of this Annual Report on Form 10-K and is incorporated herein by reference.
(c) Information with respect to Report of Independent Registered Public Accounting Firm on Internal Control over Financial Reporting is contained on page F- 3 of this Annual Report on Form 10-K and is incorporated herein by reference.
(d) Changes in Internal Control over Financial Reporting. There have not been any changes in the Company’s internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during our fourth fiscal quarter to which this Annual Report on Form 10-K relates that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
ITEM 9B.
ITEM 9B. - OTHER INFORMATION
None
PART III
ITEM 10.
ITEM 10. - DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
Information concerning our executive officers is incorporated herein by reference to information included in the Proxy Statement for our 2010 Annual Meeting of Shareholders.
Information with respect to our directors and the nomination process is incorporated herein by reference to information included in the Proxy Statement for our 2010 Annual Meeting of Shareholders.
Information regarding our audit committee and our audit committee financial experts is incorporated herein by reference to information included in the Proxy Statement for our 2010 Annual Meeting of Shareholders.
Information required by Item 405 of Regulation S-K is incorporated herein by reference to information included in the Proxy Statement for our 2010 Annual Meeting of Shareholders.
The audit committee operates under a written charter, which reflects NASDAQ listing standards and Sarbanes-Oxley Act requirements regarding audit committees. A copy of the charter is incorporated herein by reference to Exhibit A to the Proxy Statement for our 2010 Annual Meeting of Shareholders and is available on the company’s website at www.compassdiversifiedholdings.com. We intend to satisfy any disclosure requirement under Item 5.05 of Form 8-K regarding an amendment to, or waiver from, a provision of this charter by posting such information on our web site at the address and location specified above.
ITEM 11.
ITEM 11. - EXECUTIVE COMPENSATION
Information with respect to executive compensation is incorporated herein by reference to information included in the Proxy Statement for our 2010 Annual Meeting of Shareholders.
ITEM 12.
ITEM 12. - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
Information with respect to security ownership of certain beneficial owners and management is incorporated herein by reference to information included in the Proxy Statement for our 2010 Annual Meeting of Shareholders.
ITEM 13.
ITEM 13. - CERTAIN RELATIONSHIPS AND RELATED PARTY TRANSACTIONS, AND DIRECTOR INDEPENDENCE
Information with respect to such contractual relationships is incorporated herein by reference to the information in the Proxy Statement for our 2010 Annual Meeting of Shareholders.
ITEM 14.
ITEM 14. - PRINCIPAL ACCOUNTANT FEES AND SERVICES
Information with respect to principal accounting fees and services and pre-approval policies are incorporated herein by reference to information included in the Proxy Statement for our 2010 Annual Meeting of Shareholders
PART IV
ITEM 15.
ITEM 15. - EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
1.
Financial Statements
See “Index to Consolidated Financial Statements and Supplemental Data” set forth on page.
2.
Financial Statement schedule
See “Index to Consolidated Financial Statements and Supplemental Data” set forth on page.
3.
Exhibits
See “Index to Exhibits”. Set forth on page E-1.
INDEX TO EXHIBITS
SIGNATURE
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this to be signed on its behalf by the undersigned, thereunto duly authorized.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
SIGNATURE
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Compass Diversified Holdings
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
AND SUPPLEMENTAL FINANCIAL DATA
REPORT OF MANAGEMENT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
Management of Compass Diversified Holdings is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934. Compass’ internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation and fair presentation of financial statements issued for external purposes in accordance with accounting principles generally accepted in the United States of America (US GAAP). Compass’ internal control over financial reporting includes those policies and procedures that:
•
pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of assets of the company;
•
provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with U.S. GAAP, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and
•
provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of assets of the company that could have a material effect on the consolidated financial statements.
Internal control over financial reporting includes the entity level environment, controls activities, monitoring and internal auditing practices and actions taken by management to correct deficiencies as identified.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect all misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
Management assessed the effectiveness of Compass’ internal control over financial reporting as of December 31, 2009. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework. Based on this assessment, management determined that Compass maintained effective internal control over financial reporting as of December 31, 2009.
The effectiveness of our internal control over financial reporting has been audited by Grant Thornton, LLP an independent registered public accounting firm, as stated in their report which appears on page.
March 9, 2010
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Shareholders and Board of Directors of Compass Diversified Holdings
We have audited Compass Diversified Holdings (formerly Compass Diversified Trust) (a Delaware Trust) and subsidiaries’ internal control over financial reporting as of December 31, 2009, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Compass Diversified Holdings and subsidiaries’ management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Report of Management on Internal Control over Financial Reporting. Our responsibility is to express an opinion on Compass Diversified Holdings and subsidiaries’ 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, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed 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 its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, Compass Diversified Holdings and subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2009, based on criteria established in Internal Control-Integrated Framework issued by COSO.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Compass Diversified Holdings and subsidiaries as of December 31, 2009 and 2008, and the related consolidated statements of operations, stockholders’ equity, cash flows, and financial statement schedule listed in the index appearing under Item 15(a)(2) for each of the three years in the period ended December 31, 2009, and our report dated March 9, 2010 expressed an unqualified opinion thereon.
/s/ Grant Thornton LLP
New York, New York
March 9, 2010
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Shareholders and Board of Directors of Compass Diversified Holdings
We have audited the accompanying consolidated balance sheets of Compass Diversified Holdings (a Delaware Trust) and subsidiaries as of December 31, 2009 and 2008, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2009. Our audits of the basic financial statements include the financial statement schedule listed in the index appearing under Item 15(a)(2). These financial statements and financial schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these 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, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Compass Diversified Holdings and subsidiaries as of December 31, 2009 and 2008, and the results of their operations and their cash flows for each for each of the three years in the period ended December 31, 2009 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the related financial statement schedule when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Compass Diversified Holdings and subsidiaries’ internal control over financial reporting as of December 31, 2009, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our report dated March 9, 2010 expressed an unqualified opinion thereon.
/s/ Grant Thornton LLP
New York, New York
March 9, 2010
Compass Diversified Holdings
Consolidated Balance Sheets
See notes to consolidated financial statements.
Compass Diversified Holdings
Consolidated Statements of Operations
See notes to consolidated financial statements.
Compass Diversified Holdings
Consolidated Statements of Stockholders’ Equity
See notes to consolidated financial statements.
Compass Diversified Holdings
Consolidated Statements of Cash Flows
Supplemental non-cash financing and investing activity:
- Issuance of CBS Personnel’s common stock valued at $47.9 million during 2008 in connection with the acquisition of Staffmark LLC. See Note C.
- Acquisition of $7.0 million of Anodyne common stock during 2008 in connection with the extinguishment of a promissory note due the Company by an employee of Anodyne. See Note R.
- Capital leases totaling $0.9 million were entered into during 2008.
See notes to consolidated financial statements.
Compass Diversified Holdings
Notes to Consolidated Financial Statements
December 31, 2009
Note A - Organization and Business Operations
Compass Diversified Holdings, a Delaware statutory trust (“the Trust”), was incorporated in Delaware on November 18, 2005. Compass Group Diversified Holdings, LLC, a Delaware limited liability Company (the “Company”), was also formed on November 18, 2005. Compass Group Management LLC, a Delaware limited liability Company (“CGM” or the “Manager”), was the sole owner of 100% of the interests of the Company (as defined in the Company’s operating agreement, dated as of November 18, 2005), which were subsequently reclassified as the “Allocation Interests” pursuant to the Company’s amended and restated operating agreement, dated as of April 25, 2006 (as amended and restated, the “LLC Agreement”) (see Note R - Related Parties).
The Trust and the Company were formed to acquire and manage a group of small and middle-market businesses headquartered in North America. In accordance with the amended and restated Trust Agreement, dated as of April 25, 2006 (the “Trust Agreement”), the Trust is sole owner of 100% of the Trust Interests (as defined in the LLC Agreement) of the Company and, pursuant to the LLC Agreement, the Company has, outstanding, the identical number of Trust Interests as the number of outstanding shares of the Trust. Compass Group Diversified Holdings, LLC, a Delaware limited liability company is the operating entity with a board of directors and other corporate governance responsibilities, similar to that of a Delaware corporation.
Note B - Summary of Significant Accounting Policies
Accounting principles
The Company’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (US GAAP).
Basis of presentation
The results of operations for the years ended December 31, 2009, 2008 and 2007 represent the results of operations of the Company’s acquired businesses from the date of their acquisition by the Company, and therefore are not indicative of the results to be expected for the full year. Certain prior year amounts have been reclassified to conform to the current year’s presentation.
Principles of consolidation
The consolidated financial statements include the accounts of the Trust and the Company, as well as the businesses acquired as of their respective acquisition date. All significant intercompany accounts and transactions have been eliminated in consolidation. Discontinued operating entities are reflected as discontinued operations in the Company’s results of operations and statements of financial position.
The acquisition of businesses that the Company owns or controls more than a 50% share of the voting interest are accounted for under the purchase method of accounting. The amount assigned to the identifiable assets acquired and the liabilities assumed is based on the estimated fair values as of the date of acquisition, with the remainder, if any, recorded as goodwill.
Discontinued operations
On June 24, 2008, the Company sold its majority owned subsidiary, Aeroglide Corporation (“Aeroglide”), for a total enterprise value of $95.0 million. As a result, the results of operations of Aeroglide for the periods from its acquisition on February 28, 2007 through December 31, 2007, and from January 1, 2008 through the date of sale on June 24, 2008, are reported as discontinued operations in accordance with authoritative guidance.
On June 25, 2008, the Company sold its majority owned subsidiary, Silvue Technologies Group, Inc. (“Silvue”), for a total enterprise value of $95.0 million. As a result, the results of operations of Silvue for the periods from January 1, 2007 through December 31, 2007 and from January 1, 2008 through the date of sale on June 25, 2008, are reported as discontinued operations in accordance with authoritative guidance.
Use of estimates
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the
reporting period. It is possible that in 2010 actual conditions could be worse than anticipated when we developed our estimates and assumptions, which could materially affect our results of operations and financial position. Such changes could result in future impairment of goodwill, intangibles and long-lived assets, inventory obsolescence, establishment of valuation allowances on deferred tax assets and increased tax liabilities. Actual results could differ from those estimates.
Fair value of financial instruments
The carrying value of the Company’s financial instruments, including cash, accounts receivable and accounts payable approximate their fair value due to their short term nature. Term Debt with a carrying value of $76.0 million at December 31, 2009 had a fair value of approximately $71.9 million. The fair value is based on interest rates that are currently available to the Company for issuance of debt with similar terms and remaining maturities.
Revenue recognition
In accordance with authoritative guidance on revenue recognition, the Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the sellers price to the buyer is fixed and determinable, and collection is reasonably assured. Shipping and handling costs are charged to operations when incurred and are classified as a component of cost of sales.
Advanced Circuits
Revenue is recognized upon shipment of product to the customer, net of sales returns and allowances. Appropriate reserves are established for anticipated returns and allowances based on past experience. Revenue is typically recorded at F.O.B. shipping point but for sales of certain custom products, revenue is recognized upon completion and customer acceptance.
American Furniture
Revenue is recognized upon shipment of product to the customer, net of sales returns and allowances. Appropriate reserves are established for anticipated returns and allowances based on past experience. Revenue is typically recorded at F.O.B. shipping point.
Anodyne
Revenue is recognized upon shipment of product to the customer, net of sales returns and allowances. Appropriate reserves are established for anticipated returns and allowances based on past experience. Revenue is typically recorded at F.O.B. shipping point.
Fox
Revenue is recognized upon shipment of product to the customer, net of sales returns and allowances. Appropriate reserves are established for anticipated returns and allowances based on past experience. Revenue is typically recorded at F.O.B. shipping point.
HALO
Revenue is recognized when an arrangement exists, the promotional or premium products have been shipped, fees are fixed and determinable, and the collection of the resulting receivables is probable. Over 90% of HALO’s sales are drop-shipped and recorded FOB shipping point.
Staffmark
Revenue from temporary staffing services is recognized at the time services are provided by the Company employees and is reported based on gross billings to customers. Revenue from employee leasing services is recorded at the time services are provided and is reported on a net basis (gross billings to clients less worksite employee salaries and payroll-related taxes). Revenue is recognized for permanent placement services at the employee start date.
Cash equivalents
The Company considers all highly liquid investments with original maturities of three months or less to be cash equivalents.
Allowance for doubtful accounts
The Company uses estimates to determine the amount of the allowance for doubtful accounts in order to reduce accounts receivable to their estimated net realizable value. The Company estimates the amount of the required allowance by reviewing the status of past-due receivables and analyzing historical bad debt trends. The Company’s estimate also includes analyzing existing economic conditions. When the Company becomes aware of circumstances that may impair a specific customer’s ability to meet its financial obligations subsequent to the original sale, the Company will record an allowance against amounts due, and thereby reduce the net receivable to the amount it reasonably believes will be collectible.
Inventories
Inventories consist of manufactured goods and purchased goods acquired for resale. Inventories are stated at the lower of cost or market, determined on the first-in, first-out method. Cost includes raw materials, direct labor and manufacturing overhead. Market value is based on current replacement cost for raw materials and supplies and on net realizable value for finished goods.
Property, plant and equipment
Property, plant and equipment is recorded at cost. The cost of major additions or betterments is capitalized, while maintenance and repairs that do not improve or extend the useful lives of the related assets are expensed as incurred.
Depreciation is provided principally on the straight-line method over estimated useful lives. Leasehold improvements are amortized over the life of the lease or the life of the improvement, whichever is shorter.
The useful lives are as follows:
Machinery,equipment and software
2 to 10 yeras
Office furniture and equpiment
2 to 7 years
Leasedhold improvements
Shorter of useful life or lease term
Property, plant and equipment and other long-lived assets, that have useful lives, are evaluated for impairment when events or changes in circumstances indicate that the carrying value of the assets may not be recoverable. Upon the occurrence of a triggering event, the asset is reviewed to assess whether the estimated undiscounted cash flows expected from the use of the asset plus residual value from the ultimate disposal exceeds the carrying value of the asset. If the carrying value exceeds the estimated recoverable amounts, the asset is written down to the estimated present value of the expected future cash flows from using the asset.
Goodwill and intangible assets
Goodwill represents the difference between purchase cost and the fair value of net assets acquired in business acquisitions. Indefinite lived intangible assets, representing trademarks and trade names, are not amortized until their useful life is determined to no longer be indefinite. Goodwill and indefinite lived intangible assets are tested for impairment at least annually, unless circumstances otherwise dictate, by comparing the fair value of each reporting unit to its carrying value. Fair value is determined using a discounted cash flow methodology and a comparable company analysis and includes management’s assumptions on revenue, growth rates, operating margins, appropriate discount rates and expected capital expenditures. Impairments, if any, are charged directly to earnings. Intangible assets with a useful life include customer relations, technology and licensing agreements that are subject to amortization, and are evaluated for impairment whenever events or changes in circumstances indicate that the carrying value of the assets may not be fully recoverable.
During fiscal year 2009, the Company changed the date of its annual goodwill impairment testing from April 30 to March 31 in order to move the impairment testing to a fiscal quarter ending date when data necessary to perform the annual testing is more readily available and more robust. The Company believes that the resulting change in accounting principle related to the annual testing date did not delay, accelerate, or avoid an impairment charge. The Company determined that the change in accounting principle related to the annual testing date is preferable under the circumstances and does not result in adjustments to the Company’s financial statements when applied retrospectively. Please refer to Note I for the results of the Company’s 2009 annual impairment testing.
Deferred debt issuance costs
Deferred debt issuance costs represent the costs associated with the issuance of debt instruments and are amortized over the life of the related debt instrument.
Workers’ compensation liability
Workers’ compensation liability represents estimated costs of self insurance associated with workers’ compensation at the Company’s Staffmark operating segment. The reserves for workers’ compensation are based upon actuarial assumptions of individual case estimates and incurred but not reported (“IBNR”) losses. At December 31, 2009 and
2008, the current portion of these reserves is included as a component of current portion of workers’ compensation liability and the non-current portion is included as a component of workers’ compensation liability on the consolidated balance sheets.
Warranties
The Company’s Fox and Anodyne operating segments estimate the exposure to warranty claims based on both current and historical product sales data and warranty costs incurred. The Company assesses the adequacy of its recorded warranty liability quarterly and adjusts the amount as necessary.
Supplemental put
Distinct from its role as Manager of the Company, CGM is also the owner of 100% of the Allocation Interests in the Company. Concurrent with the IPO, CGM and the Company entered into a Supplemental Put Agreement, which may require the Company to acquire these Allocation Interests upon termination of the Management Services Agreement. Essentially, the put right granted to CGM requires the Company to acquire CGM’s Allocation Interests in the Company at a price based on 20% of the company’s profits upon clearance of a 7% annualized hurdle rate. Each fiscal quarter the Company estimates the fair value of this potential liability associated with the Supplemental Put Agreement. Any change in the potential liability is accrued currently as a non-cash adjustment to earnings. For the year ended December 31, 2009 the Company reversed $1.3 million of expense related to the Supplemental Put Agreement. For the years ended December 31, 2008 and 2007, the Company recognized approximately $6.4 million and $7.4 million, respectively, in expense related to the Supplemental Put Agreement. Upon the sale of any of the majority owned subsidiaries, the Company will be obligated to pay CGM the amount of the supplemental put liability allocated to the sold subsidiary.
Derivatives and hedging
The Company utilizes an interest rate swap (derivative) to manage risks related to interest rates on the last $70.0 million of its Term Loan Facility (“swap”). The Company has elected hedge accounting treatment to account for its swap and has designated the swap as a cash flow hedge and as a result unrealized changes in fair value of the hedge are reflected in comprehensive income (loss).
On February 18, 2009, the Company terminated a portion of its swap early in connection with the repayment of $75.0 million of the Term Loan Facility. In connection with the termination, the Company reclassified $2.5 million from accumulated other comprehensive loss into earnings. Refer to Note L for additional information.
Noncontrolling interest
Noncontrolling interest represents the portion of a majority-owned subsidiary’s net income that is owned by noncontrolling shareholders.
In January 2009, the Company adopted authoritative guidance relating to its accounting for noncontrolling shareholders. The authoritative guidance requires reporting entities to present noncontrolling interests as equity (as opposed to as a liability or mezzanine equity) and provides guidance on the accounting for transactions between an entity and noncontrolling interests. The adoption of the authoritative guidance resulted in the presentation of noncontrolling interest as a component of equity on the Consolidated Balance Sheets and income attributable to noncontrolling interest on the Consolidated Statements of Operations.
Income taxes
Deferred income taxes are calculated under the liability method. Deferred income taxes are provided for the differences between the basis of assets and liabilities for financial reporting and income tax purposes at the enacted tax rates. A valuation allowance is established when necessary to reduce deferred tax assets to the amount that is expected to be more likely than not realized.
Earnings per share
Basic and fully diluted income (loss) per share attributable to Holdings is computed on a weighted average basis.
The weighted average number of Trust shares outstanding for fiscal 2007 was computed based on 20,450,000 shares outstanding for the period from January 1, 2007 through December 31, 2007 and 9,875,000 additional shares outstanding issued in connection with the Company’s secondary offering for the period from May 8, 2007 through December 31, 2007, and 1,200,000 shares outstanding issued in connection with the over-allotment for the period from May 20, 2007 through December 31, 2007. The weighted average number of Trust shares outstanding for fiscal 2008 was computed based on 31,525,000 shares outstanding for the entire fiscal year. The weighted average number of Trust shares outstanding for fiscal 2009 was computed based on 31,525,000 shares outstanding for the period from January 1, 2009 through December 31, 2009 and 5,100,000 additional shares outstanding issued in connection with the Company’s secondary offering for the period from June 9, 2009 through December 31, 2009.
The Company did not have any option plan or other potentially dilutive securities outstanding during the years ended December 31, 2009, 2008 and 2007.
Advertising costs
Advertising costs are expensed as incurred and included in selling, general and administrative expense in the consolidated statements of operations. Advertising costs were $3.3 million, $5.5 million and $4.0 million during the years ended December 31, 2009, 2008 and 2007, respectively.
Research and development
Research and development costs are expensed as incurred and included in selling, general and administrative expense in the consolidated statements of operations. The Company incurred research and development expense of $3.9 million, $3.5 million and $0.9 million during the years ended December 31, 2009, 2008 and 2007, respectively.
Employee retirement plans
The Company and many of its operating segments sponsor defined contribution retirement plans, such as 401(k) or profit sharing plans. Employee contributions to the plan are subject to regulatory limitations and the specific plan provisions. The Company and its operating segments may match these contributions up to levels specified in the plans and may make additional discretionary contributions as determined by management. The total employer contributions to these plans were $0.5 million, $2.1 million and $1.3 million for the years ended December 31, 2009, 2008 and 2007, respectively.
Seasonality
Earnings of certain of the Company’s operating segments are seasonal in nature. Earnings from AFM Holdings Corporation (“AFM” or “American Furniture”) are typically highest in the months of January through April of each year, coinciding with homeowners’ tax refunds. Earnings from Staffmark are typically lower in the first quarter of each year than in other quarters due to reduced seasonal demand for temporary staffing services and to lower gross margins during that period associated with the front-end loading of certain payroll taxes and other payments associated with payroll paid to our employees. Earnings from HALO Lee Wayne LLC (“HALO”) are typically highest in the months of September through December of each year primarily as the result of calendar sales and holiday promotions. HALO generates approximately two-thirds of its operating income in the months of September through December.
Recent accounting pronouncements
In March 2009, the Financial Accounting Standards Board (“FASB”) issued additional authoritative guidance on business combinations, specifically, for the initial recognition and measurement, subsequent measurement, and disclosures of assets and liabilities arising from contingencies in a business combination as well as for pre-existing contingent consideration assumed as part of the business combination. This guidance is effective for the Company January 1, 2009.
In April 2009, the FASB amended authoritative guidance on disclosures about the fair value of financial instruments, which is effective for the Company June 30, 2009. The amended guidance requires a publicly traded company to include disclosures about the fair value of its financial instruments whenever it issues summarized financial information for interim reporting periods. In addition, the guidance requires an entity to disclose either in the body or the accompanying notes of its summarized financial information the fair value of all financial instruments for which it is practicable to estimate that value, whether recognized or not recognized in the statement of financial position. The adoption of this guidance did not have a significant impact on the Company’s Consolidated Financial Statements.
In May 2009, the FASB issued authoritative guidance on subsequent events, which is effective for the Company June 30, 2009. This guidance addresses the disclosure of events that occur after the balance sheet date, but before financial statements are filed with the Securities and Exchange Commission. The adoption of this guidance did not have a significant impact on the Company’s Consolidated Financial Statements.
In June 2009, the FASB issued amendments to authoritative guidance on consolidation of variable interest entities, which will be effective for the Company January 1, 2010. The amended guidance revises factors that should be considered by a reporting entity when determining whether an entity that is insufficiently capitalized or is not controlled through voting (or similar rights) should be consolidated. This guidance also includes revised financial statement disclosures regarding the reporting entity’s involvement and risk exposure. The Company does not expect the adoption of this guidance will have a significant impact on the Company’s Consolidated Financial Statements.
In June 2009, the FASB issued The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles (the “FASB Codification”), which is effective for the Company July 1, 2009. The FASB Codification does not alter current U.S. GAAP, but rather integrates existing accounting standards with other authoritative guidance. Under the FASB Codification there is a single source of authoritative U.S. GAAP for nongovernmental entities and this has superseded all other previously issued non-SEC accounting and reporting guidance. The adoption of the FASB Codification did not have any impact on the Company’s Consolidated Financial Statements.
In August 2009, the FASB amended authoritative guidance for determining the fair value of liabilities, which was effective October 1, 2009. The amended guidance reiterates that the fair value measurement of a liability (1) should be based on the assumption that the liability was transferred to a market participant on the measurement date and (2) should include the risk of nonperformance. In addition, the guidance establishes a hierarchy for determining the fair value of liabilities. Specifically, an entity must first determine whether a quoted price, from an active market, is available for identical liabilities before utilizing an alternative valuation technique. The adoption of this guidance did not have a significant impact on the Company’s Consolidated Financial Statements.
In September 2009, the Emerging Issues Task Force reached a consensus related to revenue arrangements with multiple deliverables. The consensus will be issued by the FASB as an update to authoritative guidance for revenue recognition and will be effective for the Company January 1, 2011. The updated guidance will revise how the estimated selling price of each deliverable in a multiple element arrangement is determined when the deliverables do not have stand-alone evidence of value. In addition, the revised guidance will require additional disclosures about the methods and assumptions used to evaluate multiple element arrangements and to identify the significant deliverables within those arrangements. The Company does not expect the adoption of this guidance will have a significant impact on the Company’s Consolidated Financial Statements.
In December 2009, the FASB amended authoritative guidance related to accounting for transfers and servicing of financial assets and extinguishments of liabilities. The guidance will be effective beginning January 1, 2010. The guidance eliminates the concept of a qualifying special-purpose entity and changes the criteria for derecognizing financial assets. In addition, the guidance will require additional disclosures related to a company’s continued involvement with financial assets that have been transferred. The adoption of this amended guidance will not have a significant impact on the Company’s Consolidated Financial Statements.
In December 2009, the FASB amended authoritative guidance for consolidating variable interest entities. The guidance will be effective beginning January 1, 2010. Specifically, the guidance revises factors that should be considered by a reporting entity when determining whether an entity that is insufficiently capitalized or is not controlled through voting (or similar rights) should be consolidated. This guidance also includes revised financial statement disclosures regarding the reporting entity’s involvement, including significant risk exposures as a result of that involvement, and the impact the relationship has on the reporting entity’s financial statements. The adoption of this amended guidance will not have a significant impact on the Company’s Consolidated Financial Statements.
Note C - Acquisition of Businesses
From January 1, 2008 through December 31, 2009, the Company completed two acquisitions as follows:
(1)
Staffmark Investment LLC (“Staffmark LLC”) was acquired by the Staffmark operating segment. In February 2009, CBS Personnel rebranded under the Staffmark trade name, as a result the Company renamed its CBS Personnel operating segment to Staffmark.
Allocation of Purchase Price
The acquisition of controlling interests in each of the Company’s businesses has been accounted for under the purchase method of accounting. The purchase price allocation was based on estimates of the fair value of the assets acquired and liabilities assumed. The fair values assigned to the acquired assets were developed from information supplied by management and valuations supplied by independent appraisal experts. The results of operations of each of the Company’s acquisitions are included in the consolidated financial statements from the date of acquisition. In accordance with authoritative guidance, a deferred tax liability aggregating $25.3 million was recorded to reflect the net increase in the financial accounting basis of the assets acquired over their related income tax basis in 2008.
2008 Acquisitions
Fox Factory
On January 4, 2008, Fox Factory Holding Corp., a subsidiary of the Company, entered into an agreement with Fox Factory, Inc. (“Fox”) and Robert C. Fox, Jr., the sole shareholder of Fox, to purchase all of the issued and outstanding capital stock of Fox. The Company made loans to and purchased a controlling interest in Fox for approximately $80.4 million, representing approximately 75.5% of the outstanding common stock on a primary basis and 69.8% on a fully diluted basis. Fox management invested in the transaction alongside CODI resulting in an initial noncontrolling ownership of approximately 24.0%.
Headquartered in Watsonville, California, Fox is a designer, manufacturer and marketer of high end suspension products for mountain bikes, all-terrain vehicles, snowmobiles and other off-road vehicles. Fox acts both as a tier one supplier to leading action sport original equipment manufacturers and provides after-market products to retailers and distributors.
In connection with the allocation of the purchase price and intangible asset valuation, goodwill of $31.3 million and intangible assets subject to amortization of $44.2 million were recorded. The intangible assets recorded include $11.7 million of customer relationships with useful lives ranging from 8 to 12 years and $32.5 million of technology with an estimated useful life of 8 years. In addition, intangible assets recorded include the value assigned to trademarks of $13.3 million which is not subject to amortization. The Company does not expect the goodwill will be deductible for tax purposes. Fox’s results of operations are reported as a separate operating segment and are included in the Company’s consolidated results of operations from the date of acquisition.
The Company’s Manager acted as an advisor to the Company in the transaction and received fees and expense payments totaling approximately $0.8 million.
Staffmark
On January 21, 2008, the Company’s majority-owned subsidiary, CBS Personnel (now doing business as Staffmark), acquired Staffmark LLC, a privately held personnel services provider. Staffmark LLC is a leading provider of commercial staffing services in the United States. Staffmark LLC provides staffing services in more than 30 states through more than 200 branches and on-site locations. The majority of Staffmark LLC’s revenues are derived from light industrial staffing, with the balance of revenues derived from administrative and transportation staffing, permanent placement services and managed solutions. Similar to CBS Personnel, Staffmark Investment LLC was one of the largest privately held staffing companies in the United States. Under the terms of the purchase agreement, CBS Personnel purchased all of the outstanding equity interests of Staffmark LLC for a total purchase price of approximately $128.6 million, exclusive of transaction fees and closing costs of $5.2 million. Staffmark LLC has become a wholly-owned subsidiary of CBS Personnel and Staffmark LLC’s results of operations are included in the Staffmark operating segment from the date of acquisition. In February 2009, CBS Personnel rebranded under the Staffmark trade name, as a result the Company renamed its CBS Personnel operating segment to Staffmark.
The aggregate purchase price consisted of cash and 1,929,089 shares of CBS Personnel common stock, valued at approximately $47.9 million, for a total purchase price of approximately $80 million. The fair value of the CBS Personnel stock issued and transferred to Staffmark LLC as partial consideration in the acquisition was determined based on an analysis of financial and market data of publicly traded companies deemed comparable to CBS Personnel, together with relevant multiples of recent merged, sold or acquired companies comparable to CBS Personnel.
The acquisition agreement pursuant to which CBS Personnel issued cash and 1,929,089 shares of CBS Personnel common stock (the “Staffmark LLC stock”) in exchange for all of the membership units of Staffmark LLC, gave the holders of Staffmark LLC’s membership units a non-transferable right (“put right”), to direct the Company, on or after January 21, 2011, to either: (i) promptly initiate such commercially reasonable actions that would result in a sale of CBS Personnel or (ii) offer to purchase the Staffmark LLC stock at its then fair market value, if such right was not otherwise extinguished pursuant to the terms of the acquisition agreement. The put right is extinguishable at any time if either a public offering of the shares of CBS Personnel or sale of CBS Personnel has occurred.
In connection with the allocation of the purchase price and intangible asset valuation, goodwill of $78.9 million and intangible assets subject to amortization of $50.1 million were recorded. The intangible assets recorded include $24.5 million of customer relationships with an estimated useful life of 12 years, $24.5 million of trademarks with an estimated useful life of 15 years and $1.1 million of licensing agreements with an estimated useful life of 3 years. The Company expects $58.4 million of goodwill will be deductible for tax purposes.
The Company’s ownership percentage of CBS Personnel is 66.4% on a primary basis and 62.4% on a fully diluted basis subsequent to the Staffmark LLC acquisition.
The Company’s Manager acted as an advisor to CBS Personnel in the transaction and received fees and expense payments totaling approximately $1.2 million.
Other acquisitions
In addition to the acquisitions discussed above, the Company’s operating segments, Anodyne and HALO, acquired add-on businesses during 2008 and 2009. In 2008, the Company’s HALO operating segment acquired three add-on businesses for a total purchase price aggregating approximately $10.3 million. Goodwill of $6.8 million was initially recorded in connection with these acquisitions. In addition to goodwill, HALO recorded $2.7 million related to customer relationships with an estimated useful life of 15 years and $0.2 million of non-compete agreements with an estimated useful life of 3 years. In 2009, the HALO operating segment acquired one add-on business for a total purchase price aggregating approximately $1.0 million. Goodwill of $0.4 million was initially recorded in connection with these acquisitions. In addition to goodwill, HALO recorded $0.4 million related to customer relationships with an estimated useful life of 15 years. Also in 2009, the Company’s ACI operating segment acquired one add-on business for approximately $0.4 million. Goodwill of $0.1 million was recorded in connection with this acquisition. In addition to goodwill, ACI recorded $0.3 million related to customer relationships with an estimated useful life of 9 years.
Note D - Discontinued Operations
2007 Disposition
On January 5, 2007, the Company sold its majority owned subsidiary, Crosman Acquisition Corporation (“Crosman”), for a total enterprise value of $143.0 million. The Company’s share of the net proceeds, after accounting for the redemption of Crosman’s noncontrolling holders and the payment of CGM’s profit allocation, was approximately $110.0 million. The Company recognized a gain on the sale of $36.0 million, or $1.77 per share.
2008 Dispositions
On June 24, 2008, the Company sold its majority owned subsidiary, Aeroglide Corporation (“Aeroglide”), for a total enterprise value of $95.0 million. The Company’s share of the net proceeds, after accounting for (i) redemption of Aeroglide’s noncontrolling holders; (ii) payment of transaction expenses; and (iii) CGM’s profit allocation; totaled $78.3 million. The Company recognized a gain on the sale of $34.0 million, or $1.08 per share.
On June 25, 2008, the Company sold its majority owned subsidiary, Silvue Technologies Group, Inc. (“Silvue”), for a total enterprise value of $95.0 million. The Company’s share of the net proceeds, after accounting for (i) redemption of Silvue’s noncontrolling holders; (ii) payment of transaction expenses; and (iii) CGM’s profit allocation; totaled $63.6 million. The Company recognized a gain on the sale of $39.4 million, or $1.25 per share.
Approximately $65 million of the Company’s net proceeds from the 2008 dispositions were used to repay amounts outstanding under the Company’s Revolving Credit Facility. The remainder of the net proceeds was used to repay $70.0 million of the Term Debt Facility in February 2009 and for general corporate purposes.
Summarized operating results for the 2008 dispositions through the dates of the respective sales were as follows (in thousands):
Note E - Operating Segment Data
At December 31, 2009, the Company had six reportable operating segments. Each operating segment represents an acquisition (Staffmark LLC is included in the Staffmark operating segment). The Company’s operating segments are strategic business units that offer different products and services. They are managed separately because each business requires different technology and marketing strategies.
A description of each of the reportable segments and the types of products and services from which each segment derives its revenues is as follows:
•
Compass AC Holdings, Inc. (“ACI” or “Advanced Circuits”), an electronic components manufacturing company, is a provider of prototype, quick-turn and production rigid printed circuit boards. ACI manufactures and delivers custom printed circuit boards to customers mainly in North America. ACI is headquartered in Aurora, Colorado.
•
American Furniture Manufacturing, Inc. (“AFM” or “American Furniture”) is a leading domestic manufacturer of upholstered furniture for the promotional segment of the marketplace. AFM offers a broad product line of stationary and motion furniture, including sofas, loveseats, sectionals, recliners and complementary products, sold primarily at retail price points ranging between $199 and $999. AFM is a low-cost manufacturer and is able to ship any product in its line within 48 hours of receiving an order. AFM is headquartered in Ecru, Mississippi and its products are sold in the United States.
•
Anodyne Medical Device, Inc. (“Anodyne”), is a leading designer and manufacturer of powered and non-powered medical therapeutic support surfaces and patient positioning devices serving the acute care, long-term care and home health care market Anodyne is headquartered in Coral Springs, Florida and its products are sold primarily in North America.
•
Fox Factory, Inc. (“Fox”) is a designer, manufacturer and marketer of high end suspension products for mountain bikes, all-terrain vehicles, snowmobiles and other off-road vehicles. Fox acts as both a tier one supplier to leading action sport original equipment manufacturers and provides after-market products to retailers and distributors. Fox is headquartered in Watsonville, California and its products are sold worldwide.
•
HALO Branded Solutions, Inc. (“HALO”), operating under the brand names of HALO and Lee Wayne, serves as a one-stop shop for approximately 38,000 customers providing design, sourcing, management and fulfillment services across all categories of its customer promotional product needs. HALO has established itself as a leader in the promotional products and marketing industry through its focus on service through its approximately 1,000 account executives. Halo is headquartered in Sterling, Illinois.
•
CBS Personnel Holdings, Inc. (doing business as Staffmark) (“Staffmark”), a human resources outsourcing firm, is a provider of temporary staffing services in the United States. Staffmark serves approximately 6,500 corporate and small business clients. Staffmark also offers employee leasing services, permanent staffing and temporary-to-permanent placement services. Staffmark is headquartered in Cincinnati, Ohio.
The tabular information that follows shows data of operating segments reconciled to amounts reflected in the consolidated financial statements. The operations of each of the operating segments are included in consolidated operating results as of their date of acquisition. Revenues from geographic locations outside the United States were not material for each operating segment, except Fox, in each of the years presented below. Fox recorded net sales to locations outside the United States, principally Asia, of $84.0 million, $92.5 million and $70.5 million for the years ended December 31, 2009, 2008 and 2007, respectively. There were no significant inter-segment transactions.
Segment profit is determined based on internal performance measures used by the Chief Executive Officer to assess the performance of each business. Segment profit excludes acquisition related amounts and charges not pushed down to the segments and are reflected in Corporate and other.
A disaggregation of the Company’s consolidated revenue and other financial data for the years ended December 31, 2009, 2008 and 2007 is presented below (in thousands):
(1)
Segment profit represents operating income (loss).
(2)
Includes $50.0 million of goodwill impairment during the year ended December 31, 2009. See Note I.
(3)
Corporate and other consists of charges at the corporate level and purchase accounting adjustments not “pushed down” to the segment. In addition, Corporate and other includes $9.8 million of Staffmark’s intangible asset impairment during the year ended December 31, 2009, not “pushed down” to the segment. See Note I.
(1)
Not including accounts receivable scheduled above.
(2)
Represents goodwill resulting from purchase accounting adjustments not “pushed down” to the respective segment. Goodwill is allocated back to the respective segment for purposes of impairment testing.
(3)
Includes $50.0 million of goodwill impairment during the year ended December 31, 2009. See Note I.
Note F - Inventories
Inventory is comprised of the following (in thousands):
Note G - Property, Plant and Equipment
Property, plant and equipment is comprised of the following (in thousands):
Depreciation expense was approximately $8.4 million, $8.5 million and $3.8 million for the years ended December 31, 2009, 2008 and 2007, respectively.
Note H - Commitments and Contingencies
Leases
The Company leases office facilities, computer equipment and software under various operating arrangements. The future minimum rental commitments at December 31, 2009 under operating leases having an initial or remaining non-cancelable term of one year or more are as follows (in thousands):
The Company’s rent expense for the fiscal years ended December 31, 2009, 2008 and 2007 totaled $14.1 million, $16.5 million and $8.3 million, respectively.
Legal Proceedings
In the normal course of business, the Company and its subsidiaries are involved in various claims and legal proceedings. While the ultimate resolution of these matters has yet to be determined, the Company does not believe that an unfavorable outcome will have a material adverse effect on the Company’s consolidated financial position or results of operations.
Note I - Goodwill and Other Intangible Assets
Goodwill impairment
The Company performed its 2009 annual goodwill impairment testing in accordance with guidelines issued by the FASB as of March 31, 2009. This annual impairment test involved a two-step process. The first step of the impairment test involved comparing the fair values of the applicable reporting units with their aggregate carrying values, including goodwill. The Company’s reporting units are the same as its operating segments.
The Company determined fair values for each of its reporting units using both the income and market approach. For purposes of the income approach, fair value was determined based on the present value of estimated future cash flows, discounted at an appropriate risk-adjusted rate. The Company used its internal forecasts to estimate future cash flows and included an estimate of long-term future growth rates based on its most recent views of the long-term outlook for each business. Discount rates were derived by applying market derived inputs and analyzing published rates for industries comparable to the Company’s reporting units. The Company used discount rates that are commensurate with the risks and uncertainty inherent in the financial markets generally and in the internally developed forecasts. Discount rates used in these reporting unit valuations ranged from approximately 15% to 16%. Valuations using the market approach reflect prices and other relevant observable information generated by market transactions involving businesses comparable to the Company’s reporting units. The Company assesses the valuation methodology under the market approach based upon the relevance and availability of data at the time of performing the valuation and weighs the methodologies appropriately.
Based on the results of the annual impairment tests performed as of March 31, 2009, an indication of impairment existed at the Company’s Staffmark reporting unit. In each of the other reporting units the result of the annual goodwill impairment test indicated that the fair value of the reporting unit exceeded its carrying value. Based on the results of the second step of the impairment test, the Company estimated that the carrying value of the Staffmark goodwill exceeded its fair value by approximately $50.0 million. As a result of this shortfall, the Company recorded a $50.0 million pretax goodwill impairment charge to impairment expense on the Consolidated Statement of Operations during the year ended December 31, 2009. The carrying amount of Staffmark exceeded its fair value due to the recent and projected significant decrease in revenue and operating profit at Staffmark resulting from the negative impact on temporary staffing and permanent placement revenues due to the depressed U.S. macroeconomic conditions resulting in downward employment trends. The results of the annual impairment tests performed as of April 30, 2008, and April 30, 2007 indicated that the fair values of the reporting units exceeded their carrying values and, therefore, goodwill was not impaired. Accordingly, there were no charges for goodwill impairment in the year ended December 31, 2008 or December 31, 2007.
Estimating the fair value of reporting units involves the use of estimates and significant judgments that are based on a number of factors including actual operating results, future business plans, economic projections and market data. Actual results may differ from forecasted results. While no impairment was indicated in the Company’s step one goodwill
impairment tests in the reporting units other than Staffmark, if current economic conditions persist longer or deteriorate further than expected, it is reasonably possible that the judgments and estimates described above could change in future periods for each of the Company’s reporting units.
The goodwill impairment charge did not have any adverse effect on the covenant calculations or compliance under the Company’s Credit Agreement.
A reconciliation of the change in the carrying value of goodwill for the periods ended December 31, 2009 and 2008 are as follows (in thousands):
Approximately $141.7 million of goodwill is deductible for income tax purposes at December 31, 2009.
Other intangible assets
In connection with the annual goodwill impairment testing, the Company tested other indefinite-lived intangible assets at the Staffmark reporting unit. As a result of this analysis we determined that the carrying value exceeded the fair value of the CBS Personnel trade name (an indefinite-lived asset), based principally on the phase-out of the CBS Personnel trade name and rebranding of the reporting unit to Staffmark beginning in February 2009. The fair value of the CBS Personnel trade name was determined by applying the income approach to forecasted revenues at the Staffmark reporting unit. The result of this analysis indicated that the carrying value of the trade name ($10.6 million) exceeded its fair value ($0.8 million) by approximately $9.8 million. Therefore, an impairment charge of $9.8 million was recorded to impairment expense on the Consolidated Statement of Operations for the year ended December 31, 2009. The remaining balance ($0.8 million) of the CBS Personnel trade name is being amortized over 2.75 years.
Other intangible assets subject to amortization are comprised of the following at December 31, 2009 and 2008 (in thousands):
Estimated charges to amortization expense of intangible assets over the next five years, is as follows, (in thousands):
The Company’s amortization expense of intangible assets for the fiscal years ended December 31, 2009, 2008 and 2007 totaled $24.6 million, $24.6 million and $12.7 million, respectively.
Note J - Fair Value Measurement
The Company adopted the fair value guidelines issued by the FASB as of January 1, 2008. These guidelines establish a valuation hierarchy for disclosure of the inputs to valuation used to measure fair value. This hierarchy prioritizes the inputs into three broad levels as follows. Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities. Level 2 inputs are quoted prices for similar assets and liabilities in active markets or inputs that are observable for the asset or liability, either directly or indirectly through market corroboration, for substantially the full term of the financial instrument. Level 3 inputs are unobservable inputs based on the Company’s own assumptions used to measure assets and liabilities at fair value. A financial asset or liability’s classification within the hierarchy is determined based on the lowest level input that is significant to the fair value measurement.
The following table provides the assets and liabilities carried at fair value measured on a recurring basis as of December 31, 2009 and 2008 (in thousands):
(1)
Represents a former employee’s option to purchase additional common stock in Anodyne. See Note R.
(1)
Represents a former employee’s option to purchase additional common stock in Anodyne. See Note R.
A reconciliation of the change in the carrying value of the Company’s level 3, supplemental put liability for the year ended December 31, 2009 and 2008 is as follows (in thousands):
Valuation Techniques
The Company’s derivative instrument consists of an over-the-counter (OTC) interest rate swap contract which is not traded on a public exchange. The fair value of the Company’s interest rate swap contract was determined based on inputs that are readily available in public markets or can be derived from information available in publicly quoted markets. The stock option of the noncontrolling shareholder was determined based on inputs that were not readily available in public markets or able to be derived from information available in publicly quoted markets. As such, the Company categorized its interest rate swap contract as Level 2 and the stock option of the noncontrolling shareholder as Level 3.
The Company’s Manager, CGM is the owner of 100% of the Allocation Interests in the Company. Concurrent with our initial public offering in 2006, CGM and the Company entered into a Supplemental Put Agreement, which requires the Company to acquire these Allocation Interests upon termination of the Management Services Agreement. Essentially, the put rights granted to CGM require us to acquire CGM’s Allocation Interests in the Company at a price based on a percentage of the increase in fair value in the Company’s businesses over its original basis in those businesses. Each fiscal quarter the Company estimates the fair value of its businesses for the purpose of determining the potential liability associated with the Supplemental Put Agreement. The Company uses the following key assumptions in measuring the fair value of the supplemental put: (i) financial and market data of publicly traded companies deemed to be comparable to each of the Company’s businesses and (ii) financial and market data of comparable merged, sold or acquired companies. Any change in the potential liability is accrued currently as an adjustment to earnings. The implementation of fair value guidelines issued by the FASB did not result in any material changes to the models or processes used to value this liability.
During 2009, the inputs utilized in connection with the fair value analysis of the Stock option of a noncontrolling shareholder were no longer available in publicly quoted markets. As a result, the inputs were unobservable and the fair value was moved from the Level 2 column to the Level 3 column of the table above. The following table details the change in the Company’s Level 3 liabilities (in thousands):
The following table provides the assets and liabilities carried at fair value measured on a non-recurring basis as of December 31, 2009 (in thousands):
(1)
Represents the fair value of goodwill at the Staffmark operating segment, including a $1.1 million reduction in goodwill allocated from the corporate level, subsequent to the goodwill impairment charge recognized during the year ended December 31, 2009. See Note I for further discussion regarding impairment and valuation techniques.
Note K - Debt
On December 7, 2007, the Company entered into its current Credit Agreement with a group of lenders led by Madison Capital, LLC (“Madison”). The Credit Agreement amended provides for a Revolving Credit Facility totaling $340.0 million and a Term Loan Facility with a balance of $76.0 million at December 31, 2009, (collectively “Credit Agreement”). The Term Loan Facility requires quarterly payments of $0.5 million that commenced March 31, 2008, with a final payment of the outstanding principal balance due on December 7, 2013. In 2009 the Company repaid $75.0 million in term debt in addition to the quarterly amortization with a portion of the unused proceeds from the sale of two of its operating segments in 2008. The Revolving Credit Facility matures on December 7, 2012. Availability under the Revolving Credit Facility is limited to the lesser of $340 million or the Company’s borrowing base at the time of borrowing. The Company incurred approximately $5.8 million in fees and costs for the arrangement of the Credit Agreement during 2007. These costs were capitalized and are being amortized over the life of the loans. Approximately $1.8 million, $2.0 million and $1.2 million were amortized to debt issuance cost in 2009, 2008 and 2007, respectively, in connection with these capitalized costs.
The Revolving Credit Facility allows for loans at either base rate or LIBOR. Base rate loans bear interest at a fluctuating rate per annum equal to the greater of (i) the prime rate of interest published by the Wall Street Journal and (ii) the sum of the Federal Funds Rate plus 0.5% for the relevant period, plus a margin ranging from 1.50% to 2.50%, based upon the ratio of total debt to adjusted consolidated earnings before interest expense, tax expense, and depreciation and amortization expenses for such period (the “Total Debt to EBITDA Ratio”). LIBOR loans bear interest at a fluctuating rate per annum equal to the London Interbank Offer Rate, or LIBOR, for the relevant period plus a margin ranging from 2.50% to 3.50% based on the Total Debt to EBITDA Ratio. The Company is required to pay commitment fees ranging between 0.75% and 1.25% per annum on the unused portion of the Revolving Credit Facility. The Company recorded commitment fees of $3.5 million, $3.1 million and $2.7 million during 2009, 2008 and 2007 respectively, to interest expense.
The Term Loan Facility bears interest at either base rate or the London Interbank Offer Rate (“LIBOR”). Base rate loans bear interest at a fluctuating rate per annum equal to the greater of (i) the prime rate of interest published by the Wall Street Journal and (ii) the sum of the Federal Funds Rate plus 0.5% for the relevant period plus a margin of 3.0%. LIBOR loans bear interest at a fluctuating rate per annum equal to LIBOR for the relevant period plus a margin of 4.0%.
The Company is subject to certain customary affirmative and restrictive covenants arising under the Credit Agreement. In addition, the Company is required to maintain certain financial ratios under the Revolving Credit Facility. The Company was in compliance with all covenants at December 31, 2009. The following table reflects required and actual financial ratios as of December 31, 2009 included as part of the affirmative covenants in our Credit Agreement:
A breach of any of these covenants will be an event of default under the Credit Agreement. Upon the occurrence of an event of default under the Credit Agreement, the Revolving Credit Facility may be terminated, the Term Loan and all outstanding loans and other obligations under the Credit Agreement may become immediately due and payable and any letters of credit then outstanding may be required to be cash collateralized, and the Agent and the Lenders may exercise any rights or remedies available to them under the Credit Agreement, the Collateral Agreement or any other documents delivered in connection therewith. Any such event would materially impair the Company’s ability to conduct its business.
The Credit Agreement allows for letters of credit in an aggregate face amount of up to $100.0 million. Letters of credit outstanding at December 31, 2009 and 2008 totaled approximately $66.2 million and $61.9 million, respectively. Letter of credit fees recorded to interest expense during the years ended December 31, 2009, 2008 and 2007 aggregated approximately $1.7 million, $1.7 million and $0.6 million, respectively.
The Credit Agreement is secured by a first priority lien on all the assets of the Company, including, but not limited to, the capital stock of the businesses, loan receivables from the Company’s businesses, cash and other assets. The Revolving Credit Facility also requires that the loan agreements between the Company and its businesses be secured by a first priority lien on the assets of the businesses subject to the letters of credit issued by third party lenders on behalf of such businesses.
On February 18, 2009, the Company reduced its debt and repaid at par, from cash on its balance sheet, $75.0 million of debt under its Term Loan Facility. The Company expensed $1.1 million of capitalized debt issuance costs in connection
with the debt repayment. This amount is included in Loss on debt extinguishment in the Consolidated Statement of Operations.
At December 31, 2009, the Company had $0.5 million in revolving credit commitments outstanding and availability of approximately $136.8 million under its Revolving Credit Facility. At December 31, 2009, the Company had $76.0 million in Term Loan Facility (“Term Loans”) outstanding. The Company intends to use the availability under the Revolving Credit Facility to pursue acquisitions of additional businesses to the extent permitted under its Credit Agreement and to provide for working capital needs.
Annual maturities of our Term Loan Facility and Revolving Credit Facility are scheduled as follows:
Note L - Derivative Instruments and Hedging Activities
On January 22, 2008, the Company entered into a three-year fixed-for-floating interest rate swap for $140.0 million with its bank lenders in order to reduce the risk of changes in cash flows associated with the variable interest payments on the last $140.0 million of debt outstanding under its Term Loan Facility. The swap effectively fixed the interest rate at 7.35% on the last $140.0 million of the Company’s outstanding Term Loan Facility.. The swap expires in January 2011. The objective of the swap is to hedge the risk of changes in cash flows associated with the future interest payments on variable rate Term Loan Facility debt with a notional amount of $140.0 million. The cash flow from the swap is expected to offset any changes in the interest payments on the last $140.0 million of variable rate Term Debt due to changes in the three-month LIBOR rate. On February 18, 2009, the Company terminated $70.0 million of the swap in connection with the repayment of $75.0 million of the Term Loan Facility. In connection with the termination, the Company reclassified $2.5 million from accumulated other comprehensive loss into earnings during the year ended December 31, 2009.
The swap is a hedge of future specified cash flows. As a result, the swap is a derivative and was designated as a hedging instrument at the initiation of the swap. The Company has applied cash flow hedge accounting. At the end of each period, the swap is recorded in the consolidated balance sheet at fair value, in either other assets if it is an asset position, or in accrued liabilities if it is in a liability position. Any related increases or decreases in the fair value are recognized on the Company’s consolidated balance sheet within accumulated other comprehensive income.
The Company assesses the effectiveness of its swap on a quarterly basis. The Company has considered the impact of the current credit crisis in the United States in assessing the risk of counterparty default. The Company believes that it is still likely that the counterparty for these swaps will continue to perform throughout the contract period, and as a result continues to deem the swaps as effective hedging instruments. A counterparty default risk is considered in the valuation of the interest rate swaps.
At December 31, 2009, management has assessed and concluded that its cash flow hedge (swap) has no ineffectiveness, as determined by the Change in Variable Cash Flows method due to the following conditions being met: (i) the floating rate leg of the swap and the hedged variable cash flows are based on three-month LIBOR; (ii) the interest rate reset dates of the floating rate leg of the swap and the hedged variable cash flows of the last $70.0 million of variable rate Term Loan Facility debt are the same; (iii) the hedging relationship does not contain any other basis differences; and (iv) the likelihood of the obligor not defaulting is assessed as being probable. If the Company partially or fully extinguishes the floating rate debt payments being hedged or were to terminate the interest swap, a portion or all of the gains or losses that have accumulated in other comprehensive income would be recognized in earnings at that time. Prospective and retrospective assessments of the ineffectiveness of the hedge have been and will be made at the end of each fiscal quarter.
At December 31, 2009, the unrealized loss on the swap, reflected in accumulated other comprehensive income, was approximately $2.0 million.
The following table provides the fair value of the Company’s cash flow hedge as well as its location on the balance sheet as of December 31, 2009 and 2008 (in thousands):
Note M - Income Taxes
Compass Diversified Holdings and Compass Group Diversified Holdings LLC are classified as partnerships for U.S. Federal income tax purposes and are not subject to income taxes. Each of the Company’s majority owned subsidiaries are subject to Federal and state income taxes.
Components of the Company’s income tax provision (benefit) are as follows (in thousands):
The tax effects of temporary differences that have resulted in the creation of deferred tax assets and deferred tax liabilities at December 31, 2009 and 2008 are as follows:
For the years ending December 31, 2009 and 2008, the Company recognized approximately $60.4 million and $86.1 million, respectively in deferred tax liabilities. A significant portion of the balance in deferred tax liabilities reflects temporary differences in the basis of property and equipment and intangible assets related to the Company’s purchase accounting adjustments in connection with the acquisition of certain of the businesses. For financial accounting purposes
the Company recognized a significant increase in the fair values of the intangible assets and property and equipment. For income tax purposes the existing, pre-acquisition tax basis of the intangible assets and property and equipment is utilized. In order to reflect the increase in the financial accounting basis over the existing tax basis, a deferred tax liability was recorded. This liability will decrease in future periods as these temporary differences reverse.
There was no valuation allowance at December 31, 2009 or 2008. A valuation allowance is provided whenever it is more likely than not that some or all of deferred assets recorded may not be realized.
The reconciliation between the Federal Statutory Rate and the effective income tax rate for 2009, 2008 and 2007 are as follows:
The Company adopted the authoritative provisions of accounting guidance on uncertainty in income taxes on January 1, 2007. The adoption did not result in a cumulative adjustment to the Company’s accumulated earnings. A reconciliation of the amount of unrecognized tax benefits for 2009 and 2008 are as follows (in thousands):
Included in the unrecognized tax benefits at December 31, 2009 and 2008 is $1.4 million and $21 thousand, respectively, of tax benefits that, if recognized, would affect the Company’s effective tax rate. The Company accrues interest and penalties related to uncertain tax positions, at December 31, 2009 and 2008, there is $127 thousand and $133 thousand accrued, respectively. Such amounts are included in the Provision (benefit) for income taxes in the accompanying consolidated statements of operations. The change in the unrecognized tax benefits during 2009 is primarily due to the uncertainty of the deductibility of amortization and depreciation established as part of initial purchase price allocations in 2008. It is expected that the amount of unrecognized tax benefits will change in the next twelve months. However, we do not expect the change to have a significant impact on our consolidated results of operations or financial position.
The Company and its operating segments file U.S. federal and state income tax returns in many jurisdictions with varying statutes of limitations. The 2005 through 2009 tax years generally remain subject to examinations by the taxing authorities.
Note N- Noncontrolling interest
Noncontrolling interest represents the portion of a majority-owned subsidiary’s net income and equity that is owned by noncontrolling shareholders.
The following tables reflect the Company’s percent ownership (on a primary basis), of its majority owned subsidiaries, which the Company refers to as its businesses, or operating segments, and related noncontrolling interest balances as of December 31, 2009 and 2008:
ACI
On October 10, 2007 as part of ACI’s amendment to its credit agreement with the Company, ACI distributed approximately $47.0 million in cash distributions to Compass AC Holdings, Inc. (“ACH”), ACI’s sole shareholder, and by ACH to its shareholders, including the Company. The Company’s share of the cash distribution was approximately $33.0 million with approximately $14.0 million being distributed to ACH’s other shareholders. The Company funded this distribution by making additional borrowings to ACI of $47.0 million.
The noncontrolling interests’ share of the distribution exceeded Advanced Circuit’s cumulative earnings (“excess distribution”) by approximately $10.0 million as of December 31, 2007. As a result, in accordance with accounting guidance, the excess distribution of approximately $10.0 million was charged to noncontrolling interest in the Company’s consolidated income statement, where it is effectively absorbed by the majority interest. This excess distribution will be absorbed in the future against noncontrolling interest income, if any, of Advanced Circuits.
Anodyne
On August 8, 2008, the Company exchanged a Promissory Note (Refer to Note R) due August 15, 2008, totaling approximately $6.9 million (including accrued interest) due from the CEO of Anodyne in exchange for shares of stock of Anodyne held by the CEO. As a result of this exchange of shares, noncontrolling interest decreased by approximately $3.9 million in 2008.
In September 2009, Anodyne redeemed outstanding shares of Anodyne stock from a noncontrolling interest holder of Anodyne for $3.0 million. This payment is included in net proceeds provided by noncontrolling interest on the Company’s Consolidated Statement of Cash Flows.
Staffmark
During 2009, the Company amended the Staffmark intercompany credit agreement which, among other things, recapitalized a portion of Staffmark’s long-term debt by exchanging $35.0 million of debt for Staffmark common stock. As a result of this transaction, the Company’s ownership percentage of the outstanding stock of Staffmark increased and the noncontrolling interest in Staffmark decreased. In addition, as a result of the exchange the Company received cash from a noncontrolling shareholder and recorded an increase to noncontrolling interest of $5.5 million. The receipt of the noncontrolling shareholder contribution is included in Net proceeds provided by noncontrolling interest on the Company’s Consolidated Statement of Cash Flows.
Note O- Stockholder’s Equity
Trust Shares
The Trust is authorized to issue 500,000,000 Trust shares and the Company is authorized to issue a corresponding number of LLC interests. The Company will, at all times, have the identical number of LLC interests outstanding as Trust shares. Each Trust share represents an undivided beneficial interest in the Trust, and each Trust share is entitled to one vote per share on any matter with respect to which members of the Company are entitled to vote.
On May 16, 2006, the Company completed its initial public offering of 13,500,000 shares of the Trust at an offering price of $15.00 per share (“the IPO”). Total net proceeds from the IPO, after deducting the underwriters’ discounts, commissions and financial advisory fee, were approximately $188.3 million. On May 16, 2006, the Company also completed the private placement of 5,733,333 shares to Compass Group Investments, Inc. (“CGI”) for approximately $86.0 million and completed the private placement of 266,667 shares to Pharos I LLC, an entity controlled by Mr. Massoud, the Chief Executive Officer of the Company, and owned by the Company’s management team, for approximately $4.0 million. CGI also purchased 666,667 shares for $10.0 million through the IPO.
In connection with the purchase of Anodyne on July 31, 2006, the Company issued 950,000 shares of the Trust as part of the payment price. The shares were valued at $13.77 per share for a total of $13.1 million.
On May 8, 2007, the Company completed a secondary public offering of 9,200,000 trust shares (including the underwriter’s over-allotment of 1,200,000 shares) at an offering price of $16.00 per share. Simultaneous with the sale of the trust shares to the public, CGI purchased, through a wholly-owned subsidiary, 1,875,000 trust shares at $16.00 per share in a separate private placement. The net proceeds of the secondary offering to the Company, after deducting underwriter’s discount and offering costs totaled approximately $168.7 million. The Company used a portion of the net proceeds to repay the outstanding balance on its Revolving Credit Facility.
On June 9, 2009, the Company completed a secondary offering of 5,100,000 Trust shares at an offering price of $8.85 per share. The net proceeds to the Company, after deducting underwriter’s discount and offering costs totaled approximately $42.1 million.
Distributions
During the year ended December 31, 2008, the Company paid the following distributions:
During the year ended December 31, 2009, the Company paid the following distributions:
On January 28, 2010, the Company paid a distribution of $0.34 per share to holders of record as of January 22, 2010.
In connection with the adoption of FASB’s noncontrolling interest guidelines, on January 1, 2009, the Company reclassified noncontrolling interest to stockholders’ equity. This reclassification was applied prospectively with the exception of presentation and disclosure requirements which were applied retrospectively for all periods presented.
Note P - Unaudited Quarterly Financial Data
The following table presents the unaudited quarterly financial data. This information has been prepared on a basis consistent with that of the audited consolidated financial statements and all necessary material adjustments, consisting of normal recurring accruals and adjustments, have been included to present fairly the unaudited quarterly financial data. The quarterly results of operations for these periods are not necessarily indicative of future results of operations. The per share calculations for each of the quarters are based on the weighted average number of shares for each period; therefore, the sum of the quarters may not necessarily be equal to the full year per share amount.
Note Q - Supplemental Data
Supplemental Balance Sheet Data (in thousands):
Supplemental Statement of Operations Data:
In connection with fire at the AFM manufacturing facility in February 2008, the Company recorded business interruption proceeds of $1.3 million to offset cost of sales and $3.1 million to offset selling, general and administrative expense during the year ended December 31, 2008. The Company recorded business interruption proceeds totaling approximately $1.5 million to offset cost of sales during the year ended December 31, 2009.
Supplemental Cash Flow Statement Data (in thousands):
Note R - Related Party Transactions
The Company has entered into the following related party transactions with its Manager, CGM:
Management Services Agreement - The Company entered into a management services agreement (“Management Services Agreement”) with CGM effective May 16, 2006. The Management Services Agreement provides for, among other things, CGM to perform services for the Company in exchange for a management fee paid quarterly and equal to 0.5% of the Company’s adjusted net assets. The Company amended the Management Services Agreement on November 8, 2006, to clarify that adjusted net assets are not reduced by non-cash charges associated with the Supplemental Put Agreement, which amendment was unanimously approved by the Compensation Committee and the Board of Directors. The management fee is required to be paid prior to the payment of any distributions to shareholders.
For the year ended December 31, 2009, 2008 and 2007, the Company incurred the following management fees to CGM, by entity (in thousands):
Staffmark paid management fees of approximately $0.3 million and $0.5 million for the years ended December 31, 2009 and 2008, respectively, to a separate manager of Staffmark LLC, unrelated to CGM.
Approximately $3.3 million and $0.6 million of the management fees incurred were unpaid as of December 31, 2009 and 2008, respectively, and included in Due to related party on the consolidated balance sheets.
LLC Agreement - In addition to providing management services to the Company, pursuant to the Management Services Agreement, CGM owns 100% of the Allocation Interests in the Company. CGM paid $0.1 million for these Allocation Interests and has the right to cause the Company to purchase the Allocation Interests it owns. The Allocation Interests give CGM the right to distributions pursuant to a profit allocation formula upon the occurrence of certain events. Certain events include, but are not limited to, the dispositions of subsidiaries. In connection with the dispositions of Silvue and Aeroglide in 2008 the Company paid CGM a profit allocation of $14.9 million.
Supplemental Put Agreement - Concurrent with the IPO, CGM and the Company entered into a Supplemental Put Agreement, which may require the Company to acquire these Allocation Interests upon termination of the Management Services Agreement. Essentially, the put rights granted to CGM require the Company to acquire CGM’s Allocation Interests in the Company at a price based on a percentage of the increase in fair value in the Company’s businesses over its basis in those businesses. Each fiscal quarter the Company estimates the fair value of its businesses for the purpose of determining its potential liability associated with the Supplemental Put Agreement. Any change in the potential liability is accrued currently as an adjustment to earnings. For the year ended December 31, 2009, the Company reversed expense related to the Supplemental Put Agreement of approximately $1.3 million. For the years ended December 31, 2008 and 2007, the Company recognized approximately $6.4 million and $7.4 million in expense related to the Supplemental Put Agreement. The Company paid approximately $14.9 million to CGM during the year ended December 31, 2008 related to the profit allocation for the dispositions of Aeroglide and Silvue.
Cost Reimbursement and Fees
The Company reimbursed its Manager, CGM, approximately $2.7 million, $2.6 million and $1.8 million, principally for occupancy and staffing costs incurred by CGM on the Company’s behalf during the years ended December 31, 2009, 2008 and 2007, respectively.
CGM acted as an advisor for each of the 2008 acquisitions (Fox and Staffmark) for which it received transaction service and expense payments of approximately $2.0 million. CGM acted as an advisor for each of the 2007 acquisitions (Aeroglide, HALO and American Furniture) for which it received transaction service and expense payments of approximately $2.1 million.
The Company has entered into the following significant related party transactions with its subsidiaries:
Anodyne
On July 31, 2006, the Company acquired from CGI and its wholly-owned, indirect subsidiary, Compass Medical Mattress Partners, LP (the “Seller”) approximately 47.3% of the outstanding capital stock, on a fully-diluted basis, of Anodyne, representing approximately 69.8% of the voting power of all Anodyne stock. On the same date, the Company entered into a Note Purchase and Sale Agreement with CGI and the Seller for the purchase from the Seller of a Promissory Note (“Note”) issued by a borrower controlled by Anodyne’s chief executive officer. The Note was secured by shares of Anodyne stock and guaranteed by Anodyne’s chief executive officer. The Note accrued interest at the rate of 13% per annum and was added to the Note’s principal balance. The Note was to mature on August 15, 2008. The Company recorded interest income totaling $0.5 million and $0.8 million in 2008 and 2007, respectively, related to this note.
On August 8, 2008 the Company exchanged the aforementioned Note, due August 15, 2008, totaling approximately $6.9 million (including accrued interest) due from the CEO of Anodyne in exchange for shares of stock of Anodyne held by the CEO. In addition, the CEO of Anodyne was granted an option to purchase approximately 10% of the outstanding shares of Anodyne, at a strike price exceeding the exchange price, from the Company in the future for which the CEO exchanged Anodyne stock valued at $0.2 million (the fair value of the option at the date of grant) as consideration.
On August 5, 2008, the Company exchanged $1.5 million in term debt due from Anodyne for 15,500 shares of common stock and 13,950 shares of convertible preferred stock of Anodyne.
Refer to Note N for the impact on noncontrolling interest with respect to these transactions.
Advanced Circuits
In connection with the acquisition of Advanced Circuits by CGI, Advanced Circuits loaned certain officers and members of management of Advanced Circuits $8.2 million for the purchase of shares of Advanced Circuit’s common stock in late 2005 and early 2006. The notes bared interest at 6% and interest was added to the notes. Advanced Circuits implemented a performance incentive program whereby the notes could either be partially or completely forgiven based upon the
achievement of certain pre-defined financial performance targets. The original measurement date for determination of any potential loan forgiveness was based on the financial performance of Advanced Circuits for the fiscal year ended December 31, 2010. Advanced Circuits had been accruing loan forgiveness over the service period measured from the issuance of the notes until the original measurement date of December 31, 2010. However, the Company accelerated the loan forgiveness to January 2010 and as a result, forgave a portion of the loan balance as described below. AS a result Advanced Circuits reversed $0.7 million of loan forgiveness previously accrued in prior years during the year ended December 31, 2009. In addition, the Company recorded the amount of interest due over the original service period of the loan by increasing the loan forgiveness accrual by $1.3 million and by recording $1.1 million of interest income during the year ended December 31, 2009. During each of the fiscal years 2008 and 2007, ACI accrued approximately $1.6 million for this loan forgiveness. This expense has been classified as a component of general and administrative expense. Approximately $5.8 million and $5.2 million is reflected as a component of other non-current liabilities in the consolidated balances sheet as of December 31, 2009 and 2008, respectively.
On January 12, 2010 the promissory notes and loan forgiveness arrangements referred to above were amended as follows: (i) $5.8 million of the outstanding loans and interest were forgiven with the remaining balance, $4.7 million repaid in Class A common stock valued at $47.50 per share, (ii) 0.1 million stock options were granted at an exercise price of $89.27 per share. The options are outstanding for ten years and vested at the grant date. The effect of this amendment was reflected as of December 31, 2009.
Refer to Note N for the impact on noncontrolling interest with respect to this transaction.
American Furniture
AFM’s largest supplier, Independent Furniture Supply (“Independent”), is 50% owned by Mike Thomas, AFM’s CEO. AFM purchases polyfoam from Independent on an arms-length basis and AFM performs regular audits to verify market pricing. AFM does not have any long-term supply contracts with Independent. Total purchases from Independent during 2009 and 2008 totaled approximately $19.4 million and $18.4 million, respectively. From August 31, 2007 (acquisition date) through December 31, 2007, purchases from Independent totaled approximately $8.4 million. The Company had unpaid balances due to Independent of $2.2 million and $2.3 million as of December 31, 2009 and December 31, 2008, respectively.
Fox
The Company leases its principal manufacturing and office facilities in Watsonville, California from Robert Fox, a founder, Chief Engineering Officer and noncontrolling shareholder of Fox. The term of the lease is through July of 2018 and the rental payments can be adjusted annually for a cost-of-living increase based upon the consumer price index. Fox is responsible for all real estate taxes, insurance and maintenance related to this property. The leased facilities are 86,000 square feet and Fox paid rent under this lease of approximately $1.1 million and $1.0 million for the years ended December 31, 2009 and 2008, respectively.
Staffmark
During 2009, the Company amended the Staffmark intercompany credit agreement which, among other things, recapitalized a portion of Staffmark’s long-term debt by exchanging $35.0 million of debt for Staffmark common stock. As a result of this transaction, the Company’s ownership percentage of the outstanding stock of Staffmark increased and the noncontrolling interest in Staffmark decreased. In addition, as a result of the exchange the Company received cash from a noncontrolling shareholder and recorded an increase to noncontrolling interest of $5.5 million. The receipt of the noncontrolling shareholder contribution is included in Net proceeds provided by noncontrolling interest on the Company’s Consolidated Statement of Cash Flows.
SCHEDULE II -Valuation and Qualifying Accounts
(1)
Represents opening allowance balances related to current year acquisitions.
(2)
Represent write-offs and rebate payments.
(3)
Represents utilization of deferred tax asset and corresponding removal of valuation allowance.
S-1
INDEX TO EXHIBITS
E-1
E-2