Item 1. Business
OVERVIEW
SGS International, Inc. (the “Registrant”) was incorporated in 2005 under the laws of the State of Delaware. In this report, “we” and the “Company” mean the Registrant and its consolidated subsidiaries unless otherwise indicated.
We are a global leader in the digital imaging and communication industry and offer design-to-print graphic services to the international consumer products packaging market. We offer a full spectrum of innovative digital solutions that streamline the capture, management, execution and distribution of graphics information. Our brand development, creative design, prepress, image carriers and print support services are utilized in each of the three main printing processes: flexography, gravure and lithography (also known as “offset”). Our customers, many of which we have served for over 20 years, include large branded consumer products companies, mass merchant retailers and the printers and converters that service them. Our services ensure that our customers are able to obtain or produce consistent, high quality packaging materials often on short turnaround times.
HISTORY OF COMPANY
The Registrant was formed by Citigroup Venture Capital Equity Partners, L.P. (now known as “Court Square Capital Partners, L.P.”) in 2005. Southern Graphic Systems, Inc. (“SGS”) was established in 1946 as a single-facility gravure operation in Louisville, Kentucky. In 1978, SGS adopted a growth strategy of strategically locating manufacturing operations based on customers’ locations and service requirements. SGS opened its first dedicated prepress facility in 1991. In 1994, SGS expanded its geographic scope to include Canada, with the opening of a gravure facility just outside Toronto. In 1995, SGS entered the growing flexographic market with the acquisition of Wilson Engraving Company. In 1998, SGS further expanded its geographic scope within North America by opening a graphics facility in Mexico City, Mexico. In November 2005, SGS acquired MCG Graphics Limited, a UK-based provider of prepress graphics and flexographic image carriers serving customers in the UK and Europe. The Registrant acquired SGS and its affiliated businesses from its then parent, Alcoa Inc., on December 30, 2005 (the “Acquisition”). In connection with the Acquisition, the Registrant offered certain of its 12% senior subordinated notes due 2013 and entered into a senior secured credit facility. In February 2007, the Company acquired the assets
of C.M. Jackson Associates, Inc., a packaging graphics firm in the U.S. with an emphasis on “store brands.” In April 2007, the Company acquired McGurk Studios Limited and Thames McGurk Limited (collectively “McGurk”), a UK-based provider of end-to-end digital design, artwork and reprographics for packaging solutions with locations in Hull and London, England, and Hong Kong. In January 2008, the Company acquired 1043497 Ontario Limited, Cooper & Williamson, Inc., Tri-Ad Graphic Communications Ltd. and Flexart Design Inc. (collectively “Tri-Ad”). Tri-Ad is a Canadian provider of packaging and retail graphics services with locations in Toronto, Ontario and outside of Montreal, Quebec. In December of 2008, the Company acquired the assets of Focus Imaging Group LLC, a U.S. based packaging graphics firm with an emphasis on design and reprographics for corrugated materials. In February 2011, the Company acquired the assets of Creative Type, a U.S. based digital print company, which increased our capacity to offer our customers short run reproduction services and sales samples or packaging mock-ups. In June 2011, the Company acquired the assets of Photoengraving Incorporated., a U.S. based firm specializing in metal decorating and image carriers for beverage can printing. Since the Acquisition we have acquired the assets of, or purchased, 14 companies, the most noteworthy of which have been described above.
INDUSTRY OVERVIEW
End markets served
We operate in the graphic services industry, which we estimate to be a $32.0 billion global industry. Within this industry, we compete principally in the value-added packaging market, providing services to consumer products companies and to the converters and printers who serve them. We estimate that the North American market for graphic services for consumer packaging products is approximately $2.1 billion and the global market for these services is approximately $6.6 billion. We focus on a variety of end markets, with food and beverage representing a large portion of our business. Other key end markets include tobacco, personal care, household products, pet food and pharmaceutical. We estimate that the remainder of the global market in the graphic services industry is comprised of the $10.0 billion advertising and promotion market, where we participate on a limited basis, and the $15.4 billion “other” market which includes catalogs, newspapers and magazines, where we do not participate.
OUR SERVICE OFFERINGS
General overview
The packaging graphic services we provide include the preparatory steps that precede the actual printing of an image onto packaging material. We are one of the very few participants in the industry capable of providing the full range of services from “design-to-print.”
Creative services and brand development
The process begins with “creative services,” where we work with the customer to develop design strategy, conceptualize the marketing campaign and ensure an accurate and consistent brand image and design packaging that takes advantage of technological improvements in the printing process. Product packaging and graphics play a key role in a consumer products company’s marketing efforts and the on-shelf appeal of its products. Our creative services at this creation and design phase of the process enable our consumer products customers to realize the full potential of synergies between high quality graphics and a brand’s core value. The creative services we provide include brand identity, concept, naming and logo development, package design, interactive development, photography, illustration and copywriting.
Prepress graphics and image carrier services
Our “prepress” services then convert the creative idea and design into an image suitable for volume printing, a key step in speeding brands to market. The steps taken in this phase of the process include (i) graphics activities such as production art, composition and typesetting, creative retouching, image assembly, file creation, color separation and digital/film output, and (ii) image carrier preparation. Our prepress process is key to ensuring that our consumer products customers’ brands and graphics are reproduced accurately and with uniform color using different package printing processes and substrates, in a timely and cost-effective manner. While color separation and other prepress services were in the past performed by hand (i.e., the “conventional” method), our employees today use
state-of-the-art computers and software programs to provide digital imaging services. It has become typical for customers to forward designs to us in digital format for image manipulation, layout and assembly. We work closely with the customer during this process and we offer a wide spectrum of proofing services, including soft proofing, online proofing and digital proofing, to facilitate customer involvement and approval.
At the final step of the prepress process, an “image carrier” is produced that transfers ink in the form of the image to the packaging substrate in the printing process. As with prepress graphics, image carrier technology has transitioned from an analog to a digital process. Laser technology in both flexography and gravure has improved resolution and quality while reducing the cost to produce image carriers.
All the major printing processes have similar steps in the prepress stage, except for image carrier preparation, and are distinguished by the method of image transfer and the kind of image carrier utilized in the process. We have particular expertise in image carriers and believe we are the clear leader in this important part of the value chain.
Other services
In addition to the packaging graphics and image carrier production services we provide, our offerings in support of other stages of the value chain are crucial elements of the overall proposition to the customer and necessary to generate the graphics and image carrier business.
The enterprise solutions we offer comprise a secure web-based suite of enterprise tools that can help automate production art services, manage digital graphic assets, review graphics online and track the entire production process, all via a standard web browser. We design and implement systems to manage workflow, and enable clients to host, organize, search and retrieve brand assets. In addition, we provide process audits and prepress, color management, printing and IT consulting services.
We also have significant competencies in interactive media and offer short run reproduction service to our clients utilizing our digital printing capabilities and offer services in the area of metal decorating and image carriers for beverage can printing.
PRINTING MARKETS SERVED
Flexography
Flexography uses an image carrier (plate) made of rubber, plastic or any other flexible material. The fast-drying inks used in flexography make it ideal for printing on materials like plastics and foils. This method is most suitable for printing flexible bags, wrappers and similar packaging. The soft photopolymer image carriers are also well-suited for printing on thick, compressible surfaces such as cardboard packaging, or corrugated material. We are a leading flexographic plate producer in North America with 14 state-of-the-art flexographic imaging facilities (13 of which have digital capability). We have two flexographic imaging facilities in the UK, both of which have digital capability. Virtually all of our locations can provide prepress graphics for the flexography process.
We estimate the North American flexography market at approximately $1.2 billion. We believe this market is growing at approximately 2% annually, a higher rate of growth than we estimate for the gravure and lithography markets. Flexographic printers continue to add flexographic printing capacity to handle the growth. Flexographic plates can be manufactured faster and more inexpensively than gravure cylinders, and allow for faster problem resolution and change-outs in the printing process. The quality and speed of flexographic printing has continued to improve over the years, allowing it to become a cost-effective alternative to the gravure process in many situations.
Gravure
In gravure printing, the image carriers are generally copper coated cylinders that are protected from wear by the application of a thin electroplate of chromium. Gravure is generally suitable for long runs of high quality printing, such as cartons for cosmetic, pharmaceutical and tobacco packaging. We are the leading packaging gravure producer in North America with nine state-of-the-art gravure engraving facilities. Virtually all of our locations can provide prepress for the gravure process.
We believe the growth rate in the gravure packaging market is minimal. While the flexography process has lowered gravure’s share of the printing market, gravure is, and we believe will continue to be, a viable market. The gravure process can be used for any type of packaging where flexography can be used, but flexography is not always an alternative to gravure. Gravure’s characteristics make it the preferred process in certain applications, such as tobacco packaging (where we estimate approximately 90% of the cartons manufactured in North America use gravure printing), fluorescent and metallic substrates, package converting involving the attachment of another layer to the substrate (such as labels), and generally where a long run involving high quality printing is necessary or desirable. The trend in the gravure printing industry is away from wide-web and toward narrower-web printing, helping to reduce the flexographic process’s cost advantage over gravure.
Lithography
Lithographic image carriers range from paper (a lower quality end-product) to aluminum (the best quality possible). Lithography is typically used for point-of-sale advertisements and labels. We have three lithographic plate facilities offering high quality digital plates. Virtually all of our locations can provide prepress graphics for the lithography process.
The North American lithography market is the largest of the three markets we serve. Most of our lithography sales are attributable to prepress graphics rather than image carriers. Lithographic plates typically are produced by the printer as they are low cost and relatively easy to manufacture. The limited number of lithographic plates we produce are for very few of our customers. The lithography process has more limited applications than flexography and gravure and is not as suited to long runs. However, lithography is generally preferred to gravure for printing on rough substrate surfaces.
COMPETITION
The packaging graphic services industry for consumer products is highly fragmented with several national firms and hundreds of regional and local participants. Only a small number of the regional and local firms have annual revenue exceeding $20.0 million, most notably Schawk, Inc., Matthews International Corporation, Phototype, and Group360, Inc. To remain competitive, each firm must maintain client relationships and recognize, develop and exploit state-of-the-art technology and contend with the customers’ increasing demand for speed-to-market. We believe that most of the firms in the industry are family-owned and lack the scale and service breadth to effectively serve the premier consumer products companies’ demands for consistent brand graphics, faster turnaround times, improved speed-to-market and customized services on a national and global basis.
Some converters with graphics service capabilities compete with us by performing such services in connection with printing work. However, these firms must still match our technical capabilities, image quality control and speed of delivery. Converters often use our services because of the rigorous demands being placed on them by clients who are requiring faster turnaround times. Increasingly, converters are being required to invest in technology to improve speed in the printing process and many have avoided spending on graphics technology.
We compete on the basis of offering our clients creative design capabilities, production art expertise, high quality customized imaging capabilities, rapid turnaround, cost of image carriers and delivery times, up-to-date knowledge of the printing press specifications of converters and printers, color expertise, digital asset management and workflow management. We have grown from a one-facility gravure cylinder engraver to an integrated strategic partner for our customers with a broad array of services.
INDUSTRY TRENDS
Our revenues are primarily driven by demand for graphics services from consumer products companies and the printers and converters that service them. In addition to growth in packaging volume, demand for our services is generated by new product launches, brand portfolio changes that result from either consolidations or divestitures, design refreshing, targeted marketing for promotional or seasonal events (e.g., events such as the Kentucky Derby, Super Bowl, World Series and Olympics), changes in labeling requirements (e.g., government-required warnings and consumer-driven preferences for “heart healthy,” “low in carbohydrates,” and “low in saturated fat” products),
changes in packaging products and changes in consumer tastes. Other recent demand drivers include Nutrition Keys (a voluntary front-of-pack nutrition labeling system), changes in packaging printers, and changes in packaging structures, substrates and formats. Key trends within the industry include:
Outsourcing
For many consumer products companies, prepress graphics and related services do not constitute a core competency and they have increasingly been outsourcing this function as graphic services providers can provide “design-to-print” services on a more cost-efficient basis. This trend of outsourcing, while advanced, continues to play a significant role in shaping the industry and has created further opportunities for graphic services providers to expand their offerings and customer base. Further, by offering design and other creative services to our customers, we become involved in our customer’s operations at an earlier stage of the graphics process which provides a greater opportunity for downstream sales.
Globalization
We believe that over the last several years a number of multi-national consumer products companies have decided to globalize their brands. As these companies begin to globalize their brands, ensuring image consistency and continuity with package designs becomes critical. These companies are increasingly looking to their existing graphic services providers, including us, to service them globally. With operations in North America, Mexico, Argentina, Europe and Asia, we have the ability to provide services to our existing multi-national customers and to seek new business from other multi-national companies. We believe we are in an excellent position to leverage our North American experience in setting up on-site locations, developing custom client workflow solutions and acquiring businesses outside North America. In addition, our secure web-based asset management system houses the brand imagery of many clients. This secure database is accessible from the internet and contains digital artwork which can be searched and downloaded from anywhere in the world. See Item 1A
Item 1A. Risk Factors
The risks described below are not the only risks facing us. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial may also materially and adversely affect our business operations. Any of the following risks could materially adversely affect our business, financial condition or results of operations.
Our indebtedness is substantial, which could adversely affect our financial health and limit our ability to obtain financing in the future and to react to changes in our business.
As of December 31, 2011, our total consolidated indebtedness was $262.3 million. In addition, we had $24.0 million of additional borrowings available under our revolving credit facility. Our large amount of debt could have important consequences, including, but not limited to, the following:
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it will require us to dedicate a substantial portion of our cash flow from operations to payments on indebtedness, which will reduce the funds available for working capital, capital expenditures, acquisitions and other general corporate expenses;
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it could make it more difficult for us to satisfy our obligations under our senior secured credit facility and our senior subordinated notes;
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it could place us at a disadvantage compared to our competitors that have proportionately less debt; and
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it could limit our ability to borrow additional funds in the future, if needed, because of applicable financial and restrictive covenants of our indebtedness.
In addition, our debt service requirements will substantially increase in 2013 as a result of the September 30, 2013 maturity of the loans under the senior secured credit facility and the December 15, 2013 maturity of the 12% Senior Subordinated Notes. If we are unable to repay our borrowings under the senior secured credit facility or obtain appropriate financing alternatives, the lenders could elect to declare all amounts borrowed, together with accrued interest, to be due and payable and could proceed against the collateral securing that indebtedness. Borrowings under the senior secured credit facility are senior in right of payment to the senior subordinated notes. If any of our indebtedness were to be accelerated, our assets may not be sufficient to repay in full that indebtedness and the senior subordinated notes.
Our debt agreements have restrictions that limit our flexibility in operating our business.
Our senior secured credit facility and the indenture under which our senior subordinated notes were issued have a number of significant covenants that, among other things, restrict our ability to:
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incur additional indebtedness;
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issue or sell capital stock;
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sell assets or consolidate or merge with or into other companies;
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pay dividends or repurchase or redeem capital stock;
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make certain investments;
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make loans, incur liens and transfer property; and
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enter into certain types of transactions with our affiliates.
These covenants, as well as our level of indebtedness, could have the effect of limiting our flexibility in planning for, or reacting to, changes in our business and the markets in which we compete.
In addition, under the senior secured credit facility, we are required to satisfy and maintain specified financial ratios and tests. Events beyond our control may affect our ability to comply with those provisions and we may not be able to meet those ratios and tests, which would result in a default under the senior secured credit facility. In the event of a default, the lenders under the senior secured credit facility could elect to declare all amounts borrowed under the senior secured credit facility, together with accrued interest, to be due and payable and could proceed against the collateral securing that indebtedness. Borrowings under the senior secured credit facility are senior in right of payment to the senior subordinated notes. If any of our indebtedness were to be accelerated, our assets may not be sufficient to repay in full that indebtedness and the senior subordinated notes.
We are subject to competitive pressures.
We compete with other providers of graphic related services. The market for such services is highly fragmented, with several national and many regional participants. We face, and will continue to face, competition in our business from many sources, including national and large regional companies, some of which have greater financial, marketing and other resources than we do. In addition, local and regional firms specializing in particular markets compete on the basis of established long-term relationships or specialized knowledge of such markets. The introduction of new technologies may create lower barriers to entry that may allow other firms to provide competing services. Furthermore, international companies that have lower production costs than we do could enter our markets.
There can be no assurance that competitors will not introduce services that achieve greater market acceptance than, or are technologically superior to, our current service offerings. There is no assurance that we will be able to continue to compete successfully or that competitive pressures will not adversely affect our business, financial condition and results of operations.
Our business is sensitive to general economic conditions. An economic decline or other circumstances that result in reductions in our customers’ marketing and advertising budgets could negatively impact our sales volume and revenues and our ability to respond to competition or take advantage of business opportunities.
Our revenues are derived from many customers in a variety of industries and businesses, some of whose spending levels can be cyclical in nature and subject to significant reductions based on changes in, among other things, general economic conditions. Our operating results may reflect our customers’ order patterns or the effects of economic downturns on their businesses. In addition, because we conduct our operations in a variety of markets, we are subject to economic conditions in each of these markets. We are subject to downward price pressures in certain of the markets we serve. Accordingly, general economic downturns, localized downturns, or downward price pressures in markets where we have operations could have a material adverse effect on our business, results of operations and financial condition.
Our operations may be subject to quarterly and cyclical fluctuations.
The timing of particular jobs or types of jobs at particular times of year may cause significant fluctuations in the operating results of our various operations in any given quarter. We are subject to factors that are beyond our control, including changes in interest costs, currency exchange rates and tax rates, costs associated with compliance with legal and regulatory requirements and the health of the consumer products industry. We also depend, to some extent, on sales to certain industries, such as the food and beverage industry. To the extent these industries experience downturns, the results of our operations may be adversely affected.
We are dependent on certain key customers and are subject to unpredictable order flows.
Our ten largest customers accounted for approximately 35% of our revenues in fiscal 2011. In fiscal 2011, no one customer accounted for more than 7% of our total revenues. While we seek to build long-term customer relationships, revenues from any particular customer can fluctuate from period to period due to such customer’s purchasing patterns. Further, our services and related business activity generally have been characterized by individual assignments from customers on a project-by-project basis, and continued engagements for successive jobs are primarily dependent upon our customers’ satisfaction with services previously provided. While technological advances have enabled us to shorten considerably our production cycle to meet our customers’ increasing speed-to-market demands, we may in turn receive less advance notice from our customers of upcoming projects. Any termination or significant disruption of our relationships with any of our principal customers could have a material adverse effect on our business, financial condition and results of operations.
We have long-term contracts with certain key customers. The terms of most of our largest contracts are initially between two and five years. However, most of these contracts may be terminated by the customer without cause upon 30 to 90 days’ notice. While terms and conditions in our customer contracts vary, in general the contracts do not obligate our customers to purchase any specific minimum volume or dollar amount of services from us. Any cancellation, deferral or significant reduction in sales to these principal customers or a significant number of smaller customers could have a material adverse effect on our business, financial condition and results of operations.
We are dependent on certain key suppliers. Any problem or interruption in our supply of primary raw materials could delay operations and adversely affect our sales.
Our primary raw material purchases include sheet photopolymer for flexographic plates, photographic film, chemicals, storage media, ink, colorants, plate materials, proofing paper and various other supplies and chemicals. We purchase the majority of our raw materials based on long-term contracts with our key supplier. Although we believe we could find other suppliers, our continued supply of raw materials is subject to a number of risks, some of which are beyond our control, which could delay operations and adversely affect our sales. In fiscal 2011, materials and supplies costs accounted for approximately 17% of our cost of goods sold.
We may be unable to effectively integrate acquired businesses.
Since the beginning of 2007, we have completed 7 noteworthy acquisitions and we will consider pursuing attractive acquisition opportunities in the future. While management has experience acquiring companies and integrating their operations into our existing operations, we may not be able to effectively integrate acquired businesses into our existing business.
Future acquisitions could result in the incurrence of debt and contingent liabilities and an increase in amortization expenses related to intangible assets, which could have a material adverse effect upon our business, financial condition and results of operations. Risks we could face with respect to acquisitions include:
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difficulties in the integration of the operations, technologies, products and personnel of the acquired company;
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risks of entering markets in which we have no or limited prior experience;
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potential loss of employees;
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diversion of management’s attention from other business concerns; and
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expenses of any undisclosed or potential legal liabilities of the acquired company.
The risks associated with acquisitions could have a material adverse effect upon our business, financial condition and results of operations. We cannot assure that we will be successful in consummating future acquisitions on favorable terms or at all.
Our foreign operations are subject to currency exchange, political, investment and other risks that could hinder us from transferring funds out of a foreign country, delay our debt service payments, cause our operating costs to increase and adversely affect our results of operations.
We currently have operations in the United States, Mexico, Canada, the United Kingdom, the Netherlands, Hong Kong, the Philippines, Argentina, and Panama. For the year ended December 31, 2011, total net sales from operations outside the United States were approximately $116 million (excluding intercompany sales), which represented approximately 31% of our consolidated net sales. As a result of our foreign operations, we are subject to certain risks which could disrupt our operations or force us to incur unanticipated costs and have an adverse effect on our ability to make payments on our debt obligations. See the information presented within Footnote B to our consolidated financial statements in Item 15, “Exhibits and Financial Statement Schedules” summarizing the concentration of sales and long-lived assets by major geographic region.
Devaluations and fluctuations in currency exchange rates may affect our operating performance by impacting revenues and expenses outside of the U.S. due to fluctuations in currencies other than the U.S. dollar or where we translate into U.S. dollars for financial reporting purposes the assets and liabilities of our foreign operations conducted in local currencies.
We are subject to various other risks associated with operating in foreign countries, such as the following:
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acts of terrorism;
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changes in government policies and regulations;
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imposition of limitations on conversions of foreign currencies into dollars or remittance of dividends and other payments by foreign subsidiaries;
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imposition or increase of withholding and other taxes on remittances and other payments by foreign subsidiaries; and
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imposition or increase of investment and other restrictions or requirements by foreign governments.
The loss of key personnel could adversely affect our current operations and our ability to achieve continued growth.
We are highly dependent upon the continued service and performance of our senior management team and other key employees. Although we generally have been successful in our recruiting efforts, we compete for qualified individuals with companies engaged in our business lines and with other companies. Accordingly, we may be unable to attract and retain suitably qualified individuals, and our failure to do so could have an adverse effect on our ability to implement our business plan. If, for any reason, these officers or key employees do not remain with us, our operations could be adversely affected until suitable replacements with appropriate experience can be found.
If we do not keep pace with technological changes, we will not be able to maintain our competitive position.
We believe our ability to develop and exploit emerging technologies has contributed to our success and has demonstrated to our customers the value of using our services rather than attempting to perform these functions in-house or through lower-cost, reduced-service competitors. We believe our success also has depended in part on our ability to adapt our business as technology advances in our industry have changed the way graphics projects are produced. These changes include a shift from traditional production of images to offering more consulting and project management services to customers. Accordingly, our ability to grow will depend upon our ability to keep pace with technological advances and industry evolutions on a continuing basis and to integrate available technologies and provide additional services commensurate with customer needs in a commercially appropriate manner. Our business may be adversely affected if we are unable to keep pace with relevant technological industry changes or if the technologies that we adopt or services we promote do not receive widespread market acceptance.
We are subject to strict environmental laws and regulations that may lead to significant, unforeseen expenses.
We are subject to various federal, state, local and foreign environmental laws, regulations and ordinances, including those that:
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govern activities or operations that may adversely affect the environment, such as discharges to air and water, as well as handling and disposal practices for solid and hazardous wastes;
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seek to protect occupational safety and health; and
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impose liability for the costs of cleaning up, and certain damages resulting from, sites of past spills, disposals or other releases of hazardous substances.
The violation of such laws and regulations can result in substantial civil and criminal fines and penalties. We may not be, at all times, in compliance with all such requirements. As is the case with manufacturers in general, we have made and will continue to make capital expenditures to comply with environmental requirements. Although we do not believe that we are currently subject to any material environmental liabilities, the operation of manufacturing plants entails risks in these areas and there can be no assurance that we will not discover previously unknown environmental non-compliance or contamination. Noncompliance with or liability for cleanup under the environmental laws applicable to us could have a material adverse effect on our results of operations and financial condition. In addition, changes in environmental laws and regulations, or the interpretation or enforcement thereof, the discovery of previously unknown contamination or other liabilities relating to our current or former properties and operations, developments in environmental litigation or technological advances could increase the amount of future expenditures and could have a material adverse effect on our results of operations and financial condition.
We may be subject to losses that might not be covered in whole or in part by our insurance coverage. These uninsured losses could result in substantial liabilities to us that would negatively impact our financial condition.
We carry comprehensive liability, fire and extended coverage insurance on all of our facilities, and other specialized coverage, including errors and omissions coverage, with policy specifications and insured limits which we believe to be reasonable for similar properties and purposes. However, there are certain types of risks and losses, such as losses resulting from wars or acts of God, that generally are not insured because they are either uninsurable or not economically insurable. Should an uninsured loss or a loss in excess of insured limits occur, we could incur significant liabilities, and if such loss affects property we own, we could lose capital invested in that property or the anticipated future revenues derived from the activities conducted at that property, while remaining liable for any lease or other financial obligations related to the property. In addition to substantial financial liabilities, an uninsured loss or a loss that exceeds our coverage could adversely affect our ability to replace property or capital equipment that is destroyed or damaged, and our productive capacity may diminish.
Our ability to report our financial results or prevent fraud is dependent on our ability to maintain an effective system of internal controls.
Effective internal controls are necessary for us to provide reliable financial reports and effectively prevent fraud. Any inability to provide reliable financial reports or prevent fraud could harm our business. If we fail to remedy or maintain the adequacy of our internal controls, as such standards are modified, supplemented or amended from time to time, we could be subject to regulatory scrutiny, civil or criminal penalties or shareholder litigation. In addition, failure to maintain adequate internal control could result in financial statements that do not accurately reflect our financial condition.
To service our indebtedness, we will require a significant amount of cash. Our ability to generate cash depends on many factors beyond our control.
Our ability to make payments on and to refinance our indebtedness, including the senior subordinated notes, and to fund planned capital expenditures, acquisitions and research and development efforts will depend on our ability to generate cash in the future. This, to a certain extent, is subject to general economic, financial, competitive, legislative, regulatory and other factors that are beyond our control.
Based on our current level of operations, we believe our cash flow from operations, available cash and available borrowings under our senior secured credit facility (or replacements for it) will be adequate to meet our future liquidity needs. During 2012, we will explore alternatives to our current financing prior to the maturity of the senior secured credit facility and senior subordinated notes. These alternatives may include the issuance of additional long-term debt, refinancing our credit facility or other restructurings or financings.
There is no assurance, however, that our business will generate sufficient cash flow from operations, or that future borrowings will be available to us under our senior secured credit facility (or replacements for it) in an amount sufficient to enable us to pay our indebtedness, including the senior subordinated notes, or to fund our other liquidity needs or that there will not be material adverse developments in our business, liquidity or capital requirements. If we are unable to generate sufficient cash flow from operations in the future to service our indebtedness and to meet our other commitments, we may need to refinance or restructure all or a portion of our indebtedness, sell material assets or operations or obtain additional debt or equity capital. There is no assurance that we would be able to accomplish any of these alternatives on a timely basis or on satisfactory terms, if at all, or that these actions would enable us to continue to satisfy our capital requirements. In addition, the terms of our existing or future debt agreements, including the senior subordinated notes and our senior secured credit facility, may limit our ability to pursue any of these alternatives.
With our indebtedness levels, we may still be able to incur substantial additional debt, which could exacerbate the risks associated with our substantial leverage.
We may be able to incur additional debt in the future, including debt that is senior to or equal in right of payment to the senior subordinated notes. Although the indenture governing the senior subordinated notes and our
senior secured credit facility contain restrictions on our ability to incur indebtedness, those restrictions are or will be subject to a number of exceptions. Additional indebtedness we incur may be senior to or equal in right of payment with the senior subordinated notes. Adding new debt to current debt levels could intensify the related risks that we now face.
Indebtedness under our senior secured credit facility is subject to floating interest rates, which may cause our interest expense to increase.
Changes in economic conditions could result in higher interest rates, thereby increasing our interest expense and reducing our funds available for operations and other purposes. A 1% increase in market interest rates would result in an annual increase in our interest expense and a decrease in our earnings before income taxes, of approximately $0.7 million for 2012. Any borrowings under our senior secured revolving credit facility would be subject to similar fluctuations.
Item 1B.
Item 1B. Unresolved Staff Comments
Not applicable.
Item 2.
Item 2. Properties
We began operations in Louisville, Kentucky and continue to maintain our headquarters there. We have a broad geographic reach through our network of 39 operating facilities located across the United States, Canada, Mexico, the United Kingdom, Hong Kong, Argentina and the Philippines. Virtually all of these operating facilities provide prepress graphics services; 16 of them engrave flexographic plates; and nine of them engrave gravure cylinders. Due to shipping costs, proximity to the customer is particularly important with respect to image carriers. While graphic services can be provided at a greater distance from the customer, it is still a competitive advantage to be able to have face-to-face contact with the customer on short notice when necessary or desirable.
We also operate on-site at numerous consumer products company locations and several printer locations. On-site services typically involve packaging graphics services and project management work. We also operate at several facility-managed locations. This work typically involves engraving of flexographic plates at printers. We have expanded our on-site and facility-managed presence to strengthen customer relationships, improve cost efficiencies, and increase speed and accuracy of the end-services. Image quality, consistency and response times are becoming increasingly important to our customers and on-site and facility-managed locations help us to better serve our customers’ needs.
As of March 16, 2012, excluding our headquarters in Louisville, we have 39 operating facility locations.
Item 3.
Item 3. Legal Proceedings
Various lawsuits, claims and proceedings have been or may be instituted or asserted against entities within the Company. While the amounts claimed may be substantial, the ultimate liability cannot be determined because of the considerable uncertainties that exist. Therefore, it is possible that results of operations or liquidity in a particular period could be materially affected by certain contingencies. However, based on currently available facts and in light of legal and other defenses available to us, management believes that the disposition of matters that are pending or asserted will not have a materially adverse effect on the Company’s financial position, results of operations, and liquidity. As discussed below in Management’s Discussion and Analysis of Financial Condition and Results of Operations, the Company entered into a confidential settlement of a legal proceeding in 2011.
Item 4.
Item 4. Mine Safety Disclosures
Not applicable.
PART II
Item 5.
Item 5. Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
PUBLIC TRADING MARKET
There is no established public trading market for the Registrant’s Common Stock.
As of March 16, 2012, there was one holder of record of the Registrant’s Common Stock.
DIVIDENDS
The Registrant has never paid any cash dividends on its Common Stock and does not anticipate paying any cash dividends in the foreseeable future. The instruments governing the Registrant’s senior secured credit facility prohibit it from paying dividends other than (i) dividends to Southern Graphics Inc. (“Holdco”), the Registrant’s parent, for out-of-pocket legal, accounting and filing costs and other expenses in the nature of overhead incurred by Holdco in the ordinary course of its business, (ii) dividends to Holdco to permit Holdco to repurchase or redeem shares of its capital stock held by officers, directors or employees upon their death, disability, retirement, severance or termination of employment, in each case up to an aggregate of $3,000,000 per year, (iii) payments to Holdco to allow it to pay applicable income taxes, and (iv) dividends to Holdco to enable it to repurchase or redeem its equity interests held by Court Square Capital Partners, L.P. (“CSC”, formerly known as Citigroup Venture Capital Equity Partners, L.P.) or one of its related entities if Holdco concurrently issues a commensurate amount of equity interests to Lyon Southern, Inc. or another equity investor reasonably satisfactory to the administrative agent and the arrangers under such facility. The indenture governing the senior subordinated notes contains additional restrictions on paying dividends. The Registrant currently intends to retain future earnings to help fund the development and growth of its business and to reduce outstanding indebtedness.
See Item 12 “Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters” with respect to information on equity compensation plans.
RECENT SALES OF UNREGISTERED SECURITIES
The Registrant had no sales of unregistered securities in 2011.
Item 6.
Item 6. Selected Financial Data
The following table presents selected consolidated financial information and other data for the periods indicated. The historical statement of operations data and statement of cash flows data for the years ended December, 31, 2011, December 31, 2010, and December 31, 2009, and the balance sheet data for December 31, 2011 and December 31, 2010 are derived from our audited consolidated financial statements, included elsewhere in this Form 10-K. The historical statement of operations data and statement of cash flows data for the year ended December 31, 2008 and December 31, 2007, and the balance sheet data for December 31, 2009, December 31, 2008 and December 31, 2007 are derived from our audited consolidated financial statements not contained in this Form 10-K.
The information contained in this table should also be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and accompanying notes thereto included elsewhere in this Form 10-K.
The selected financial data were impacted by acquisitions. See Item 1 “Business” for a listing of noteworthy acquisitions occurring during the period from January 2007 through December 2011. Also see Item 7
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The statements in the discussion and analysis regarding our expectations regarding the performance of our business, our liquidity and capital resources and other non-historical statements are forward-looking statements. These forward-looking statements are subject to numerous risks and uncertainties. Our actual results may differ materially from those contained in or implied by any of these forward-looking statements. You should read the following discussion together with the financial statements and the related notes included elsewhere in this Form 10-K.
OVERVIEW
We are a global leader in the digital imaging industry, offering design-to-print graphic services to the international consumer products packaging market primarily in North America, Europe and Asia. Our global service platform and financial capability provide a distinct competitive advantage over the majority of companies in our industry. We offer a full spectrum of innovative digital solutions that streamline the capture, management, execution, and distribution of graphics information. Our brand development, creative design, prepress, image carriers and print support services are utilized in each of the three main printing processes: flexography, gravure and lithography. Our customers, many of which we have served for over 20 years, include large branded consumer products companies, mass merchant retailers and the printers and converters that service them. Our services ensure that our customers are able to obtain or produce consistent, high quality packaging materials often on short turnaround times.
We achieved record sales in 2011 of $379.3 million, an increase of 7.6%, or $26.6 million, from $352.7 million for 2010. This increase in sales was driven by volume growth across our customer base, most notably with large consumer packaged goods companies (CPGs), and resulted in increased sales throughout our operations in the United States, Canada, Europe and Asia. In addition, foreign currency fluctuations, most notably the weakening of the U.S. dollar compared to the Canadian dollar and British pound, positively impacted sales by $4.2 million. Furthermore, acquired business generated $7.3 million of incremental sales for 2011.
In February 2011, we acquired the assets of Creative Type, a digital print company in Dallas, Texas that include label printers and other equipment associated with digital printing. This acquisition broadens our digital printing capabilities and increases our capacity to offer our customers short run reproduction services and sales samples or packaging mock-ups.
In April 2011, we acquired the assets of a Canadian provider of packaging and retail graphics services. This acquisition enables us to obtain additional sales volumes and expand our customer base.
In June 2011, we expanded our service offerings in the areas of metal decorating and image carriers for beverage can printing with the acquisition of the assets of Photoengraving Incorporated, a company based in Tampa, Florida. Our expanded capabilities lead to additional opportunities with our existing customers and allow us to further expand our customer base.
In September 2011, we acquired the assets of an Ohio-based gravure engraving/imaging business. This acquisition further strengthens our position as the leading engraver of gravure cylinders in North America.
In October 2011, we acquired a photo studio in Chicago, Illinois, which expands our capabilities within this market. We will continue to pursue attractive acquisition opportunities in the future.
Income from operations for 2011 decreased 7.7%, or $4.9 million, to $58.7 million from $63.6 million for 2010. This reduction in income from operations is due to the combination of an increase in cost of goods sold percentage and an increase in selling, general and administrative expenses. The chart below provides cost of goods sold (exclusive of depreciation), selling and marketing expenses, and general and administrative expenses, each expressed as a percentage of sales.
The increase in cost of goods sold percentage to 61.0% for 2011 compared to 59.7% for 2010 resulted from our operating at a level above capacity for a significant portion of 2010 and achieving profit margins in 2010 that were not sustainable in the long-term. The investments we made to increase our capacity, including an increase in headcount to support our higher sales volumes, resulted in a margin for 2011 that we consider more sustainable.
The increase in selling, general and administrative expenses is due to a combination of factors, including a one-time final confidential settlement in 2011 of a legal proceeding for an amount under $5.0 million. In addition, we continue to invest in selling and marketing expenses in order to stimulate future organic sales growth. The record sales level for 2011 demonstrates that these investments to stimulate additional organic sales growth are being realized.
RESULTS OF OPERATIONS
The following table sets forth our results of operations for the periods presented (dollars in thousands).
The following table summarizes the concentrations of sales by major geographic region (dollars in thousands).
Year ended December 31, 2011 compared to the year ended December 31, 2010
Sales. Sales for fiscal 2011 increased 7.6%, or $26.6 million, to $379.3 million from $352.7 million for fiscal 2010. This increase in sales was driven primarily by volume growth across our customer base, most notably with large CPGs, and acquisitions. Our increased sales volumes and expanded service offerings to our larger customers enabled us to offset pricing pressures from customers and gain market share. Acquisitions contributed incremental sales of $7.3 million. Additionally, sales were positively impacted by fluctuations in foreign currency exchange rates. The weakening of the United States dollar, as compared to the Canadian dollar and British pound, positively impacted sales by $2.7 million and $1.3 million, respectively. The weakening of the United States dollar as compared to other currencies positively impacted sales by $0.2 million.
Sales in the United States increased by $14.3 million for fiscal 2011 compared to fiscal 2010 primarily due to organic sales growth with large CPGs. In addition, acquisitions contributed $5.6 million of incremental sales in the
United States. After excluding the impact of foreign currency fluctuations, sales in Canada increased approximately $2.9 million for fiscal 2011 compared to fiscal 2010 due to organic sales growth with CPGs. An acquisition in Canada in April 2011 generated $1.7 million of sales. After excluding the impact of foreign currency fluctuations, sales in Europe increased by $3.2 million for fiscal 2011 compared to fiscal 2010. This increase was also due to organic growth with large CPGs. Sales in Asia increased by $2.1 million for fiscal 2011 compared to fiscal 2010 due to our decision to transfer business to our lower cost locations there, as well as organic growth. These increases in sales were slightly offset by a decline in sales in Mexico of $0.1 million.
Cost of Goods Sold. Cost of goods sold for fiscal 2011 increased 9.8%, or $20.7 million, to $231.3 million from $210.6 million for fiscal 2010. The increase in cost of goods sold was due to the significant increase in sales, including the incremental cost of goods sold associated with acquisitions, and the aforementioned investments to increase capacity to support higher sales volumes. The increase in cost of goods sold associated with acquisitions was $4.0 million. Foreign currency fluctuations increased cost of goods sold by $2.5 million.
Cost of goods sold expressed as a percentage of sales increased to 61.0% for fiscal 2011 from 59.7% for fiscal 2010. This increase in cost of goods sold as a percentage of sales is due to our operating at a level above capacity for a significant portion of 2010 and achieving profit margins in 2010 that were not sustainable in the long-term. The investments we made to increase our capacity, including an increase in headcount to support our higher sales volumes, resulted in a margin for 2011 that we consider more sustainable.
Selling, General and Administrative Expenses. Selling, general and administrative expenses for fiscal 2011 increased 18.4%, or $10.1 million, to $64.7 million from $54.6 million for fiscal 2010. This increase was due to a combination of factors, including a one-time final confidential settlement in 2011 of a legal proceeding for an amount under $5.0 million. Exclusive of this one-time settlement, general and administrative expenses, expressed as a percentage of sales, were lower in fiscal 2011 than in fiscal 2010. Selling and marketing expenses were $4.4 million higher in fiscal 2011 due to our investments to stimulate additional organic sales growth, as well as additional expenses resulting from the increased level of sales. In addition, the weakening of the United States dollar as compared to the Canadian dollar and British pound resulted in a combined increase of selling, general and administrative expenses of $0.6 million in fiscal 2011 compared to fiscal 2010.
Depreciation and Amortization Expenses. Depreciation and amortization expenses for fiscal 2011 increased 3.2%, or $0.8 million, to $24.7 million from $23.9 million for fiscal 2010. The increase in depreciation and amortization associated with acquisitions was $0.7 million. The remaining fluctuation is not significant.
Interest Expense. Interest expense for fiscal 2011 decreased 1.4%, or $0.4 million, to $26.2 million for fiscal 2011 from $26.6 million for fiscal 2010. This minor decrease resulted from the interest savings associated with the Company’s debt reduction efforts during fiscal 2010 essentially being offset by an increase in interest rates. The principal repayments on the senior term loan and acquisition facilities during fiscal 2010 and fiscal 2011 resulted in a combined reduction in interest expense of $1.2 million for fiscal 2011 compared to fiscal 2010. These interest expense savings were partially offset by a $0.8 million increase in interest expense stemming from an increase in interest rates on the senior term loan and acquisition facilities due to the refinancing of our senior secured credit facility in the fourth quarter of 2010.
Other Expense, net. Other expense, net decreased from fiscal 2010 by $0.5 million to $0.1 million of expense for fiscal 2011. Other expense, net, primarily consists of recognized gains and losses on foreign exchange and miscellaneous non-operating expense (income) items. Recognized losses on foreign exchange were $0.4 million in fiscal 2011 compared to $0.9 million in fiscal 2010. The remaining fluctuation is not significant.
Provision for Income Taxes. The effective tax rate for fiscal 2011 was 29.7% compared to 41.9%, for fiscal 2010. The significant decrease in the effective tax rate was primarily due to two items. First, an income tax benefit of $1.6 million was recorded during fiscal 2011 associated with the reversal of withholding taxes on intercompany interest accrued but unpaid. This reversal is the result of the Company’s election to repatriate intercompany interest back to the United States for tax purposes and a corresponding reduction of the withholding rate from 25% to 0% on the intercompany interest accrued but unpaid. Furthermore, an additional income tax benefit of $1.2 million was recorded during fiscal 2011 related to a revision in the calculation of estimated state tax liabilities expected in the
United States. This tax benefit was primarily related to aligning our tax accounts with an election made in the first quarter of 2011 and resulted from a reduction in the deferred state tax liability and the associated expense for intercompany interest income repatriated from foreign subsidiaries. If not for these tax benefits recorded in 2011, our effective tax rate would have been approximately 38% which is within the range of our expected effective tax rate of between 38% and 40%.
Year ended December 31, 2010 compared to the year ended December 31, 2009
The following table sets forth our results of operations for the periods presented (dollars in thousands).
nm - Percentage change is not meaningful
Sales. Sales for fiscal 2010 increased 9.0%, or $29.2 million, to $352.7 million from $323.5 million for fiscal 2009. This increase in sales was driven primarily by volume growth across our customer base, most notably with large CPGs. In addition, sales were positively impacted by fluctuations in foreign currency exchange rates. The weakening of the United States dollar, as compared to the Canadian dollar, positively impacted sales by $5.5 million. This positive impact on sales was slightly offset by the strengthening of the United States dollar compared to the British pound and the euro, which negatively impacted sales by $0.5 million on a combined basis.
Sales in the United States increased by $17.5 million for fiscal 2010 compared to fiscal 2009 primarily due to organic sales growth with large CPGs. In addition, the increase in sales in the United States was positively impacted by changes in labeling requirements for the tobacco industry imposed by the United States government. While sales to our customers in the tobacco industry increased $3.0 million in fiscal 2010 compared to fiscal 2009, the tobacco industry represents less than 5% of our total business and we expect it will become a smaller percentage of our business as we continue to expand. After excluding the impact of foreign currency fluctuations, sales in Canada increased approximately $3.6 million for fiscal 2010 compared to fiscal 2009 due to organic sales growth with CPGs, primarily in the beverage industry. In addition, sales to customers in the tobacco industry increased by $0.5 million for fiscal 2010 compared to fiscal 2009 in response to changes in labeling requirements for the tobacco industry imposed by the Canadian government. After excluding the impact of foreign currency fluctuations, sales in Europe increased by $0.4 million for fiscal 2010 compared to fiscal 2009. This increase was primarily due to organic growth with large CPGs, offset by a decline in sales to retail companies. Sales in Mexico increased by $1.9 million for fiscal 2010 compared to fiscal 2009 due to organic growth. The remaining increase in sales of $0.8 million was generated from our operations in Asia.
Cost of Goods Sold. Cost of goods sold for fiscal 2010 increased 3.8%, or $7.7 million, to $210.6 million from $202.9 million for fiscal 2009. The increase in cost of goods sold was due to the significant increase in sales, as previously discussed, partially offset by effective cost control. In addition, foreign currency fluctuations increased
cost of goods sold, on a net basis. The weakening of the United States dollar as compared to the Canadian dollar increased cost of goods sold by $3.5 million, but this was slightly offset by the strengthening of the United States dollar compared to the British pound and the euro, which reduced cost of sales by $0.3 million on a combined basis.
Cost of goods sold expressed as a percentage of sales decreased to 59.7% for fiscal 2010 from 62.7% for fiscal 2009. This reduction in cost of goods sold as a percentage of sales is due to a combination of factors, including the benefits of cost cutting initiatives implemented in prior years and leveraging our existing resources on increased sales volumes. In addition, we further managed to effectively control cost of goods sold by distributing some of the sales volume increase across our locations that historically provide a higher gross profit percentage.
Selling, General and Administrative Expenses. Selling, general and administrative expenses for fiscal 2010 increased 7.0%, or $3.6 million, to $54.6 million from $51.0 million for fiscal 2009. This increase was primarily due to the incremental selling and marketing expenses required to drive the organic sales growth in fiscal 2010 and to stimulate further sales growth in subsequent periods, as well as additional expenses resulting from the increased level of sales. In addition, the weakening of the United States dollar as compared to the Canadian dollar resulted in an increase of selling, general and administrative expenses of $0.7 million in fiscal 2010 compared to fiscal 2009. These increases to selling, general, and administrative expenses were partially offset by the reduction of $0.8 million in reserves previously recorded, which resulted in a decrease in selling, general, and administrative expenses for fiscal 2010. In addition, fiscal 2009 included certain additional expenses to consolidate operations that did not reoccur in fiscal 2010
Depreciation and Amortization Expenses. Depreciation and amortization expenses for fiscal 2010 increased 1.5%, or $0.3 million, to $23.9 million from $23.6 million for fiscal 2009. Depreciation and amortization expense increased due to the previously discussed weakening of the United States dollar as compared to the Canadian dollar, which resulted in an increase of $0.4 million of depreciation and amortization expenses for fiscal 2010 compared to fiscal 2009. The remaining fluctuation is not significant as the incremental depreciation and amortization on assets placed in service during fiscal 2010 or the latter portion of fiscal 2009 was offset by the impact of assets that became fully depreciated in either fiscal 2010 or fiscal 2009.
Interest Expense. Interest expense for fiscal 2010 decreased 11.2%, or $3.4 million, to $26.5 million for fiscal 2010 from $29.9 million for fiscal 2009. This decrease is due to the Company’s debt reduction strategy, the corresponding impact on the amortization of deferred financing fees from the Company’s debt reduction strategy, and lower interest rates on the senior secured term loan. The Company’s debt reduction strategy included the repurchase in February 2009 of $25.5 million in principal of our 12% Senior Subordinated Notes (“Notes”), as well as principal repayments on the senior secured credit facility of $42.4 million and $14.4 million for fiscal 2010 and fiscal 2009, respectively. As a result of these principal repayments, combined interest expense on the Notes and senior secured credit facility was $1.2 million less in fiscal 2010 than fiscal 2009. In addition, the amortization of deferred financing fees was $1.3 million less in fiscal 2010 compared to fiscal 2009 as a result of the accelerated amortization of deferred financing fees associated with the timing of the Company’s principal repayments to reduce its debt. Also, lower interest rates on the senior secured credit facility during fiscal 2010 resulted in interest savings of $0.7 million compared to fiscal 2009. The weighted average interest rate on the senior secured credit facility was 3.1% during fiscal 2010 compared to 3.6% in fiscal 2009. The 3.1% weighted average interest rate during fiscal 2010 also takes into account the 1.0% increase on the margin for loans under the amended and restated credit agreement we entered into as of October 25, 2010.
Gain on Debt Extinguishment. The $10.5 million gain on debt extinguishment in fiscal 2009 is due to the acquisition of $25.5 million in principal of our Notes.
Other Expense, net. Other expense, net decreased by $1.3 million to $0.5 million of expense for fiscal 2010 from $1.8 million of expense for fiscal 2009. Other expense, net, primarily consists of recognized gains and losses on foreign exchange and miscellaneous non-operating expense (income) items. Recognized losses on foreign exchange were $0.9 million in fiscal 2010 compared to $1.7 million in fiscal 2009. The remaining decrease was primarily due to a gain of $0.6 million on a minor acquisition made during 2010.
Provision for Income Taxes. The effective tax rate for fiscal 2010 was 41.9% compared to 43.3%, for fiscal 2009. The decrease in the effective tax rate was primarily due to the global dispersion of income before taxes, as a higher percentage of the Company’s income before taxes in fiscal 2010 was generated by subsidiaries outside the United States than for fiscal 2009. The subsidiaries outside the United States generally have a lower statutory tax rate than the United States.
The provision for taxes on income for 2010 and 2009 includes $0.8 million in each year for certain tax withholding on intercompany interest. In early January 2011, the company filed an election that resulted in elimination of these withholding taxes before they would become due and payable.
OFF-BALANCE SHEET ARRANGEMENTS
We do not have any material off-balance sheet arrangements that have, or are reasonably likely to have, a current or future effect on our financial condition, changes in financial condition, revenue or expenses, results of operations, liquidity, capital expenditures or capital resources.
CONTRACTUAL OBLIGATIONS
The following table reflects the contractual obligations and commercial commitments as of December 31, 2011.
The interest payments on debt include interest on $102.4 million of variable rate debt in the senior secured credit facility through September 2013 and interest on $159.5 million of the Notes through December 15, 2013. Interest payments on the debt outstanding on the senior secured credit facility are based on LIBOR + 3.5%. The interest payment amounts in the table above on the senior secured term loan were calculated using the interest rates in effect on December 31, 2011. Interest payments on the Notes are fixed at 12%.
LIQUIDITY AND CAPITAL RESOURCES
At December 31, 2011, we had $12.9 million in cash and cash equivalents and $42.4 million in working capital compared with $9.5 million in cash and cash equivalents and $46.9 million in working capital at December 31, 2010. The $3.4 million increase in cash and cash equivalents resulted from the $46.5 million in cash provided by operations and net borrowings on the revolving credit facility under our senior secured credit facility (the “Revolver”) of $16.0 million, partially offset by $23.5 million in net cash paid for acquisitions, $15.4 million in capital expenditures, and $20.1 million in principal repayments of long-term debt. The $4.5 million decrease in working capital is due to borrowings on the Revolver and the increase in accounts payable. These decreases in working capital were partially offset by increases in cash, accounts receivable, inventories and deferred income taxes.
Our Revolver provides for $40.0 million of borrowing availability. During 2011, we made borrowings on the Revolver of $24.0 million and subsequently repaid $8.0 million. The borrowings on the Revolver were utilized to fund attractive acquisition opportunities during 2011 and to finance a voluntary redemption of $15.0 million of our 12% senior subordinated notes in December 2011. We will realize interest savings in the future as a result of shifting a portion of our debt from the Notes to the Revolver, which bears interest at LIBOR plus 3.5%. We plan to utilize future cash generated from operating activities to reduce our borrowings outstanding on the Revolver, as well as to fund attractive acquisition opportunities.
We expect that cash generated from operating activities and availability under the Revolver will continue to be our principal sources of liquidity. As of December 31, 2011, $24.0 million was available and unused. We made repayments on the Revolver of $4.0 million between January 1, 2012 and March 16, 2012. As of March 16, 2012, $28.0 million was available and unused. The Revolver is available until September 30, 2013. Unused portions of the Revolver are charged a fee of 0.75% per annum. Based on our current level of operations, we believe our cash flow from operations and availability under the Revolver will be adequate to meet our liquidity needs for at least the next twelve months. We cannot assure you, however, that our business will generate sufficient cash flows from operations, or that future borrowings will be available to us under our Revolver in an amount sufficient to enable us to repay our indebtedness, or to fund our other liquidity needs.
We are highly leveraged and our aggregate indebtedness at December 31, 2011 was $262.3 million. In 2013, our debt service requirements will substantially increase as a result of the September 30, 2013 maturity of the loans under our senior secured credit facility and the December 15, 2013 maturity of the Notes. Our ability to operate our business, service our debt requirements and reduce our total debt will depend upon our future operating performance.
Our senior secured credit facility contains customary financial and other covenants, including a maximum leverage ratio and a minimum interest coverage ratio, as defined in the Amended and Restated Credit Agreement we entered into as of October 25, 2010. Our senior secured credit facility also places certain restrictions on our ability to make capital expenditures. As of December 31, 2011, we were in compliance with all covenants. Below are the required financial covenant levels and the actual levels as of December 31, 2011:
(1) The maximum annual capital expenditures consists of $15.0 million plus $3.1 million of allowed carry over from the fiscal year ended December 31, 2010.
(2) The $14.0 million does not include $1.4 million of capital expenditures associated with Permitted Acquisitions under the senior secured credit facility.
We believe that our financing arrangements provide us with sufficient financial flexibility to fund our operations, debt service requirements and other committed obligations. Our ability to access additional capital in the long-term depends on the availability of capital markets and pricing on commercially reasonable terms as well as our credit profile at the time we are seeking funds. From time-to-time, we review our long-term financing and capital structure. During 2012, we will explore alternatives to our current financing prior to the maturity of the senior secured credit facility and Notes. These alternatives may include the issuance of additional long-term debt, refinancing our credit facility or other restructurings or financings.
Capital expenditures
Capital expenditures were $15.4 million for fiscal 2011. Capital expenditures for fiscal 2012 are expected to be approximately $17 million including approximately $1.5 million of capital expenditures related to recent acquisitions. Capital expenditures are discretionary and generally made to replace existing assets, support new
business or customer initiatives, increase productivity, facilitate cost reductions, or meet regulatory requirements. Our operations typically do not have large capital requirements. By comparison, our depreciation expense on properties, plants, and equipment was $13.9 million in fiscal 2011.
Income taxes
As of December 31, 2011, we have utilized all of our Net Operating Loss Carryforwards (NOLs) in the United States and Canada. Given our ability to generate income and the utilization of these NOLs, we expect to generate taxable income in 2012 and pay significantly more cash income taxes than we have in the past.
Cash flow
Year ended December 31, 2011 compared to the year ended December 31, 2010
Cash flows from operating activities. Net cash provided by operating activities was $46.5 million for fiscal 2011 as compared to $56.7 million for fiscal 2010. The primary reason for this decrease was the reduction in income from operations for fiscal 2011 compared to fiscal 2010. In addition, increases in receivables and inventories resulted in a further reduction in cash provided by operating activities. The impacts of these items were partially offset by the fiscal 2010 payment of $4.2 million for an exclusive supply agreement.
Cash flows from investing activities. Net cash used in investing activities was $38.9 million for fiscal 2011 as compared to $13.9 million for fiscal 2010. The increase in cash used in investing activities is due to an increase in net cash paid for business acquisitions of $21.5 million to $23.5 million in fiscal 2011 from $2.0 million in fiscal 2010 and an increase in capital expenditures of $3.5 million to $15.4 million for fiscal 2011 compared to $11.9 million for fiscal 2010.
Cash flows from financing activities. Net cash used in financing activities was $4.1 million for fiscal 2011 as compared to $44.1 million for fiscal 2010. The primary reason for this decrease was the Company’s decision to utilize cash for debt reduction in fiscal 2010 compared to using cash and borrowings on the Revolver to fund acquisitions in fiscal 2011. During fiscal 2010, the Company used $42.4 million of cash to reduce the outstanding principal on the senior secured credit facility compared to the $5.0 million in principal payments on the senior secured credit facility in fiscal 2011 and the $15.0 million paid in fiscal 2011 to voluntarily redeem Notes. In addition, the company borrowed $16.0 million on the Revolver in connection with funding acquisitions and to partially finance the aforementioned $15.0 million voluntary redemption of Notes.
Year ended December 31, 2010 compared to the year ended December 31, 2009
Cash flows from operating activities. Net cash provided by operating activities was $56.7 million for fiscal 2010 as compared to $41.8 million for fiscal 2009. The primary reason for this increase was the greater income from operations, which increased to $63.6 million for fiscal 2010 compared to $46.0 million for fiscal 2009. In addition, cash paid for interest decreased to $25.4 million for fiscal 2010 compared to $26.6 million for fiscal 2009. The impacts of these items were partially offset by increases in working capital during fiscal 2010 and the payment of $4.2 million for an exclusive supply agreement.
Cash flows from investing activities. Net cash used in investing activities was $13.9 million for fiscal 2010 as compared to $12.8 million for fiscal 2009. The increase in cash used in investing activities was due to an increase in capital expenditures of $3.0 million to $11.9 million for fiscal 2010 compared to $8.9 million for fiscal 2009, partially offset by a reduction in net cash paid for business acquisitions. The net cash paid for business acquisitions decreased $1.9 million to $2.0 million for fiscal 2010 compared to $3.9 million for fiscal 2009.
Cash flows from financing activities. Net cash used in financing activities was $44.1 million for fiscal 2010 as compared to $30.0 million for fiscal 2009. The primary reason for this increase was the Company’s capability to make more principal repayments on outstanding debt during fiscal 2010 than during fiscal 2009. This capability was a direct result of the significant cash provided by operations. During fiscal 2010, the Company used $42.4 million of cash to reduce the outstanding principal on the senior secured credit facility compared to the $14.4 million in principal payments on the senior secured credit facility in fiscal 2009 and the $15.0 million paid in fiscal 2009 to extinguish an aggregate principal amount of $25.5 million of its Notes.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires us 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 amount of revenues and expenses during the reporting period.
On an on-going basis, we evaluate our estimates and assumptions, including those related to revenue recognition, accounts receivable and the allowance for doubtful accounts, work-in-process inventory, impairment of goodwill, other intangible assets and long-lived assets, accrued health and welfare benefits, and the income tax provision. We base our estimates and assumptions on our historical experience and other relevant factors that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Reported results would differ under different assumptions or conditions. Actual results may differ from our estimates, and such differences could be material to the consolidated financial statements.
We believe the following critical accounting policies affect our more significant estimates and assumptions used in the preparation of our consolidated financial statements:
Revenue Recognition - We recognize revenue in the period when the following requirements have all been met: (i) there is persuasive evidence of an arrangement, (ii) the sales price is fixed or determinable, (iii) title, ownership, and risk of loss have been transferred to the customer, and (iv) collectability is reasonably assured. The majority of the Company’s service offerings result in the delivery of an electronic image file, an engraved gravure cylinder, or a flexographic printing plate after satisfaction of all the terms and conditions of the underlying arrangement. The Company recognizes revenue from the sale of such services when the deliverable is provided electronically or shipped and risk of loss has passed to the customer. For all other services that do not result in an electronic file or image carrier being delivered to the customer, revenues are recognized in the period the service is performed and accepted by the customer.
In circumstances where we derive revenue from arrangements involving multiple service offerings, total estimated revenue is allocated to each element based on the relative fair value of each element. The amount of revenue allocated to each element is limited to the amount that is not contingent upon the delivery of another element in the future. Revenue for each element is then recognized as described above depending upon when the service is performed and accepted by the customer, the electronic file was provided, or the image carrier was shipped.
We recognize customer rebates as sales deductions, and they are accrued as earned by the customer based on a systematic allocation of the total estimated rebates to be paid to the underlying sales that result in progress toward earning the rebate. In addition, we provide for estimated customer claims, which also are recorded as sales deductions and are accrued based on estimated claims. The amount of future claims can be reasonably estimated based on historical experience and specific notification of pending claims. Also, we record cash discounts as sales deductions. Cash discounts are recorded based on historical discounts given to customers.
We record an accrual at the end of each month for items that have shipped, but which have not yet been invoiced to the customer.
Accounts Receivable and Allowance for Doubtful Accounts - Trade accounts receivable are recorded at the invoiced amount and do not bear interest. The allowance for doubtful accounts is our best estimate of the amount of probable credit losses in the existing accounts receivable. We determine the allowance by reviewing the accounts receivable from customers which are past due, as well as considering historical write-off experience and the creditworthiness of significant customers based on ongoing credit evaluations. In addition, we also maintain allowances for customer claims due to rejected services, billing errors, disputed amounts, etc., which result in credit memos charged to net sales. Management’s estimated allowances are based on historical experience and specific notification of pending claims. In our opinion, these allowances are adequately established and sufficient to cover future collection problems. However, should business conditions deteriorate and more customers have financial problems, these allowances may be increased, which would negatively impact our results of operations.
Work-in-process Inventory - Work-in-process inventories are recorded based on the estimated costs incurred for orders that have not satisfied the revenue recognition criteria. This estimate is based on an itemized listing of unbilled orders, completion percentage for these unbilled orders, an estimated amount to be billed based on historical experience and customer information, and gross profit margin. Although we believe the current estimated amount for work-in-process inventory is reasonable, variations between the estimated amount to be billed and the actual billings to the customer, variations between the estimate completion percentage and actual completion percentage, and variations in gross profit margin could materially affect the recorded work-in-process inventory and cost of goods sold, impacting financial condition and results of operations
Impairment of Goodwill, Other Intangible Assets and Long-Lived Assets - We have goodwill and other intangible assets, most notably customer relationships. Goodwill represents the excess of costs over the fair value of net assets of businesses acquired. Customer relationships are amortized on a straight-line basis over the periods benefited, with a weighted average useful life of approximately 20 years. Intangible assets with finite useful lives are amortized generally on a straight-line basis over the periods benefited, with a weighted average useful life of approximately 20 years.
Goodwill is subject to an assessment for impairment on a reporting unit basis by applying a fair-value-based test annually and more frequently if circumstances indicate a possible impairment. We perform the annual test for impairment during the fourth quarter. All other long-lived and intangible assets are reviewed for impairment whenever events or circumstances indicate that the carrying amount of the asset may not be recoverable. If a reporting unit’s carrying value exceeds its fair value, and the reporting unit’s carrying value of goodwill exceeds the implied fair value of that goodwill, an impairment loss is recognized in an amount equal to that excess.
The Company adopted Accounting Standards Update (“ASU”) 2011-08, “Intangibles - Goodwill and Other” effective October 1, 2011. In accordance with the provisions of ASU 2011-08, the Company determined, on the basis of qualitative factors, that the fair value of the Company’s assets (including goodwill) is more likely than not greater than the carrying value of the Company’s assets. As such, further testing for impairment was unnecessary and no write-down in the carrying value of goodwill was recorded.
In connection with its goodwill impairment analysis for fiscal 2010 and fiscal 2009, the Company considered the three generally accepted approaches for valuing a business: the Income, Market and Cost approaches. Based on the nature of the Company’s businesses, its single reporting unit’s current and expected financial performance, and comparable external market data from which to establish fair value, the Company determined that a 50% weighting of the Income approach and a 50% weighting of the Market approach is appropriate in estimating the fair value of the single reporting unit under the first step of its impairment analysis. As such, the Company uses a discounted cash flow analysis consistent with our five year plan and market value of invested capital data from comparable companies that are publicly traded. The other key estimates and factors used include, but are not limited to, revenue and expense growth rates, changes in working capital, foreign exchange rates, and interest rates.
Accrued Health and Welfare Benefits - We are partially self-insured for health and welfare benefits. Our liability is limited by stop-loss insurance coverage provided by a third party. The accrual for health and welfare benefits is the Company’s best estimate of health and welfare costs incurred, but not paid as of the balance sheet date. We estimate our liability for claims incurred by applying a lag factor to our historical claims experience. The validity of the lag factor is evaluated periodically and revised if necessary. Although we believe the current estimated liabilities for health and welfare claims are reasonable, changes in the lag in reporting claims, changes in claims experience, unusually large claims, and other factors could materially affect the recorded liabilities and expense, impacting financial condition and results of operations.
Income Tax Provision - Significant judgment is required in developing our income tax provision which is further complicated by the multiple taxing jurisdictions in which we operate. Results of Internal Revenue Service or other jurisdictional audits, statute closings on prior tax returns, and future tax law changes could have a material impact on our future tax liabilities and provisions, impacting financial condition and results of operations. In addition, realization of certain deferred tax assets is dependent upon our ability to generate future taxable income. The Company records a valuation allowance to reduce its deferred tax assets to the amount that it believes is more
likely than not to be realized. While the Company has considered future taxable income and ongoing tax planning strategies in assessing the need for the valuation allowance, in the event the Company were to determine that it would not be able to realize all or part of its net deferred tax assets in the future, an adjustment to the deferred tax assets would be charged to income in the period such determination was made. In addition, the Company applies a more-likely-than-not recognition threshold for all tax uncertainties. Such uncertainties include any claims by the Internal Revenue Service for income taxes, interest, and penalties attributable to audits of open tax years.
Recently Issued and Adopted Accounting Standards
See Footnote A to our consolidated financial statements following Item 15 of this Annual Report on Form 10-K.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
We are exposed to foreign currency exchange rate risk due to our operations in Canada, Mexico, the United Kingdom, the Netherlands, Hong Kong, the Philippines, Argentina, and Panama. Our results of operations can be impacted through foreign currency exchange rate risk (a) to the balance sheet components (assets and liabilities) and (b) through our foreign denominated revenue and expenses in Canada, Mexico, the United Kingdom, the Netherlands, Hong Kong, and the Philippines. A 10% strengthening in the Canadian dollar against the U.S. dollar would have increased fiscal 2011 net income by $2.1 million. A 10% strengthening in any of the other currencies utilized by our subsidiaries, the British pound, the euro, the Mexican peso, the Hong Kong dollar, the Philippine peso, the Argentine peso, and Panamanian balboa against the U.S. dollar, would not have a material effect on the Company’s results of operations.
We do not use derivative financial instruments.
We have $102.4 million of variable rate debt outstanding at December 31, 2011. A 1% increase in the average interest rate would increase future interest expense by $0.7 million for 2012. To the extent we incur additional debt under our senior secured revolving credit facility, our exposure to variable rate interest rates will increase.
Item 8.
Item 8. Financial Statements and Supplementary Data
See Financial Statements following Item 15 of this Annual Report on Form 10-K.
Item 9.
Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure
Not applicable.
Item 9A.
Item 9A. Controls and Procedures
Disclosure Controls and Procedures
The Company’s management, with 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 the end of such period, the Company’s disclosure controls and procedures are effective in ensuring that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified by the rules and forms of the U.S. Securities and Exchange Commission (“SEC”), and accumulated and communicated to the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.
Management Report on Internal Control Over Financial Reporting
We, as management of the Company, are responsible for establishing and maintaining adequate internal control over financial reporting. Pursuant to the rules and regulations of the SEC, internal control over financial reporting is a process designed by, or under the supervision of, the Company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the Company’s board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles and 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 the assets of the Company;
•
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
•
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.
Management assessed the design and effectiveness of the Company’s internal control over financial reporting as of December 31, 2011. 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.
The Company completed several acquisitions during 2011. The majority of our 2011 acquisitions were incorporated into our control structure and are included in management’s assessment. The largest of our 2011 acquisitions was an acquisition of the operations of a Tampa, Florida based company effective June 20, 2011. As permitted by the SEC, management’s assessment as of December 31, 2011 did not include the internal controls of the Tampa acquisition, which is included in the Company’s consolidated financial statements as of December 31, 2011.
Based on management’s assessment, which excluded an assessment of internal control of the operations acquired in Tampa, management has concluded that the Company’s internal control was effective as of December 31, 2011 to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external reporting purposes in accordance with GAAP.
Report of Independent Registered Public Accounting Firm on Internal Control Over Financial Reporting
This annual report does not include an attestation report of the Company’s registered public accounting firm regarding internal control over financial reporting. Internal control over financial reporting was not subject to attestation by the Company’s registered public accounting firm in accordance with recent amendments to Section 404 of the Sarbanes-Oxley Act of 2002 pursuant to Section 989G of the Dodd-Frank Wall Street Reform and Consumer Protection Act that permit the Company to provide only management’s report in this annual report.
Changes in internal control over financial reporting
The Company is in the process of implementing the Order to Cash module in its enterprise resource planning system for most of its U.S. and Canadian locations. This implementation is being completed in stages and will result in certain changes to business processes and internal controls impacting financial reporting. Management is taking the necessary steps to monitor and maintain appropriate internal controls during this period of change. The Company also continues to integrate recent acquisitions into corporate processes. No potential internal control changes due to recent acquisitions would be considered material to, or are reasonably likely to materially affect, our internal control over financial reporting. The Tampa acquisition is expected to be fully integrated into corporate processes by the end of the second quarter of 2012. All other 2011 acquisitions have been fully integrated into corporate processes.
Except as discussed above, there have been no changes to the Company’s internal control over financial reporting during the quarter ended December 31, 2011 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
Not applicable.
PART III
Item 10.
Item 10. Directors, Executive Officers and Corporate Governance
The following sets forth certain information with respect to the persons who are members of the Registrant’s Board of Directors and our executive officers.
* As of March 31, 2012.
Henry R. Baughman has been employed by us since 1973. He became President and a director of Southern Graphic Systems, Inc. in 1999. Prior to becoming President he held various senior executive level positions with us. Mr. Baughman is a graduate of Rochester Institute of Technology. Mr. Baughman became President and Chief Executive Officer of SGS International, Inc. and one of our directors upon completion of the Acquisition in December 2005. As our President, Mr. Baughman leads our strategic planning, acquisition process, resource units and customer value determination system. Mr. Baughman’s qualifications as a director of our company include his employment with the company since 1973, his experience in senior executive level positions with us (including as President and Chief Executive Officer), his knowledge of the industry and markets in which we participate, and his service since 2005 as a director of SGS International, Inc.
Luca C. Naccarato has been employed by us since 1993. He became Executive Vice President of Southern Graphic Systems, Inc. in 2000 and of SGS International, Inc. upon completion of the Acquisition in December 2005. He is also the Chief Executive Officer of Southern Graphic Systems-Canada, Co./ Systemes Graphiques Southern-Canada, Co. As our Executive Vice President, Mr. Naccarato is responsible for integrating our new acquisitions, managing our operations, and developing annual growth and business objectives. Prior to joining us, Mr. Naccarato worked for a mid-sized packaging graphics and gravure supplier near Toronto, Canada.
James M. Dahmus has been employed with us since April 2006. He joined the Company as Chief Financial Officer and was promoted to Senior Vice President, Chief Financial Officer, Treasurer and Assistant Secretary on May 31, 2007. He served as the Senior Vice President and Chief Financial Officer of Sunny Delight Beverages Co., an international consumer products company, from 2004 until April 2006. From 2003 until 2004, he was the CFO and Executive VP for ADVO®, the largest direct marketing company in the world with $1.4 billion in revenue. Prior to that, he served in a variety of business leadership roles at Convergys and Cincinnati Bell beginning in 1995,
including President of Asia/Pacific, CFO of the Software Division, and Corporate Controller. Prior to that, he served for 15 years at Procter & Gamble, with 13 of those years in finance and two as a brand manager of Pringles®. He received his MBA from Northwestern University, where he was an Austin Scholar, and his BA from Penn State University, graduating Magna Cum Laude and with Honors.
Joseph M. Silvestri has been a Managing Partner at Court Square Capital Partners, a private equity firm, since July 2006, and became one of our directors in connection with our formation in November 2005. Mr. Silvestri previously was a Managing Partner of Citigroup Venture Capital (“CVC”), also a private equity firm, having joined CVC in 1990. Mr. Silvestri received his B.S. from Penn State University and his MBA from Columbia Business School. Mr. Silvestri has served as a director of MacDermid, Incorporated since 1999 and currently serves on the compensation committee of that company’s board. He has served as a director of Triumph Group since 2008, having previously served as a director from 1993 to 2005; he currently serves on the audit, finance, and nominating and corporate governance committees of that company’s board. Mr. Silvestri is also a director of Auto Europe Group and Newmarket, Inc. Mr. Silvestri’s qualifications as a director of our company include his experience in managing private equity investments in a variety of portfolio companies, his prior and current service as a director of a number of publicly and privately held companies, his knowledge of the markets and industry in which we participate and related markets and industries, and his service since 2005 as a director of SGS International, Inc.
John P. Civantos has been a Partner at Court Square Capital Partners, a private equity firm, since July 2006, and became one of our directors in connection with our formation in November 2005. Mr. Civantos previously was a Partner of CVC, having joined CVC in 2004 after serving for several years with the leveraged buyout firm Hicks, Muse, Tate & Furst. Prior to that, he was with Morgan Stanley & Co. Mr. Civantos served as a director of MSX-IBS Holdings, Inc. from 2007 to 2011 and on the compensation committee of that company’s board from 2008 to 2011. Mr. Civantos has served as a director of Remy International, Inc. since 2004 and on that company’s board’s audit committee since 2005. Mr. Civantos’ qualifications as a director of our company include his experience in managing private equity investments in a variety of portfolio companies, his prior and current service as a director of a number of publicly and privately held companies, his knowledge of the markets and industry in which we participate and related markets and industries, and his service since 2005 as a director of SGS International, Inc.
Thomas L. Hammond became one of our directors in December 2005. He was our president from 1978 to 2002, and our Chief Executive Officer from 2000 until 2002, when he retired. He has a BS in mechanical engineering from Purdue University and a J.D. from the University of Louisville. Mr. Hammond’s qualifications as a director of our company include his prior employment with the company, his experience in senior executive level positions with us (including as President and Chief Executive Officer), his knowledge of the industry and markets in which we participate, and his service since 2005 as a director of SGS International, Inc.
Richard Leong became one of our directors in February 2006. Mr. Leong served as the Managing Director of Flexo Manufacturing Corporation, a Philippines-based maker of flexible packaging, from 2004 to June 2009 and served as that company’s Executive Vice President from 1996 to 2003. He served as the Chairman of Tigerpack Ltd. (Shanghai), a flexible packaging maker located in China, from 1997 to 2011. Mr. Leong became Managing Director of Lyon Capital Management Pte. Ltd., an asset management company based in Singapore, in October 2009. Mr. Leong served as the Chief Investment Advisor to Lyon Capital Partners, a private investment fund, until September 2009. Lyon Capital Management Pte. Ltd. provides investment advisory services to, and is affiliated with, Lyon Capital Partners and our shareholder Lyon Southern, Inc. Mr. Leong is also a director of Kirk Engineering Pty Ltd. and of the Malulani Group LLC. Mr. Leong received his BS in Economics, with a concentration in Decision Sciences, from the Wharton School of the University of Pennsylvania. Mr. Leong’s qualifications as a director of our company include his experience as an investment advisor, his experience in senior executive level positions with, and service as a director of, companies participating in the markets and industry in which we participate and related markets and industries, and his service since 2006 as a director of SGS International, Inc.
AUDIT COMMITTEE FINANCIAL EXPERT
Messrs. Silvestri, Civantos and Leong comprise our audit committee (the “Audit Committee”). The Audit Committee has determined that it does not have an “audit committee financial expert” as that term is defined in the
Securities and Exchange Commission rules and regulations. However, the Audit Committee believes that its members have demonstrated the capability of analyzing and evaluating our financial statements and understanding internal controls and procedures for financial reporting.
RECOMMENDATION OF NOMINEES TO THE BOARD OF DIRECTORS
The Registrant does not have in place procedures by which its security holders may recommend nominees to its Board of Directors.
CODE OF ETHICS
SGS International, Inc. has implemented a Code of Ethics which applies to our principal executive officer, principal financial officer, principal accounting officer and controller or persons performing similar functions (“covered employees”). The Code of Ethics may be found on our website at http://www.sgsintl.com. We intend to disclose any amendments to or waivers of the Code of Ethics on behalf of our covered employees by posting such information on our website.
Item 11.
Item 11. Executive Compensation
Compensation Discussion and Analysis
General Philosophy
The Compensation Committee has responsibility for establishing and monitoring our compensation philosophy. Executive officers shown in the Summary Compensation Table (each, an “Executive”) are compensated through a combination of base salary, bonus plan awards, equity-based awards and various other benefits that are designed to be competitive with the overall compensation paid to executives in comparable companies and to align the Executive’s interests with the long term interests of the Company’s shareholders. Base salaries and annual bonus awards are designed to reward performance. Our Compensation Committee annually reviews the base salaries and the performance targets for Executive bonus compensation. Executive bonus compensation is designed to be earned based on the achievement of Company-wide performance objectives and goals, personal performance, and the Executive’s demonstrated adherence to Company values.
Targeted Overall Compensation
Our Executives, Messrs. Baughman, Naccarato and Dahmus, each have employment agreements with the Company that set forth their compensation and terms and conditions of employment. Their compensation levels were initially set by the Company at prevailing levels for comparable positions in similarly sized companies in our industry. The Compensation Committee reviews their compensation annually and makes adjustments as appropriate.
Compensation Setting Process
The Compensation Committee reviews and approves compensation and awards for the Company’s officers at the level of Senior Vice President and above and provides oversight of management’s decisions concerning the compensation of other Company officers. Base salary is designed to be competitive by position in the marketplace, and is set at levels sufficient to attract and retain top management talent. Base salaries are reviewed periodically and compensation decisions are based on paying our Executives a competitive compensation package as well as rewarding them annually based on their performance. Based on their collective experience within our industry and with similarly sized companies and similar industries, the Compensation Committee determines whether Executives are being offered competitive compensation packages. The Compensation Committee considers base salary, group benefits and annual bonus awards when making any compensation package changes. The Compensation Committee does not engage consultants to conduct peer group analysis or benchmarking with respect to compensation.
Base Salary
Base salary compensates each Executive for the primary responsibilities of his position. As described in our 2009 Annual Report on Form 10-K, the Company implemented a special compensation plan for the 2009 calendar year. The primary purpose of this plan was to encourage collaboration among departments, plants and regions within our organization. Additionally, this plan was designed to help improve overall production and quality while reducing waste and lowering our costs. The plan was based on achievement of the Company’s 2009 business plan with respect to EBITDA (earnings before interest, taxes, depreciation and amortization), adjusted for certain expenses as allowed by the Compensation Committee. Because the Company achieved 100% of its 2009 EBITDA target under the special compensation plan, all of the Company’s employees, including the Executives, received a 3% increase in base salary effective January 1, 2010. Accordingly, effective as of such date, Mr. Baughman’s base salary was increased from $360,000 to $370,800, Mr. Dahmus’ base salary was increased from $275,000 to $283,250 and Mr. Naccarato’s base salary was increased from $303,188 to $312,284. In addition, effective March 1, 2010 the Compensation Committee increased the base salaries of Messrs. Baughman and Dahmus to $381,924 and $291,747, respectively.
Based on its review of competitive compensation packages, the Compensation Committee approved increases to the base salaries of Messrs. Baughman, Dahmus and Naccarato of 6%, 6%, and 4%, respectively, effective April 1, 2011. The base salaries of Messrs. Baughman, Dahmus and Naccarato increased to $404,839, $309,252, and $324,775, respectively, effective April 1, 2011.
The Company implemented a compensation plan for the 2011 calendar year. The primary purpose of this plan was to encourage collaboration among departments, plants and regions within our organization. Additionally, this plan was designed to help improve overall production and quality while reducing waste and lowering our costs. The plan was based on achievement of the Company’s 2011 business plan with respect to EBITDA (earnings before interest, taxes, depreciation and amortization), adjusted for certain expenses as allowed by the Compensation Committee. The Compensation Committee believes that EBITDA, adjusted for certain expenses, is useful for assessing the Company’s operating performance, is an indicator of our ability to generate cash to pay interest and support debt, and allows us to compare our performance against companies within and across industries.
The plan, which covered all salaried and hourly employees (including the Executives) who were employed as of January 1, 2011 and remained employed as of the applicable payment date(s), provided for up to two one-time payments, to be paid in July and December of 2011, each from a pool equal to one percent of the collective January 1, 2011 salaries/wages of the employees in that pool. For the Executives, the pool comprised the Executives and any other officers at the level of Senior Vice President and above. The Compensation Committee had discretion to award each of the Executives and other officers in the Executives’ pool more or less than one percent of such Executive’s or other officer’s individual salary, but the total payment to all Executives and other officers in the Executives’ pool was not to exceed one percent of such individuals’ collective salaries as of January 1, 2011.
Payments under the plan were to be made only if the Company achieved or was within $1,000,000 of its goal for EBITDA (as adjusted for certain expenses) for the first six months of 2011 and/or achieved or was within $2,000,000 of its goal for EBITDA (as adjusted for certain expenses) for the full 2011 calendar year. The Company achieved within $1,000,000 of its goal for EBITDA for the first six months of 2011 and each Executive received a payment in July 2011 equal to one percent each Executive’s salary as of January 1, 2011. As the Company did not achieve within $2,000,000 of its goal for EBITDA (as adjusted for certain expenses) for the full 2011 calendar year, no additional payment was made in December. The payments made to Messrs. Baughman, Dahmus and Naccarato under the 2011 Special Compensation Plan were $3,819, $2,917, and $3,123, respectively.
Annual Bonus Compensation
The Company established the Management Incentive Bonus Plan to drive behaviors and motivate our employees to maximize profit and improve the Company’s productivity and cash flow. The bonus plan’s goal is to provide for commensurate reward for the eligible employees, including Executives, contributing to those profits and efficiencies.
The Compensation Committee reviews the bonus targets and related goals and objectives annually. For the 2011 plan year we established EBITDA (earnings before interest, taxes, depreciation and amortization), adjusted for certain expenses as allowed by the Compensation Committee, and cash flow, adjusted for certain interest and taxes, capital spending, changes in working capital and other items allowed by the Compensation Committee, as financial performance metrics for the Executives. EBITDA performance measures our operational cash flow generated. The Compensation Committee believes that EBITDA (as adjusted for certain expenses) is useful for assessing the operating performance of the business, is an indicator of our ability to generate cash to pay interest and support debt and is an appropriate performance measure for the Company because it allows us to compare our performance against companies within and across industries. The Compensation Committee believes that cash flow (as adjusted for certain items) is a meaningful performance measure because it closely measures our progress toward achieving our Company objective of reducing debt-related service costs and improving Company net worth.
Each Executive has an individual bonus target expressed as a percentage of base salary. For the 2011 plan year, EBITDA (as adjusted for certain expenses) was weighted at 80% and cash flow (as adjusted for certain items) was weighted at 20% of their total management incentive bonus. The Company exceeded its minimum threshold for 2011 EBITDA (as adjusted for certain expenses), but did not reach the target level. The company exceeded its target for 2011cash flow (as adjusted for certain items).
Messrs. Baughman, Dahmus and Naccarato had target bonus amounts set at 50% of their respective base salary, while their threshold and maximum bonus opportunities were set at 1% and 100% of their base salaries, respectively. The bonuses for Messrs. Baughman, Dahmus and Naccarato are calculated according to a special performance grid which reflects their status as the Company’s three highest ranking officers. The fact that the Company achieved a level between the minimum threshold and target for 2011 EBITDA (as adjusted for certain expenses), exceeded its target for 2011 cash flow (as adjusted for certain items), and the relative weighting of those two measures, resulted in each such Executive receiving a bonus equal to 34.14% of his base salary, or 68.28% of his target bonus. The resulting bonus payment amounts are shown in the Summary Compensation Table, below, in the column entitled “Non-Equity Incentive Plan Compensation.”
For 2012, the Compensation Committee has determined that no changes to the Executives’ threshold, target and maximum bonus opportunities will be made. In addition, for 2012, bonuses under the Management Incentive Bonus Plan will continue to be based on the Company’s achievement of EBITDA and cash flow goals, with the same weighting for each goal as was in effect during 2011.
Equity Ownership
Our compensation philosophy includes adding an equity based element to our compensation package for senior management. Equity ownership is intended to motivate Executives to make stronger business decisions, improve financial performance and enhance the long term interests of the Company’s stockholders. Each Executive was given the opportunity to, and did, purchase common and preferred stock of Southern Graphics Inc. in 2006. See the discussion under “Equity Investment” in Item 13. Also in 2006, Mr. Dahmus was granted options to purchase shares of Southern Graphics Inc. No equity-based awards were granted to Executives subsequent to the options granted to Mr. Dahmus in 2006, as the Compensation Committee determined that each Executive’s ownership interest in the Company was sufficient to ensure his long-term commitment to the Company. The Company may, in its discretion, grant options under the Southern Graphics Inc. Stock Incentive Plan (the “Stock Incentive Plan”) to senior management, including Executives, in the future.
Severance Benefits
Each Executive is party to an employment agreement with the Company that provides for severance benefits in the event of his involuntary termination of employment or his termination of employment due to disability. The purpose of such severance benefits is to assist the Executive with his transition into new employment, recognizing that it may take time for that person to find comparable employment elsewhere. Each Executive’s potential severance is described below under the heading “Potential Payments upon Termination or Change in Control.”
Other Benefits
Reflecting the Company’s culture of respect and value for all employees, the Company offers salaried employees, including the Executives, a group benefits package that is competitive in our industry. Executives may participate in a group retirement savings plan, various group health and welfare benefit plans and a deferred compensation plan.
The Retirement Savings Plan is available to all employees, including the Executives. The plan is funded with both employer and employee contributions. Plan participants may voluntarily contribute from 1% to 100% of their annual pay to the plan on a pre-tax basis, not to exceed the annual dollar IRS limitation, which was $16,500 in 2011. The plan provides for Company matching contributions of up to 6% of the plan participant’s pre-tax eligible contributions. Employer contributions to this plan become 100% vested after three years of service. All of the Executives are 100% vested in this plan.
The Executives are also eligible to participate in the Deferred Compensation Plan. This plan allows plan participants to continue to contribute a percentage of their annual pay on a pre-tax basis after they have reached the annual dollar IRS limitation in the Retirement Savings Plan. The plan is funded with both employer and employee contributions. Plan participants may voluntarily contribute from 1% to 100% of their annual pay to the plan on a pre-tax basis. The plan provides for Company matching contributions of up to 6% of the plan participant’s pre-tax eligible contributions. Employer contributions to this plan become 100% vested after three years of service. All of the participating Executives are 100% vested in this plan.
Each Executive receives a monthly auto allowance to assist with travel expenses. The monthly auto allowances in 2011 for Messrs. Baughman, Dahmus and Naccarato were $1,300, $1,000, and $1,300, respectively.
Each fiscal year, the Compensation Committee reviews the Company’s executive compensation policies and programs to ensure that they are appropriate. The Compensation Committee also determines each year whether incentive compensation will be awarded to the Company’s non-Executive employees. After considering the various forms of compensation paid to the Company’s employees, the Compensation Committee has concluded that the Company’s compensation policies and programs are not reasonably likely to have a material adverse effect on the Company. This conclusion is based on the following factors:
•
A majority of the Company’s employees do not receive any performance-based compensation;
•
A significant portion of the compensation paid to the Company’s employees who are eligible to receive performance-based compensation consists of base salary, which is not dependent upon the Company’s performance;
•
The Company’s bonus program for Executives includes safeguards that reduce the incentive to engage in risky behavior. For example, the Management Incentive Bonus Plan limits the amount of bonus compensation that participants may receive (regardless of how well the Company performs), provides that the Company must achieve minimum financial goals, and reserves to the Company the right to forego payment of any incentive award under circumstances where prudence dictates conservation of Company cash; and
•
The Executives currently own, and historically have owned, a significant amount of the outstanding common stock of the Company’s parent, Southern Graphics Inc. Such ownership interest reduces the incentive for the Executives to engage in actions designed to achieve only short-term results.
Tax and Accounting Considerations
Because our equity securities are not publicly traded, we are not subject to the deduction limitations of Section 162(m) of the Internal Revenue Code. In addition, although the Compensation Committee may consider the accounting implications of our compensation arrangements, it is not a key factor in making compensation decisions.
Compensation Committee Report
The Compensation Committee has reviewed and discussed with management the Compensation Discussion and Analysis included in this annual report. Based on the review and discussion, the Compensation Committee recommended to the Board of Directors that the Compensation Discussion and Analysis be included in this annual report.
COMPENSATION COMMITTEE
Joseph M. Silvestri
John P. Civantos
Thomas L. Hammond
Compensation Summary
The following table summarizes the principal components of compensation for our Chief Executive Officer, Chief Financial Officer and Executive Vice President for our 2011, 2010 and 2009 fiscal years. We refer to these persons as our “named executive officers.”
SUMMARY COMPENSATION TABLE
(1) Represents each named executive officer’s fiscal year bonus earned under the Management Incentive Bonus Plan for the relevant year. Please see the description in the Compensation Discussion and Analysis above under the heading “Annual Bonus Compensation,” for an explanation of each Executive’s 2011 threshold, target and maximum bonus opportunity under the Management Incentive Plan. In addition, the amounts for 2011 and 2009 also include awards under the Company’s special 2011 compensation plan and special 2009 compensation plan, respectively. Under the special 2011 compensation plan, employees received a bonus award from a pool equal to one percent of the collective January 1, 2011 salaries/wages of the employees in that pool. For the Executives, the pool comprised the Executives and any other officers at the level of Senior Vice President and above. The bonus award was a result of the Company’s EBITDA achievement and related EBITDA goal. Bonuses equal to 1% of base salary were awarded to each of the Executives under the Company’s special 2011 compensation plan, and totaled $3,819, $2,917, and $3,123 for Messrs. Baughman, Dahmus, and Naccarato, respectively. As described in our 2009 Annual Report on Form 10-K, pursuant to the terms of the special 2009 compensation plan, all employees of the Company (including the Executives) received
a bonus award equal to 1.5% of their salary in July 2009 (based on the Company’s achievement of its EBITDA goal) and an additional bonus award equal to 1.5% of their salary in January 2010 (based on the Company’s achievement of its 2009 full-year business plan). Accordingly, bonuses equal to 3% of base salary were awarded to each of the Executives under the Company’s special 2009 compensation plan, and totaled $10,800, $8,250, and $9,095 for Messrs. Baughman, Dahmus, and Naccarato, respectively.
(2) Amounts reported under the “All Other Compensation” column consist of the following:
(1) The Retirement Savings Plan provides for matching contributions not greater than 100% of the participant’s elective deferrals that do not exceed the first 6% of the plan participant’s compensation.
(2) The Deferred Compensation Plan provides for matching contributions not greater than 100% of the participant’s elective deferrals that do not exceed the first 6% of the plan participant’s compensation.
(3) Other compensation includes auto allowance ($15,600, $12,000, and $15,600 for Messrs. Baughman, Dahmus and Naccarato, respectively), phone allowance (zero, $990, and zero for Messrs. Baughman, Dahmus and Naccarato, respectively), unused paid vacation ($7,786, $5,948, and zero for Messrs. Baughman, Dahmus and Naccarato, respectively), and relocation expenses (zero, zero, and $25,056 for Messrs. Baughman, Dahmus and Naccarato, respectively).
Employment Agreements
We entered into employment agreements with Messrs. Baughman and Naccarato in connection with the closing of the Acquisition. The term of these employment agreements was initially three years for Mr. Baughman but was subsequently extended to five years, and was initially four years for Mr. Naccarato but was subsequently extended to five years. Mr. Baughman’s and Mr. Naccarato’s employment agreements were amended on March 12, 2009 and December 15, 2009, respectively, to extend the term of each agreement through December 31, 2010. The term of each agreement will automatically renew for successive one-year periods, unless either party gives written notice to the other not less than ninety days prior to the end of the then current term. Because notice of non-renewal has not been provided, the term of each such agreement has been extended through December 31, 2012. Based on its review of competitive compensation packages, the Compensation Committee approved increases to the base salaries of Messrs. Baughman and Naccarato of 6% and 4%, respectively, effective April 1, 2011. The base salaries of Messrs. Baughman and Naccarato increased from $381,924 to $404,839 and from $312,284 to $324,775, respectively.
We entered into an employment agreement with Mr. Dahmus on April 10, 2006. The term of the employment agreement was initially three years, but Mr. Dahmus’ employment agreement was amended on March 12, 2009 to extend the term through April 10, 2011. The employment agreement will automatically renew for successive one-year
periods, unless either party gives written notice to the other not less than ninety days prior to the end of the then current term. Because notice of non-renewal has not been provided, the term of Mr. Dahmus’ employment agreement has been extended through April 10, 2013. Based on its review of competitive compensation packages, the Compensation Committee approved a 6% increase to the base salary of Mr. Dahmus effective April 1, 2011. The bases salary of Mr. Dahmus increased from $291,747 to $309,252.
Each Executive is entitled to receive the base salary set forth in his employment agreement (adjusted as described above), which will be reviewed annually throughout the term. In addition to base salary, the Executives are entitled to participate in our employee benefit plans for senior management. The Executives are also eligible to participate in our senior management bonus plans with annual incentive targets of up to 50% of base salary.
Each Executive’s employment will terminate automatically upon his death. We may terminate an Executive’s employment for any disability that has continued for a period of 180 days. We may also terminate an Executive’s employment at any time for “cause” (as defined below) upon written notice. We may also terminate an Executive’s employment at any time without cause, upon written notice. An Executive may terminate his employment upon not less than thirty days written notice prior to the effective date of such termination. If an Executive terminates his employment for “good reason” (as defined below) it will be deemed to be a termination of the Executive’s employment without cause by us.
“Cause” generally means any of the following: (i) gross or willful misconduct; (ii) willful and repeated failure to comply with the directives of our board of directors or any of our supervisory personnel; (iii) any criminal act or act of dishonesty or willful misconduct or any act of fraud, dishonesty or misappropriation involving us or any of our subsidiaries; (iv) any conviction or plea of guilty or nolo contendere to a felony or a crime involving dishonesty; (v) breach of the terms of any confidentiality, non-competition, non-solicitation or employment agreement the Executive has with us or any of our subsidiaries; (vi) acts of malfeasance or negligence in a matter of material importance to us or any of our subsidiaries; (vii) the material failure to perform the duties and responsibilities of the Executive’s position after written notice and a reasonable opportunity to cure (not to exceed 30 days), (viii) grossly negligent conduct; or (ix) activities materially damaging to us or any of our subsidiaries.
“Good reason” generally means, after written notice by the Executive to our board of directors and a reasonable opportunity for us to cure (not to exceed 30 days), any of the following: (i) the Executive’s base salary is not paid or is reduced by more than ten percent in the aggregate other than as part of a salary reduction program pursuant to which the base salaries of all executive officers are reduced by the same percentage at the same time and for the same period of time; (ii) the Executive’s target incentive payments are reduced; or (iii) the Executive’s job duties and responsibilities are diminished. The expiration of the term of an Executive’s employment agreement (including notice of non-renewal) is not considered “good reason.”
If an Executive’s employment is terminated for any reason, the Executive is entitled to receive the employee benefits to which he is entitled pursuant to the terms of the relevant employee benefit plans in which the Executive participates. If an Executive’s employment is terminated because of disability, the Executive will receive his normal compensation for the period of disability prior to termination of employment, and then will be entitled to receive a pro rata portion of his target bonus from the senior management bonus plan. If an Executive’s employment is terminated by us without cause or by the Executive for good reason, subject to his execution and non-revocation of a release, he is entitled to: (i) receive 50% of his base salary during the twenty-four month period following termination for Messrs. Baughman and Naccarato, and 50% of his base salary during the twelve month period following termination for Mr. Dahmus; (ii) receive a pro rata share of the estimated bonus for the year in which the termination occurs; and (iii) continued participation in the employee welfare benefit plans for the Executive and his dependents (other than disability and life insurance) for twenty-four months following such termination for Messrs. Baughman and Naccarato and twelve months following such termination for Mr. Dahmus.
If an Executive is terminated for cause, dies or voluntarily terminates employment other than for good reason, he is entitled to payment only of earned and unpaid base salary to the date of termination and, in the case of death, payment of earned and unpaid incentive payments.
The employment agreements also provide that, during an Executive’s employment and for a period of twenty-four months after the end of the Executive’s employment with us for Messrs. Baughman and Naccarato and twelve months after the end of the Executive’s employment for Mr. Dahmus, referred to below as the “non-competition period,” the Executive may not: (i) compete, directly or indirectly, with us; (ii) solicit or hire current and former employees; or (iii) solicit current and former customers. In consideration of an Executive’s non-competition and non-solicitation agreement with respect to periods after termination of employment, we will pay the Executive an amount equal to 50% of his base salary during the non-competition period if the Executive’s employment was terminated without cause or for good reason. The expiration of the term of the employment agreements (including notice of non-renewal) is not considered a termination without cause. If an Executive breaches any of the non-competition or non-solicitation restrictions, the Executive will waive and forfeit any and all rights to any further payments under his employment agreement and will repay any severance pay received under such agreement to us.
GRANTS OF PLAN-BASED AWARDS
Below is a summary of the non-equity incentive plan awards granted to each named executive officer in 2011:
(1) Please see the description in the Compensation Discussion and Analysis above, under the heading “Annual Bonus Compensation,” for an explanation of each Executive’s threshold, target and maximum bonus opportunity for 2011 under the Management Incentive Bonus Plan. The Estimated Future Payouts Under Non-Equity Incentive Plan Awards are determined using the Management Incentive Bonus Plan and are based on 2011 salaries. Based on the Company’s 2011 performance, Messrs. Baughman, Dahmus and Naccarato earned bonuses under the Management Incentive Bonus Plan equal to $138,225, $105,589 and $110,889 respectively.
OUTSTANDING EQUITY AWARDS AT FISCAL YEAR-END
Below is a summary of the outstanding equity awards held by each named executive officer as of December 31, 2011:
(1) On July 25, 2006, the Board of Directors of Southern Graphics Inc. adopted the Stock Incentive Plan. Also on July 25, 2006, the Board of Directors of Southern Graphics Inc. approved the grant under the Stock Incentive Plan to James M. Dahmus of options to acquire an aggregate of 1,500 shares of Southern Graphics Inc. Class A common stock, par value $.01 per share. The options granted on July 25, 2006, are non-qualified stock options that will terminate on July 25, 2016, and have an exercise price that has declined (but not below the fair market value of the underlying shares on the grant date) through July 1, 2010. The option price has declined in accordance with a schedule that was established at the grant date and is set forth in Mr. Dahmus’s option agreement. The option price is $113 in accordance with such schedule. The options became exercisable with respect to 300 shares on December 31 of each of 2006, 2007, 2008, 2009 and 2010.
Nonqualified Deferred Compensation
Executives are eligible to participate in the Deferred Compensation Plan. The plan is unfunded and benefits under the plan are paid from the general assets of the Company. Executives whose salary deferrals to our Retirement Savings Plan are limited by Internal Revenue Code limitations may elect to reduce their salary and credit to the plan the excess, if any, of: (i) the amount of salary deferrals that would have been credited pursuant to the Retirement Savings Plan on their behalf for the plan year had the statutory limitations not been applicable; over (ii) the amount of salary deferrals actually credited for the year by the participant to the Retirement Savings Plan. Salary reduction credits under the plan are in the same percentage as most recently elected under the Retirement Savings Plan. For each payroll period for which the Company credits salary to the plan on behalf of the participant, matching credits are also credited to the plan on behalf of the participant. The matching credits for each payroll period are equal to an amount not greater than 100 percent of that portion of the salary reduction credits that do not exceed 6% of the participant’s salary for the payroll period. Effective June 1, 2008, eligible plan participants, including Executives, may defer all or a portion of their awards under the Management Incentive Bonus Plan into the Deferred Compensation Plan, in 10% increments. There are no employer matching contributions on awards earned under the Management Incentive Bonus Plan that are deferred in the Deferred Compensation Plan. The balance of a plan participant’s benefit under the plan will be distributed upon the plan participant’s termination of employment or
death (to the plan participant’s beneficiary) in a lump sum, unless the participant elects to have the benefit paid in annual installments over a period of not more than ten years. Participants may invest their Deferred Compensation Plan account balance in any of the funds available under our Retirement Savings Plan and earnings are credited based on the performance of such funds.
NONQUALIFIED DEFERRED COMPENSATION
(1) Registrant Contributions are reported as “Contributions to Non-Qualified Deferred Compensation” in the All Other Compensation Table that supplements the Summary Compensation Table, and Executive Contributions are included in the “Base Salary” or “Non-Equity Incentive Plan Compensation” column in the Summary Compensation Table.
(2) The Aggregate Balance at Last FYE includes amounts reported in compensation in prior years. Registrant Contributions for Mr. Baughman were $17,381 in 2010 and $16,152 in 2009. Executive Contributions for Mr. Baughman were $46,350 in 2010 and $96,759 in 2009. Registrant Contributions for Mr. Naccarato were $12,822 in 2010 and $12,277 in 2009. Executive Contributions for Mr. Naccarato were $34,193 in 2010 and $32,738 in 2009.
Potential Payments upon Termination or Change in Control
The provisions of each Executive’s employment agreement regarding amounts he is entitled to receive upon certain terminations of employment are described in detail above in the section entitled “Employment Agreements.” The table below is the summary of the estimated termination and change in control benefits that would be paid to or received by each named executive officer if the relevant event occurred on December 31, 2011.
Mr. Baughman may also be entitled upon termination to certain payments under a Supplemental Pension Agreement with the Company dated as of April 6, 1999. However, in connection with the Acquisition, Alcoa Inc. retained the liabilities associated with the supplemental agreement. Mr. Baughman’s benefit under the supplemental agreement is determined in part with reference to his benefit under the Southern Graphic Systems, Inc. Pension Plan, which was also retained by Alcoa Inc. in the Acquisition. The amounts that Mr. Baughman would ultimately receive under the supplemental agreement will depend on the date Mr. Baughman elects to receive the benefits and will be between approximately $6,000 per month and $12,000 per month.
In addition, the amounts that each of the Executives would have received under the Deferred Compensation Plan if his employment was terminated for any reason on December 31, 2011 are reported above in the Nonqualified Deferred Compensation table.
TERMINATION AND CHANGE IN CONTROL BENEFITS
(1) If terminated without cause or for good reason, Mr. Baughman would be paid severance in the amount equal to fifty percent (50%) of his base salary and a non-competition/non-solicitation payment in the amount equal to fifty percent (50%) of his base salary, in each case for a period of twenty four (24) months. If Mr. Baughman were to breach his non-competition or non-solicitation restrictions, he would forfeit all rights to further payments and would be required to repay any severance he had received. Additionally, Mr. Baughman would be entitled to continued participation in the welfare benefit plans for a period of twenty four (24) months. Finally, Mr. Baughman would be paid an incentive bonus amount equal to the full target incentive bonus for the year terminated prorated by the number of months worked in the year terminated. For purposes of this table, the incentive bonus amount is assumed to equal the full target bonus for one year. In the case of termination for disability, Mr. Baughman would be entitled only to a pro-rata portion of his target incentive bonus for the year terminated.
(2) If terminated without cause or for good reason, Mr. Dahmus would be paid severance in the amount equal to fifty percent (50%) of his base salary and a non-competition/non-solicitation payment in the amount equal to fifty percent (50%) of his base salary, in each case for a period of twelve (12) months. If Mr. Dahmus were to breach his non-competition or non-solicitation restrictions, he would forfeit all rights to further payments and would be required to repay any severance he had received. Additionally, Mr. Dahmus would be entitled to continued participation in the welfare benefit plans for a period of twelve (12) months. Finally, Mr. Dahmus would be paid an incentive bonus amount equal to the full target incentive bonus for the year terminated prorated by the number of months worked in the year terminated. For purposes of this table, the incentive bonus amount is assumed to equal the full target bonus for one year. In the case of termination for disability, Mr. Dahmus would be entitled only to a pro-rata portion of his target management incentive bonus for the year terminated.
(3) If terminated without cause or for good reason, Mr. Naccarato would be paid severance in the amount equal to fifty percent (50%) of his base salary and a non-competition/non-solicitation payment in the amount equal to fifty percent (50%) of his base salary, in each case for a period of twenty four (24) months. If Mr. Naccarato were to breach his non-competition or non-solicitation restrictions, he would forfeit all rights to further
payments and would be required to repay any severance he had received. Additionally, Mr. Naccarato would be entitled to continued participation in the welfare benefit plans for a period of twenty four (24) months. Finally, Mr. Naccarato would be paid an incentive bonus amount equal to the full target incentive bonus for the year terminated prorated by the number of months worked in the year terminated. For purposes of this table, the incentive bonus amount is assumed to equal the full target bonus for one year. In the case of termination for disability, Mr. Naccarato would be entitled only to a pro-rata portion of his target management incentive bonus for the year terminated.
Compensation of Directors
Below is a summary of 2011 Director compensation. Directors (other than management directors) are paid $15,000 per year for serving on our Board of Directors and are reimbursed for out-of-pocket expenses incurred in connection with attending our Board of Directors meetings. Management directors receive no additional compensation for serving on the Board of Directors but are reimbursed for out-of-pocket expenses incurred in connection with attending our Board of Directors meetings.
DIRECTOR COMPENSATION
(1) Messrs. Silvestri and Civantos are affiliates of Court Square Advisor LLC, which receives an annual fee from the Company pursuant to an Advisory Agreement.
Compensation Committee Interlocks and Insider Participation
Messrs. Silvestri, Civantos and Hammond comprise our Compensation Committee. Messrs. Silvestri and Civantos are affiliates of Court Square Advisor LLC, which receives an annual fee of $0.5 million per year plus reasonable out-of-pocket expenses from the Company, pursuant to an Advisory Agreement. See the discussion under “Advisory Agreement” in Item 13.
Messrs. Silvestri and Civantos were officers of the Registrant before the Acquisition and resigned their positions on December 30, 2005 effective with the Acquisition. Mr. Hammond was the former Chief Executive Officer of Southern Graphic Systems, Inc. from 2000 until 2002, when he retired. None of our executive officers has a relationship that would constitute an interlocking relationship with executive officers or directors of another entity or insider participation in compensation decisions; however, Mr. Baughman, our President and Chief Executive Officer, makes recommendations to the Compensation Committee regarding compensation (other than his own) for the Company’s executive officers and officers at the level of Senior Vice President and above.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
All of the Registrant’s outstanding capital stock is held by Southern Graphics Inc. (“SGS Holdco”). The following table sets forth certain information regarding the beneficial ownership of SGS Holdco by (i) each person or entity known to us to own more than 5% of any class of the outstanding securities of SGS Holdco, (ii) each
member of the Registrant’s board of directors and each of our named executive officers and (iii) all members of the Registrant’s board of directors and executive officers as a group. The outstanding securities of SGS Holdco consist of approximately 996,674 shares of common stock and 969,719 shares of preferred stock. To our knowledge, each of such stockholders has sole voting and investment power as to the stock shown unless otherwise noted. Beneficial ownership of the securities listed in the table has been determined in accordance with the applicable rules and regulations promulgated under the Exchange Act.
Pursuant to Rule 13d-3 under the Securities Exchange Act of 1934, as amended, a person has beneficial ownership of any securities as to which such person, directly or indirectly, through any contract, arrangement, undertaking, relationship or otherwise has or shares voting power and/or investment power and as to which such person has the right to acquire such voting and/or investment power within 60 days. Percentage of beneficial ownership as to any person as of a particular date is calculated by dividing the number of shares beneficially owned by such person by the sum of the number of shares outstanding as of such date and the number of shares as to which such person has the right to acquire voting and/or investment power within 60 days.
Includes shares of Common Stock (717,467.988) and Preferred Stock (773,271.028) held by Court Square Capital Partners, L.P., shares of Common Stock (7,400.479) and Preferred Stock (7,976.069) held by CSC SSB Fund, L.P. and shares of Common Stock (6,593.814) and Preferred Stock (7,106.676) held by CVC Executive Fund LLC.
Includes options to acquire 1,500 shares of Common Stock under the Southern Graphics Inc. Stock Incentive Plan.
Court Square Advisor LLC, an independent company formed by the former managers of CSC, manages and has voting power with respect to the shares owned by Court Square Capital Partners, L.P., CSC SSB Fund, L.P., and CVC Executive Fund LLC. Messrs. Silvestri and Civantos are affiliates of Court Square Advisor LLC, which manages CSC’s investment in Southern Graphics Inc., and disclaim beneficial ownership of the shares held by CSC, CSC SSB Fund, L.P. and CVC Executive Fund LLC. The address of Mr. Silvestri and Mr. Civantos is c/o Court Square Capital Partners, L.P., Park Avenue Plaza, 55 East 52nd Street, 34th Floor, New York, NY 10055.
Includes shares of Common Stock held by the Silvestri 2002 Trust. Mr. Silvestri disclaims beneficial ownership of the shares held by the Silvestri 2002 Trust.
EQUITY COMPENSATION PLANS
The Registrant has no equity compensation plans under which equity securities of the Registrant are authorized for issuance. The following table provides information relating to the Southern Graphics Inc. Stock Incentive Plan as of December 31, 2011:
Southern Graphics Inc. is the sole shareholder of the Registrant’s outstanding common stock. This plan was approved by the Board of Directors of Southern Graphics Inc.
Item 13.
Item 13. Certain Relationships and Related Transactions, and Director Independence
EQUITY INVESTMENT
In connection with the Acquisition, CSC and SGS Holdco entered into a Stockholders’ Agreement providing for CSC’s investment in SGS Holdco and containing agreements among its stockholders with respect to certain rights and restrictions and with respect to its corporate governance. SGS Holdco contributed the proceeds from the sale of its equity interest to the Registrant. The following is a summary description of the principal terms of the equity investment provisions of the Stockholders’ Agreement.
Pursuant to the Stockholders’ Agreement and a related subscription agreement, CSC and certain employees of CSC purchased 1,000,000 shares of common stock of SGS Holdco for $10.0 million and 970,000 shares of perpetual preferred stock of SGS Holdco for $97.0 million. Since the closing of the Acquisition and through the end of December 2006, Messrs. Baughman, Dahmus and Naccarato along with other management investors purchased approximately 105,094.32 shares of common stock and 5,493.572 shares of perpetual preferred stock of SGS Holdco, in the aggregate, at the same purchase price per share as CSC. The proceeds from the sale of shares to management investors were used to repurchase an equivalent number of shares of SGS Holdco from CSC. In transactions in 2007 and January of 2008, SGS Holdco repurchased an aggregate of 10,849.06 shares of its common stock and 915.095 shares of its perpetual preferred stock from three management investors in connection with their termination of employment with the Company at an aggregate price of $232,220, and sold 7,522.934 of such common shares and 634.544 of such perpetual preferred shares to three new management investors for an aggregate price of $200,550. The common stock of SGS Holdco purchased by the management investors will vest in five equal annual installments or, in the case of Mr. Baughman, he will be fully vested upon retirement. All vesting of such common stock is subject to the employee’s continuous employment with us and the terms and conditions of the Stockholders’ Agreement, including SGS Holdco’s repurchase rights upon termination of employment. In addition, Mr. Hammond made an investment of $200,000 in SGS Holdco. Mr. Hammond purchased approximately 1,700 shares of common stock and 1,830 shares of perpetual preferred stock of SGS Holdco at the same price per share and in the same ratio as CSC. The purchase price for such shares consisted of $150,000 in cash and the waiver of a $50,000 consulting fee owed to Mr. Hammond from the Registrant. The proceeds were used to repurchase from CSC the same number of shares of common stock and perpetual preferred stock of SGS Holdco. In other transactions, Lyon Southern, Inc. (“Lyon”), an affiliate of Lyon Capital Management Pte. Ltd., of which Richard Leong serves as Managing Director, purchased approximately 127,000 shares of common stock and 137,000 shares of perpetual preferred stock of SGS Holdco, and other third party investors purchased approximately 8,500 shares of common stock and 9,150 shares of perpetual preferred stock of SGS Holdco, in each case at the same price per share and in the same ratio as CSC, with the proceeds being used to repurchase from CSC the same number of shares of
common stock and perpetual preferred stock of SGS Holdco. SGS Holdco has the right to redeem the shares of perpetual preferred stock at any time at a price equal to $100 per share plus dividends accrued to the date of redemption. The following chart sets forth a summary of such stock sales:
OTHER PROVISIONS OF THE STOCKHOLDERS’ AGREEMENT
Pursuant to the Stockholders’ Agreement, the stockholders of SGS Holdco will agree to take all actions so that its Board of Directors is composed of up to six directors, which so long as SGS Holdco has not consummated a public offering will include SGS Holdco’s CEO and up to five individuals designated by CSC. SGS Holdco’s board of directors currently consists of Messrs. Silvestri, Civantos, Baughman, Hammond and Leong.
The Stockholders’ Agreement contains provisions that, with some exceptions, restrict the ability of the stockholders to transfer any common stock or preferred stock of SGS Holdco except pursuant to the terms of the Stockholders’ Agreement. If holders of more than 50% of the common stock of SGS Holdco approve the sale of either the Company or SGS Holdco, which is known under the Stockholders’ Agreement as an approved sale, each stockholder has agreed to consent to the sale and, if the sale includes the sale of stock of SGS Holdco, each stockholder has agreed to sell all of its common stock and preferred stock of SGS Holdco on the terms and conditions approved by holders of a majority of the common stock of SGS Holdco then outstanding. In the event SGS Holdco proposes to issue and sell, other than in a public offering under a registration statement, any shares of its common stock or any securities containing options or rights to acquire any shares of its common stock or any securities convertible into its common stock to CSC or any of its respective affiliates, SGS Holdco must first offer to each of the other stockholders a pro rata portion of such shares. These preemptive rights will not be applicable to certain issuances of shares of SGS Holdco, including issuances of common stock of SGS Holdco upon conversion of shares of one class of common stock into shares of another class. Subject to some limitations (including the ability of CSC to sell to affiliates and to sell a portion of its holdings to other investors) CSC may not sell any of its shares of common stock without offering the other stockholders of SGS Holdco a pro rata opportunity to participate in the sale.
The related subscription agreement for management investors also provides for additional restrictions on transfer of shares of SGS Holdco by our executive officers and other employees, including the right of SGS Holdco to repurchase shares upon termination of the stockholder’s employment within five years of the date the stockholder acquired such shares. If the management investor resigns or is terminated without cause, the repurchase price for vested shares of common stock of SGS Holdco will be their fair market value and the repurchase price for unvested shares will be their cost. If the management investor is terminated for cause, the repurchase price for all shares of common stock of SGS Holdco will be based on the lower of cost or fair market value. The Stockholders’ Agreement also provides for a right of first refusal in favor of SGS Holdco in the event a management investor elects to transfer shares of stock of SGS Holdco.
The Stockholders’ Agreement also provides that in consideration for the opportunity to purchase common stock of SGS Holdco, each management investor released all claims against us and SGS Holdco (other than claims for compensation and benefits in the ordinary course of business) and agreed for a period of one year after his termination of employment to not (i) compete directly or indirectly with us, (ii) solicit or hire current and former employees, and (iii) solicit current and former customers.
REGISTRATION RIGHTS AGREEMENT
As part of the Stockholders’ Agreement, CSC and the other stockholders of SGS Holdco are parties to a registration rights agreement. Under the registration rights agreement, upon the written request of CSC, SGS Holdco
will prepare and file a registration statement with the Securities and Exchange Commission concerning the distribution of all or part of the shares of SGS Holdco held by CSC or its affiliates and use its best efforts to cause the registration statement to become effective. If at any time SGS Holdco files a registration statement for its common stock pursuant to a request by CSC, or otherwise (other than a registration statement on Form S-8, Form S-4 or any similar form, a registration statement filed in connection with a share exchange or an offering solely to our employees or its existing stockholders, or a registration statement registering a unit offering, which we refer to as a qualified offering), SGS Holdco will use its best efforts to allow the other parties to the registration rights agreement to have their shares of common stock of SGS Holdco (or a portion of their shares under some circumstances) included in the offering of common stock of SGS Holdco. Registration expenses of the selling stockholders (other than underwriting fees, brokerage fees and transfer taxes applicable to the shares sold by such stockholders or in some cases the fees and expenses of any accountants or other representatives retained by a selling stockholder) will be paid by SGS Holdco.
ADVISORY AGREEMENT
In connection with the Acquisition, we entered into an advisory agreement with CVC Management LLC. This agreement was assigned to Court Square Advisor LLC (“CS Advisor”) on July 31, 2006. CS Advisor may provide financial, advisory and consulting services to us under the advisory agreement. In exchange for these services, CS Advisor will be entitled to an annual advisory fee of $0.5 million per year plus reasonable out-of-pocket expenses. We have also agreed to pay CS Advisor a transaction fee in connection with the consummation of any acquisition, divestiture or financing with a value in excess of $25,000,000, including any refinancing, by us or any of our subsidiaries, in an amount equal to 1% of the value of the transaction, plus reasonable out-of-pocket expenses. This advisory agreement has an initial term of ten years from December 30, 2005, subject to automatic one year extensions thereafter unless terminated by either party upon written notice 90 days prior to the expiration of the initial term or any extension thereof. The advisory agreement automatically terminates on a change of control upon payment of the relevant transaction fee, and also terminates, upon payment of a fee based on the discounted value of the remaining annual advisory fees, on an initial public offering of SGS Holdco’s common stock. There are no minimum levels of service required to be provided pursuant to the advisory agreement. The advisory agreement includes customary indemnification provisions in favor of CS Advisor. Messrs. Silvestri and Civantos are affiliates of CS Advisor.
RELATED PERSONS POLICIES AND PROCEDURES
Our Board of Directors is responsible for reviewing and recommending action regarding potential material transactions with any related party. Related parties include any of our directors or executive officers, certain of our stockholders and their immediate family members. We expect our directors, officers and employees to act and make decisions that are in our best interests and encourage them to avoid situations which present a conflict between our interests and their own personal interests.
To identify related party transactions not otherwise brought to the Board’s attention, each year we require our directors, executive officers and certain stockholders to complete Director and Officer Questionnaires identifying any transactions with us in which the stockholder, officer or director or their family members have an interest. We review related party transactions due to the potential for a conflict of interest. A conflict of interest occurs when an individual’s private interest interferes, or appears to interfere, in any way with our interests.
If a potential conflict is identified the Board of Directors will review and discuss the transaction. At a minimum, we are required to comply with Section 144 of the Delaware General Corporation Law and therefore we may request that any implicated director recuse himself from the discussions and vote regarding the transaction.
Joseph Silvestri, one of our directors, has served and continues to serve as a director of one of our vendors. Investment funds managed by Mr. Silvestri’s affiliate, Court Square Capital Partners, acquired majority ownership of this vendor in April 2007. The Company purchased products from this vendor for approximately $5,155,000 in 2011, $5,531,000 in 2010, and $3,262,000 in 2009. The Company believes that these purchases, which represent approximately 1% or less of total revenues of the vendor in all three periods, were made on terms at least as favorable as would have been available from other parties. The Company used, and continues to use, this vendor as an additional source for the type of products purchased. John Civantos, who is also one of our directors, is also an affiliate of this vendor.
DIRECTOR INDEPENDENCE
As defined by NASDAQ Rule 5605(a)(2)
Member of Audit Committee
Member of Compensation Committee
Item 14.
Item 14. Principal Accountant Fees and Services
Aggregate fees billed to the Company for the fiscal years ending December 31, 2011 and 2010 by the Company’s principal accounting firm, BDO USA, LLP, were as follows:
Audit fees consist of fees billed or agreed to be billed for services relating to the audit of our Company’s annual financial statements and reviews of the interim financial statements. The tax fees for the fiscal year ended December 31, 2011 relate to professional services in connection with filings with the United States Internal Revenue Service. The Audit Committee pre-approves both the type of services to be provided by the Company’s principal accounting firm and the estimated fees related to these services. The services provided by BDO USA, LLP were pre-approved by the Audit Committee.
PART IV
Item 15.
Item 15. Exhibits and Financial Statement Schedules
Financial Statements
Our consolidated financial statements are filed on the pages listed below, as part of Part II, Item 8 of this report:
Schedules other than those mentioned above have been omitted because they are inapplicable, or not required, or the information is included in the financial statements or footnotes.
The following Exhibits are filed as part of this report:
* Management contract or compensatory plan or arrangement required to be filed as an exhibit pursuant to Item 601 of Regulation S-K.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Date: March 21, 2012
SGS INTERNATIONAL, INC.
By:
/s/ HENRY R. BAUGHMAN
Name:
Henry R. Baughman
Title:
President, Chief Executive Officer and Director
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.
Report of Independent Registered Public Accounting Firm
Board of Directors and Stockholder
SGS International, Inc.
Louisville, Kentucky
We have audited the accompanying consolidated balance sheets of SGS International, Inc. and subsidiaries as of December 31, 2011 and 2010 and the related consolidated statements of income, comprehensive income and stockholder’s equity, and cash flows for each of the three years in the period ended December 31, 2011. In connection with our audits of the financial statements, we have also audited the financial statement schedule listed in the accompanying index under Item 15. These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and 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. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements and schedule. 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 SGS International, Inc. and subsidiaries at December 31, 2011 and 2010, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2011, in conformity with accounting principles generally accepted in the United States of America.
Also, in our opinion, the financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.
/s/ BDO USA, LLP
Nashville, Tennessee
March 21, 2012
SGS International, Inc. and Subsidiaries
Consolidated Balance Sheets
As of December 31, 2011 and December 31, 2010
(in thousands of dollars, except share and per share data)
The accompanying notes are an integral part of the consolidated financial statements.
SGS International, Inc. and Subsidiaries
Consolidated Statements of Income
Years Ended December 31, 2011, December 31, 2010, and December 31, 2009
(in thousands of dollars)
The accompanying notes are an integral part of the consolidated financial statements.
SGS International, Inc. and Subsidiaries
Consolidated Statements of Comprehensive Income and Stockholder’s Equity
Years Ended December 31, 2011, December 31, 2010, and December 31, 2009
(in thousands of dollars)
The accompanying notes are an integral part of the consolidated financial statements.
SGS International, Inc. and Subsidiaries
Consolidated Statements of Cash Flows
Years Ended December 31, 2011, December 31, 2010, and December 31, 2009
(in thousands of dollars)
The accompanying notes are an integral part of the consolidated financial statements.
SGS International, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
Years Ended December 31, 2011, December 31, 2010, and December 31, 2009
(Dollars in thousands, except per share amounts and where otherwise noted)
A. Summary of Significant Accounting Policies
General Nature of Business
SGS International, Inc. (“the Company”), headquartered in Louisville, Kentucky, operates in one operating business segment, prepress graphic services. The Company provides a variety of services that include the preparatory steps that precede the actual printing of an image onto packaging material. The Company supplies photographic images, digital images, flexographic printing plates and rotogravure cylinders for the packaging printing industry. The Company has 39 locations in the United States, Canada, Mexico, the United Kingdom, the Netherlands, Hong Kong, the Philippines, and Argentina.
Principles of Consolidation
The accompanying consolidated financial statements include the accounts of SGS International, Inc., its wholly owned subsidiaries and companies more than fifty percent owned. These subsidiaries include Southern Graphic Systems, Inc., Project Dove Holdco, Inc., Project Dove Manitoba, L.P., Southern Graphic Systems-Canada, Co., Southern Graphic Systems Mexico, S. De R.L. De C.V, SGS Packaging Europe Holdings Limited, SGS Packaging Europe Limited, MCG Graphics Limited, The Box Room Limited, McGurk Studios Limited, Thames McGurk Limited, SGS Packaging Netherlands B.V., and SGS Asia Pacific Limited. These subsidiaries also include SGS Argentina S.R.L. from its inception in July 2011, SGS International Panama, S. de R.L. from its inception in September 2011, and SGS Packaging Chile Limitada from its inception in January 2009 through its dissolution in April 2010. These subsidiaries also included Backwell Design Inc. from May 2, 2008 through October 13, 2009, and Gemini Graphic Imaging Inc. from May 2, 2008 through September 9, 2009. On December 31, 2008, Backwell Design Inc. and Gemini Graphic Imaging Inc. transferred all of their assets and liabilities to Southern Graphic Systems-Canada, Co. and were dissolved on October 13, 2009 and September 9, 2009, respectively.
On June 30, 2010, The Box Room Limited, McGurk Studios Limited, and Thames McGurk Limited transferred all their assets and liabilities to MCG Graphics Limited. MCG Graphics Limited then changed its name to SGS Packaging Europe Limited. SGS Packaging Europe Limited was then renamed MCG Graphics Limited.
Use of Estimates
The consolidated financial statements are prepared in conformity with accounting principles generally accepted in the United States of America and require management to make certain estimates and assumptions. These assumptions may affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements. They may also affect the reported amounts of revenues and expenses during the reporting period. Areas that require significant judgments, estimates and assumptions include revenue recognition, accounts receivable and the allowance for doubtful accounts, work-in-process inventory, impairment of goodwill, other intangible assets and long-lived assets, accrued health and welfare benefits, and tax matters. Management uses historical experience and all available information to make these judgments. Actual results could differ from those estimates upon subsequent resolution of some matters.
Cash and Cash Equivalents
Cash and cash equivalents include all short-term, highly liquid investments that are readily convertible to known amounts of cash and have original maturities of three months or less.
Accounts Receivable and Allowance for Doubtful Accounts
Trade accounts receivable are recorded at the invoiced amount and do not bear interest. The allowance for doubtful accounts is the Company’s best estimate of the amount of probable credit losses in our existing accounts receivable. The Company determines the allowance by reviewing the accounts receivable from customers which are past due, as well as considering historical write-off experience and the creditworthiness of significant customers based on ongoing credit evaluations. Account balances are charged off against the allowance when it is probable the receivable will not be recovered. In addition, the Company maintains allowances for customer claims due to rejected services, billing errors, disputed amounts, and other items, which result in credit memos charged to net sales. The Company determines the allowance for claims based on historical experience and specific notification of pending claims. The Company does not have any off-balance-sheet credit exposure related to its customers.
Properties, Plants and Equipment
Properties, plants and equipment are recorded at cost. Depreciation is recorded principally on the straight-line method at rates based on the estimated useful lives of the assets, averaging 20 years for structures, between 3 and 10 years for machinery and equipment, and 3 years for software. The provision for depreciation also includes depreciation on assets under capital lease arrangements. Properties, plants and equipment are evaluated for impairment when indicators of impairment exist. (Gains) losses from the sale of assets of ($63), $305, and $160 are included in other expense (income) for the years ended December 31, 2011, 2010, and 2009, respectively. Repairs and maintenance are charged to expense as incurred.
Capitalized software costs are included in properties, plants and equipment. Capitalized costs include internal labor costs and external costs of materials and services during application development. Costs incurred during the preliminary project stage, as well as maintenance and training costs are expensed as incurred.
Goodwill and Other Intangible Assets
The Company has goodwill and other intangible assets, most notably customer relationships. Goodwill represents the excess of costs over the fair values of net assets of businesses acquired. Customer relationships are amortized generally on a straight-line basis over the periods benefited, with a weighted average useful life of approximately 20 years. Intangible assets with finite useful lives are amortized generally on a straight-line basis over the periods benefited, with a weighted average useful life of 20 years. Goodwill is not amortized, but instead is tested for impairment at least annually. The Company performs the annual test for impairment during the fourth quarter. The impairment test compares the carrying amount of the reporting unit to the fair value of the reporting unit.
The Company adopted Accounting Standards Update (“ASU”) 2011-08, “Intangibles - Goodwill and Other” effective October 1, 2011. In accordance with the provisions of ASU 2011-08, the Company determined, on the basis of qualitative factors, the fair value of the Company’s assets (including goodwill) is more likely than not greater than the carrying value of the Company’s assets. As such, further testing for impairment was unnecessary and no write-down in the carrying value of goodwill was recorded.
In connection with its goodwill impairment analysis for the years ended December 31, 2010 and December 31, 2009, the Company considered the three generally accepted approaches for valuing a business: the Income, Market and Cost approaches. Based on the nature of the Company’s businesses, its reporting unit’s current and expected financial performance, and comparable external market data from which to establish fair value, the Company determined that a 50% weighting of the Income approach and a 50% weighting of the Market approach appropriate in estimating the fair value of the single reporting unit under the first step of its impairment analysis. As such, the Company uses a discounted cash flow analysis consistent with its five year plan and market value of invested capital data from comparable companies that are publicly traded. The other key estimates and factors used include, but are not limited to, revenue and expense growth rates, changes in working capital, foreign exchange rates, and interest rates. The impairment tests in 2010 and 2009 supported the carrying value of goodwill, and as such, no write-downs in the carrying value of goodwill were recorded.
Impairments of Other Intangible Assets and Long-Lived Assets
Other intangible assets and long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable. Recoverability of assets is determined by a comparison of the projected undiscounted future cash flows from use and disposition of assets to the carrying amounts of those assets. When the sum of projected undiscounted cash flows is less than the carrying amount, impairment losses are recognized. In determining such impairment losses, discounted cash flows are utilized to determine the fair value of the assets being evaluated. The Company has not recorded impairment losses on other intangible assets or long-lived assets in the consolidated financial statements for 2011, 2010, or 2009.
Deferred Financing Costs
Deferred financing costs reflect costs incurred in connection with obtaining the financing for the Company’s acquisition of Southern Graphic Systems, Inc. and its affiliated businesses from its then parent, Alcoa Inc., on December 30, 2005 and the registration of the senior subordinated notes. Deferred financing costs are primarily amortized (included in interest expense) using the effective interest method, over the life of the related debt. During 2011, 2010 and 2009, the Company accelerated the amortization of deferred financing costs related to the December 2011 redemption of $15,000 of the Company’s 12% senior subordinated notes, the February 2009 cancellation of $25,500 of the Company’s 12% senior subordinated notes, and the optional principal repayments on the senior term loan. The Company recorded additional deferred financing costs of $1,094 related to the October 25, 2010 amendment and extension of its senior secured credit facility.
Accrued Health and Welfare Benefits
The Company is partially self-insured for health and welfare benefits. Our liability is limited by stop-loss insurance coverage provided by a third party. The accrual for health and welfare benefits is the Company’s best estimate of health and welfare costs incurred but not paid as of the balance sheet date. The Company estimates the liability for claims incurred by applying a lag factor to historical claims experience. As of December 31, 2011 and 2010, the Company had accrued $1,172 and $892, respectively, within accrued expenses for accrued health and welfare benefits.
Revenue Recognition
The Company records revenue in the period when the following requirements have all been met: (i) there is persuasive evidence of an arrangement, (ii) the sales price is fixed or determinable, (iii) title, ownership, and risk of loss have been transferred to the customer, and (iv) collectability is reasonably assured.
The majority of the Company’s service offerings result in the delivery of an electronic image file, an engraved gravure cylinder, or a flexographic printing plate after satisfaction of all the terms and conditions of the underlying arrangement. The Company recognizes revenue from the sale of such services when the deliverable is provided electronically or shipped and risk of loss has passed to the customer. For all other services that do not result in an electronic file or image carrier being delivered to the customer, revenues are recognized in the period the service is performed and accepted by the customer.
In circumstances where we derive revenue from arrangements involving multiple service offerings, total estimated revenue is allocated to each element based on the relative fair value of each element. The amount of revenue allocated to each element is limited to the amount that is not contingent upon the delivery of another element in the future. Revenue for each element is then recognized as described above depending upon when the service is performed and accepted by the customer, the electronic file was provided, or the image carrier was shipped.
Revenues are recorded net of allowances for customer rebates and cash discounts. The Company records an accrual at the end of each month for items that have shipped, but which have not yet been invoiced to the customer.
Rebates
The Company receives rebates from certain vendors. The Company records these rebates as a reduction of cost of goods sold. Receivables for vendor rebates are included as a component of prepaid expenses and other current assets.
The Company also grants rebates to certain customers. The Company records these rebates as a reduction of sales. Liabilities for customer rebates are included as a component of accrued expenses.
Inventories and Cost of Goods Sold
Raw materials inventory is valued at the lower of cost or market with cost determined using the first-in, first-out method. Work-in-process inventory is valued at the lower of cost or net realizable value. The cost of inventory is determined net of vendor rebates. There is no finished goods inventory since all deliverables are shipped upon completion. Raw materials inventory and work-in-process inventory are as follows:
Shipping and Handling Costs
The Company includes amounts invoiced to customers for shipping and handling costs as a component of net sales. Net sales included $4,822, $4,598, and $4,779 for amounts invoiced to customers for shipping and handling costs for the years ended December 31, 2011, 2010 and 2009, respectively.
Income Taxes
The provision for income taxes is determined using the asset and liability approach of accounting for income taxes. Under this approach, deferred taxes represent the future tax consequences expected to occur when the reported amounts of assets and liabilities are recovered or paid. The provision for income taxes represents income taxes paid or payable for the current year, plus the change in deferred taxes during the year. Deferred taxes result from differences between the financial and tax bases of the Company’s assets and liabilities and are adjusted for changes in tax rates and tax laws when changes are enacted. Valuation allowances are recorded to reduce the deferred tax assets when it is more likely than not that a tax benefit will not be realized. Amounts payable for non-U.S. income taxes are reflected in accrued income taxes.
The Company recognizes interest and penalties related to uncertain tax positions in income tax expense. There were no such amounts recognized for the years ended December 31, 2011, 2010 or 2009.
Tax returns filed for all years subsequent to and including the one-day ended December 31, 2005 are currently still subject to examination by taxing authorities.
Stock-Based Compensation
On July 25, 2006, the Board of Directors of Southern Graphics Inc. (the parent of SGS International, Inc.) adopted the Southern Graphics Inc. Stock Incentive Plan. The total shares available for grant under the Southern Graphics Inc. Stock Incentive Plan are not to exceed 31,000 shares. There were no options granted during the years ended December 31, 2011, 2010 or 2009. As of December 31, 2011 and 2010, there were options outstanding to acquire an aggregate of 9,100 shares and there were 21,900 remaining shares available for grant.
Compensation expense for share-based awards granted is based on the grant date fair value estimated and determined using the straight-line expense attribution method. The fair value of share-based awards is determined using the Black-Scholes option pricing model. The Company recorded less than $0.1 of compensation expense for share-based awards for the each of the years ended December 31, 2011, 2010, and 2009.
As of December 31, 2011 and 2010, there was $0.1 of total unrecognized compensation cost related to nonvested options outstanding. That cost is expected to be recognized over 10 years with an annual charge of less than $0.1.
The additional disclosures relating to the assumptions utilized in calculating the fair value of these options, have been omitted as the options and related disclosures are not material to the consolidated financial statements.
Foreign Currency
The local currency is the functional currency for locations in Canada, Mexico, the United Kingdom, the Netherlands, Hong Kong, the Philippines, and Argentina. Assets and liabilities of those operations denominated in foreign currencies are translated into U.S. dollars using period-end exchange rates, and income and expenses are translated using average exchange rates for the reporting period. Gains or losses from the translation are recorded as currency translation adjustment in other comprehensive income. Gains or losses resulting from transactions denominated in foreign currencies are included in other income or expense, within the consolidated statements of income. In 2011, 2010, and 2009, transaction losses recognized in the statement of operations due to exchange rate changes were $395, $860, and $1,735, respectively. We also have certain intercompany loans that are deemed to be permanently reinvested. Transaction gains and losses on these intercompany loans are charged to cumulative translation adjustment in other comprehensive income.
Fair Value Measurements
Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Assets and liabilities recorded at fair value are categorized upon the level of judgment associated with the inputs used to measure their values. These categories include (in descending order of priority): Level 1 inputs are observable inputs such as quoted prices in active markets; Level 2 inputs are inputs other than quoted prices in active markets that are either directly or indirectly observable; and Level 3 inputs are unobservable inputs in which little or no market data exists, therefore requiring an entity to develop its own assumptions.
Recently Issued and Adopted Accounting Standards
In December 2010, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2010-29, “Disclosure of Supplementary Pro Forma Information for Business Combinations.” ASU 2010-29 provides reporting guidance concerning the disclosure of supplementary pro forma information for business combinations, including clarifying the acquisition date that should be used for reporting pro forma financial information disclosures when comparative financial statements are presented. The Company adopted ASU 2010-29 effective January 1, 2011. The adoption of ASU 2010-29 had no impact on the Company’s results of operations or financial position.
In June 2011, the FASB issued ASU 2011-05, “Presentation of Comprehensive Income.” ASU 2011-05 requires companies to retrospectively present comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements, and eliminates the current option of presenting components of comprehensive income as part of the statement of changes in stockholder’s equity. ASU 2011-05 also will require companies to present on the face of the financial statements reclassification adjustments for items that are reclassified from other comprehensive income to net income. ASU 2011-05 became effective for the Company on January 1, 2012, although earlier adoption was permitted. The adoption of ASU 2011-05 will not have a material impact on the Company’s results of operations or financial position.
In September 2011, the FASB issued ASU 2011-08, “Intangibles - Goodwill and Other.” ASU 2011-08 allows an entity to first assess qualitative factors to determine whether it is necessary to perform the two-step quantitative goodwill impairment test. Under ASU 2011-08, an entity would not be required to calculate the fair value of a reporting unit unless the entity determines, based on a qualitative assessment, that it is more likely than not that its fair value is less than its carrying amount. The Company adopted ASU 2011-08 effective October 1, 2011. The adoption of ASU 2011-08 did not have a material impact on the Company’s results of operations or financial position.
B. Nature of Operations
The Company operates in a single reportable segment whose service offerings include package design, prepress, imaging and managing the entire graphics development cycle for customers in a broad spectrum of industries. Revenues for each of these service offerings have not been provided as the Company believes all of these offerings are, and as such manages them as, a similar service group. Additionally, it is not practicable for us to provide revenues by service offering. There was no single customer that comprised in excess of 10% of total revenues in 2011, 2010, or 2009.
The following summarizes the concentrations of sales and long-lived assets by major geographic region. Sales are attributed to the geographic region based on the point of origin of the sale.
C. Prepaid Expenses and Other Current Assets
D. Properties, Plants and Equipment, net
Depreciation expense on properties, plants, and equipment was $13,934, $13,668, and $13,497 for the years ended December 31, 2011, 2010 and 2009, respectively.
E. Goodwill and Other Intangible Assets
The changes in goodwill, cost of customer relationships and cost of other intangibles during 2011 are due to the following:
Amortization expense on customer relationships and other intangible assets was $10,754, $10,244, and $10,065 for the years ended December 31, 2011, 2010 and 2009, respectively.
Amortization of customer relationships and other intangible assets is estimated to be approximately $11,000 per year from 2011 through 2015.
Amortization of the payment for the exclusive supply agreement entered into during the year ended December 31, 2010 is recorded as a reduction in net sales. Such amortization was $833 and $736 for the years ended December 31, 2011 and 2010, respectively. Such amortization is expected to be $833 annually from 2012 through 2014 and $97 for 2015.
F. Accrued Expenses
G. Acquisitions
The Company has consummated acquisitions for a variety of reasons, including obtaining additional scale, acquiring a specific design or technical skill, achieving geographic diversification, strengthening existing customer relationships, forming new customer relationships and/or acquiring an underutilized asset that could more efficiently perform existing services within our organization.
Acquisitions during the year ended December 31, 2011
During the year ended December 31, 2011, the Company completed five acquisitions with an aggregate purchase price of $24,540. On February 11, 2011, Southern Graphic Systems, Inc. acquired the assets of Creative Type, a digital print company in Dallas, Texas. On April 29, 2011, Southern Graphic Systems-Canada, Co. acquired the assets of a Canadian provider of packaging and retail graphics services. On June 20,
2011, Southern Graphic Systems, Inc. acquired the assets of Photoengraving Incorporated, a business based in Tampa, Florida that provides the Company with expanded capabilities in the area of metal decorating and image carriers for beverage cans. On September 16, 2011, Southern Graphic Systems, Inc. acquired the assets of an Ohio-based gravure engraving / imaging business. On October 14, 2011, Southern Graphic Systems, Inc. acquired a photo studio in Chicago, Illinois.
The payment of $1,275 of the aggregate purchase price has been deferred until subsequent periods. The deferred purchase price consists of $400 presented as accrued expenses and $875 presented as non-current liabilities in the accompanying consolidated balance sheet.
The purchase price allocations for these acquisitions are provided below.
Results of operations of the acquisitions are included in the consolidated statements of operations from the date of each acquisition. Pro forma results of the Company, assuming each acquisition, or all the acquisitions in the aggregate, had been made at the beginning of each period presented, would not have been materially different from the results reported.
The Company made no material acquisitions during the years ended December 31, 2010 or 2009.
H. Long-Term Obligations
On October 25, 2010, the Company completed an amendment and extension of its senior secured credit facility originally provided under a credit agreement dated as of December 30, 2005 (the “Original Credit Agreement”). The Original Credit Agreement provided the Company a $193,700 senior secured credit facility offered by a syndicate of banks, financial institutions and other entities led by UBS Securities LLC and Lehman Brothers Inc. consisting of a $118,700 term loan facility, a $35,000 revolving credit facility, and a $40,000 loan facility for acquisitions. The Original Credit Agreement was amended by an amended and restated credit agreement dated as of October 25, 2010 (the “Amended and Restated Credit Agreement”). The Amended and Restated Credit Agreement incorporated the following amendments, among others: (i) extend the maturity of the revolving loans/commitments, term loans and acquisition loans until September 30, 2013; (ii) increase the aggregate amount of revolving commitments to $40,000; (iii) increase the margin for extending loans to LIBOR plus 3.5%; (iv) change the amortization for extending term loans and acquisition
loans to $5,000 per annum, payable on a quarterly basis; (v) permit $25,000 of repurchases of the Registrant’s outstanding 12% Senior Subordinated Notes Due 2013; and (vi) refresh covenant baskets as of October 25, 2010. Certain lenders who did not consent to the terms of the Amended and Restated Credit Agreement were repaid their loans effective November 29, 2010 and November 30, 2010.
The senior secured term loan and acquisition loan borrowings are payable in quarterly installments of $1,250 on a combined basis through June 2013, with the remaining amount due at maturity on September 30, 2013. The $57,671 of senior secured term loan borrowings outstanding at December 31, 2011 consisted of $44,478 of borrowings denominated in United States dollars, $7,418 of borrowings denominated in Canadian dollars, and $5,775 of borrowings denominated in pounds sterling. The senior secured term loan and acquisition loan borrowings under the Amended and Restated Credit Agreement bear interest at a variable rate of LIBOR plus 3.5%. At December 31, 2011, the weighted average interest rate on the senior secured term loan borrowings was 4.0% and the weighted average interest rate on the senior secured acquisition loan borrowings was 3.8%.
The senior secured credit facility requires mandatory prepayment, subject to certain exceptions and limitations, with: 100% of the net cash proceeds from asset sales by the Company; 100% of the net cash proceeds of issuances of debt or preferred stock by the Company; and 50% of the Company’s excess cash flow, as defined in the Amended and Restated Credit Agreement.
At December 31, 2011, $16,000 was outstanding on the revolving credit facility (the “Revolver”). At December 31, 2010, no amounts were drawn on the Revolver. Under the Amended and Restated Credit Agreement, the Revolver provides for $40,000 of borrowing availability. Unused portions of the Revolver are charged a fee of 0.75% under the Amended and Restated Credit Agreement compared to a fee of 0.50% under the Original Credit Agreement. Fees incurred on the unused portion of the Revolver were $280, $171, and $94 for the years ended December 31, 2011, 2010, and 2009, respectively. Borrowings on the Revolver bear interest at a variable rate of LIBOR plus 3.5% and are presented in current liabilities because of the Company’s intent and ability to repay these borrowings in 2012. At December 31, 2011, the interest rate on the borrowings on the Revolver was 3.8%. The Revolver is available through September 30, 2013.
The senior secured credit facility contains customary financial and other covenants, including a maximum leverage ratio and a minimum interest coverage ratio, as defined in the senior secured credit facility agreement. The senior secured credit facility also places certain restrictions on our ability to make capital expenditures. As of December 31, 2011, the Company was in compliance with these covenants.
In December 2005, the Company issued $200,000 of 12% senior subordinated notes maturing on December 15, 2013 (“Notes”). In February 2009, the Company’s wholly-owned subsidiary, Southern Graphic Systems, Inc., acquired an aggregate principal amount of $25,500 of the Notes for a cash purchase price of $15,000, together with accrued interest on the Notes. In December 2011, the Company voluntarily redeemed an additional $15,000 of the Notes. With the cancellation of these repurchased Notes in February 2009 and the redemption of Notes in December 2011, $159,500 aggregate principal amount of Notes remain outstanding. The Notes bear interest at the rate of 12% per year, which is payable semi-annually in arrears on June 15 and December 15 of each year. The Notes are general unsecured obligations and are guaranteed on a senior subordinated basis by certain of the Company’s subsidiaries and rank secondary to the Company’s senior secured credit facility. The Notes contain restrictive covenants as stated in the indenture agreement, including limitations on the Company’s ability to incur additional debt.
The capital lease obligations relate to vehicles and computer graphic design and related equipment. Lease payments are due in equal monthly installments and the leases mature at various dates through December 2017.
The following table provides the amount of long-term debt, including capital lease obligations, maturing in each of the next five years and thereafter.
I. Interest Expense
Interest expense consists of the following:
J. Other Expense, net
Other expense, net consists of the following:
K. Gain on Debt Extinguishment
In privately negotiated transactions that settled on February 13 and February 18, 2009, respectively, the Company’s wholly-owned subsidiary, Southern Graphic Systems, Inc., acquired SGS International, Inc.’s 12% senior subordinated notes maturing on December 15, 2013 in an aggregate principal amount of $25,500 for a cash purchase price of $15,000, resulting in a gain on debt extinguishment of $10,500.
L. Related Party Transactions
The Company incurred and paid management advisory fees of $500 annually during 2011, 2010 and 2009 to a related party in accordance with the Advisory Agreement between the Company and CVC Management LLC, which was assigned to Court Square Advisor LLC on July 31, 2006. The Company will pay $500 annually in advisory fees through 2015 in accordance with this Advisory Agreement.
One of our vendors is a related party as the majority owner of that vendor is a third party that could exert significant influence over both the Company and that vendor. Purchases from that vendor were approximately $5,155, $5,531, and $3,262, during the years ended December 31, 2011, 2010, and 2009, respectively. Payable amounts outstanding to this vendor were approximately $605 and $670 at December 31, 2011 and 2010, respectively. Our payable terms with this vendor are consistent with the terms offered by other vendors in the ordinary course of business and there were no significant changes in terms with this vendor during the years ended December 31, 2011, 2010, or 2009.
M. Lease Expense
Certain buildings and office space are under non-cancelable operating lease agreements. Total expense for all leases was $8,722, $8,884, and $9,017, in 2011, 2010, and 2009, respectively. Under long-term leases, minimum annual rentals are $6,114 in 2012, $4,501 in 2013, $3,705 in 2014, $2,710 in 2015, $2,335 in 2016 and $6,166 thereafter.
N. Employee Benefit Contribution Plans
Defined Contribution Plan
The Company offers the Southern Graphic Systems, Inc. Savings Plan (the “Savings Plan”), a defined contribution plan under Section 401(k) of the Internal Revenue Code, for the benefit of eligible employees and their beneficiaries. The Savings Plan is funded with both employer and employee contributions. Participants in the Savings Plan may voluntarily contribute a portion of their annual pay into the Savings Plan, not to exceed an annual dollar limitation established by the United States Internal Revenue Service. The Savings Plan provides that the Company may make matching contributions in an amount to be determined by the Board of Directors, which amount for each payroll period shall not be greater than 100% of the participant’s elective deferrals that do not exceed the first 6% of the participant’s compensation for the payroll period. In addition, the Savings Plan provides that, for any plan year, the Company may make discretionary contributions in an amount to be determined by the Board of Directors as of the last day of the plan year on behalf of each participant, subject to certain Internal Revenue Code limitations.
The Company offers a separate defined contribution plan under Section 401(k) of the Internal Revenue Code for the benefit of eligible employees at its Tampa, Florida facility, and their beneficiaries. This plan, the Photoengraving Inc. 401(k) Plan (the “Tampa Plan”), is separate from the Savings Plan and is offered to eligible employees as a result of June 2011 acquisition of the assets of Photoengraving Incorporated. The Tampa Plan provides for a Company match that is different than the Savings Plan. The Company intends to discontinue the Tampa Plan at the end of 2012.
Employer contributions to the Savings Plan and the Tampa Plan are included in costs of operations and were $3,957, $3,571, and $3,520 in 2011, 2010, and 2009, respectively. There were no discretionary contributions in 2011, 2010, or 2009.
Nonqualified Deferred Compensation Plan
The Company has a nonqualified deferred compensation plan, the Southern Graphic Systems, Inc. Deferred Compensation Plan (“NQDC Plan”), for the benefit of employees defined by the Internal Revenue Service as highly compensated. The NQDC Plan is funded with both employer and employee contributions. Participants in the NQDC Plan may voluntarily contribute up to an amount equal to (a) the amount the participant would have deferred under the Savings Plan if the annual qualified plan limits did not apply minus (b) the participant’s actual deferral to the Savings Plan. The NQDC Plan provides that the Company may make matching contributions in an amount to be determined by the Board of Directors, which amount for each payroll period shall not be greater than 100% of the participant’s elective deferrals that do not exceed the first 6% of the participant’s compensation for the payroll period. In addition, the NQDC Plan provides that, for any NQDC Plan year, the Company may make discretionary contributions in an amount to be determined by the
Board of Directors as of the last day of the NQDC Plan year on behalf of each participant, subject to certain Internal Revenue Code limitations. Employer contributions to the NQDC Plan are included in costs of operations and were $90, $72, and $74 in 2011, 2010, and 2009, respectively. There were no discretionary contributions in 2011, 2010, or 2009.
Changes in the fair value of the trading securities related to the NQDC Plan and the corresponding change in the associated liability are included within other expense (income) in the Consolidated Statements of Operations. Historically, these changes have resulted in no impact to the Consolidated Statements of Operations.
O. Income Taxes
As a result of certain tax elections made in 2011, Project Dove Manitoba, L.P. is now being taxed as a U.S. entity. Therefore, the income before taxes for this entity is included in U.S. income in 2011, but was recorded as foreign income before taxes in previous years. Additionally, deferred tax assets and liabilities related to Project Dove Manitoba L.P. were previously recorded as foreign deferred tax items. In 2011, these deferred amounts have been moved to the U.S. and are recorded as U.S. deferred items. These changes resulted in a significant foreign deferred tax benefit and U.S. deferred tax expense in 2011.
The components of income (loss) before taxes were:
The provision (benefit) for taxes on income consisted of:
The reconciliation between the provision for taxes on income (loss) computed by applying the federal statutory tax rate to income (loss) before taxes and the actual provision is as follows:
(1) The impact for the rate changes in 2011 were primarily due to a revision in the calculation of state tax liabilities expected in the United States following the election to repatriate income from foreign subsidiaries.
The components of net deferred tax assets and liabilities at December 31, 2011 and 2010 were as follows:
At December 31, 2010, the Company recorded a valuation allowance against a portion of its foreign tax credit carryforwards because it was more likely than not that this portion of the carryforwards will not be realized. During the year ended December 31, 2011, the Company determined the foreign tax credit carryforwards could be utilized and accordingly released the related valuation allowance.
As of December 31, 2010, the Company recorded a deferred tax liability on $23,342 of interest income in a U.S. controlled foreign corporation that would become taxable income when repatriated. In January of 2011, the Company filed an election to repatriate this income, therefore, the related tax liability was realized in 2011 resulting in the utilization of a significant portion of the net operating loss carryforwards.
The Company has not recorded a deferred tax liability for undistributed earnings of certain international subsidiaries because such earnings are considered permanently invested in foreign countries. As of December 31, 2011 and 2010, undistributed earnings of international subsidiaries considered permanently reinvested were approximately $12,361 and $5,735, respectively. The unrecognized deferred tax liability is dependent on many factors, including withholding taxes under current tax treaties and foreign tax credits. Determination of the amount of unrecognized deferred income tax liability related to these earnings is not practicable. The Company does not consider undistributed earnings from certain other international operations to be permanently reinvested. A portion of the estimated tax liabilities upon repatriation of earnings from these international operations is expected to be offset with foreign tax credits.
During 2010 the Company elected to defer the recognition, for tax purposes, of a $10,500 gain on debt extinguishment, which had previously been included as income in the Company’s 2009 tax provision calculations. Under this election, income is deferred until the fifth year after the gain on debt extinguishment, and is then recognized ratably over the subsequent five years. Making this election resulted in an increase of both deferred tax liabilities, as a result of deferring the $10,500 gain for tax purposes, and deferred tax assets, in the form of net operating loss carryforwards. In addition, this resulted in an alternative minimum tax (AMT) credit for estimated AMT taxes paid as a result of including the gain in the 2009 tax provision calculations. This AMT credit was reversed in 2010 due to the election to defer the recognition of the $10,500 gain on debt extinguishment.
On December 15, 2008 the United States and Canada exchanged instruments of ratification to place in force the Fifth Protocol of the U.S.-Canada Tax Treaty (Fifth Protocol). Included in the Fifth Protocol were provisions that affected certain hybrid entities that receive or pay cross border payments. The hybrid provisions in the Fifth Protocol became effective January 1, 2010. To minimize the overall tax impact of the Fifth Protocol, SGS filed an election to essentially repatriate $23,342 of intercompany interest back to the United States for tax purposes and reduce the withholding tax rate on all future intercompany interest, including amounts previously accrued but unpaid from 25% to 0%. As of December 31, 2010, the Company recorded a net deferred tax liability and associated withholding tax expenses totaling $1,594 on intercompany interest accrued but unpaid. This tax expense was reversed in 2011 when the election the Company filed became effective.
P. Fair Value of Financial Instruments
The estimated fair value of the Company’s investments in the non-qualified Southern Graphic Systems, Inc. Deferred Compensation Plan and the related offsetting liability are presented at fair value in the Company’s balance sheets. Investments in the Southern Graphic Systems, Inc. Deferred Compensation Plan are included in other assets and the offsetting liability is included in non-current liabilities on the Company’s consolidated balance sheets.
The following table shows assets measured at fair value as of December 31, 2011 on the Company’s balance sheet, and the input categories associated with those assets:
(a) The Company also has an offsetting liability related to the Deferred Compensation Plan, which is not disclosed in the table above as it is not independently measured at fair value.
The fair value of financial instruments including cash and cash equivalents, accounts receivable and accounts payable approximates carrying value. The Company’s Notes have a carrying value of $159,500 and an estimated fair value of $160,648 at December 31, 2011. The estimated fair value of the Notes is determined using quoted prices in markets that are not active. The estimated fair value is $160,648 based on the average price of the Notes either traded or purchased by third parties between January 1, 2012 and February 29, 2012.
The Company’s capability to repurchase the senior subordinated debt at fair value is limited due to the terms of the Company’s senior secured credit facility.
Q. Cash Flow Information
Cash paid for interest was $24,989, $25,433, and $26,566 for the years ended December 31, 2011, 2010, and 2009, respectively.
Cash paid for income taxes was $3,571, $147 and $880 for the years ended December 31, 2011, 2010 and 2009, respectively.
Assets acquired under capital lease obligations were $461 for the year ended December 31, 2010. There were no assets acquired under capital lease obligations for the years ended December 31, 2011 or December 31, 2009.
R. Contingencies and Commitments
Various lawsuits, claims and proceedings have been or may be instituted or asserted against entities within the Company. While the amounts claimed may be substantial, the ultimate liability cannot be determined because of the considerable uncertainties that exist. Therefore, it is possible that results of operations or liquidity in a particular period could be materially affected by certain contingencies. However, based on currently available facts and in light of legal and other defenses available to us, management believes that the disposition of matters that are pending or asserted will not have a materially adverse effect on the Company’s financial position, results of operations, and liquidity.
Selling, general, and administrative expenses for the year ended December 31, 2011 include a one-time final confidential settlement of a legal proceeding for an amount less than $5.0 million.
S. Supplemental Guarantor Information
The Company’s debt includes the senior secured credit facility and the 12% senior subordinated notes. The U.S. borrowings under the senior secured credit facility have been guaranteed by Southern Graphics Inc. (the parent of SGS International, Inc.), Southern Graphic Systems, Inc. and Project Dove Holdco, Inc. The Canadian borrowings under the senior secured credit facility have been guaranteed by SGS Packaging Europe Holdings Limited, SGS Packaging Europe Limited, MCG Graphics Limited, Southern Graphic Systems
Mexico, S. De R.L. De C.V., The Box Room Limited, SGS Packaging Netherlands, B.V., McGurk Studios Limited, Thames McGurk Limited, SGS Asia Pacific Limited, SGS Argentina S.R.L., Southern Graphic Systems, Inc., Project Dove Holdco, Inc., Project Dove Manitoba, L.P., Southern Graphics Inc., and SGS International, Inc. The senior subordinated notes are general unsecured obligations and are guaranteed on a senior subordinated basis by the Company’s domestic subsidiaries and rank secondary to the Company’s senior secured credit facility. Guarantor subsidiaries for the senior subordinated notes include Southern Graphic Systems, Inc. and Project Dove Holdco, Inc. Non- Guarantor subsidiaries for the senior subordinated notes include the direct and indirect foreign subsidiaries. The subsidiary guarantors are 100% owned by SGS International, Inc., the guarantees are full and unconditional, and the guarantees are joint and several.
Following are condensed consolidating financial statements of the Company. Investments in subsidiaries are either consolidated or accounted for under the equity method of accounting. Intercompany balances and transactions have been eliminated.
Supplemental Condensed Consolidating Balance Sheet
December 31, 2011
(in thousands of dollars, except share and per share data)
Supplemental Condensed Consolidating Balance Sheet
December 31, 2010
(in thousands of dollars, except share and per share data)
Supplemental Consolidating Statement of Operations
For the Year Ended December 31, 2011
(in thousands of dollars, except share and per share data)
Supplemental Consolidating Statement of Operations
For the Year Ended December 31, 2010
(in thousands of dollars, except share and per share data)
Supplemental Consolidating Statement of Operations
For the Year Ended December 31, 2009
(in thousands of dollars, except share and per share data)
Supplemental Condensed Consolidating Statement of Cash Flows
For the Year Ended December 31, 2011
(in thousands of dollars, except share and per share data)
Supplemental Condensed Consolidating Statement of Cash Flows
For the Year Ended December 31, 2010
(in thousands of dollars, except share and per share data)
Supplemental Condensed Consolidating Statement of Cash Flows
For the Year Ended December 31, 2009
(in thousands of dollars, except share and per share data)
Schedule II-Valuation and Qualifying Accounts