Pro forma compensation expense for options is reflected over the vesting period; therefore, future pro forma compensation expense may be greater as additional options are granted. No options were granted during the nine months ended October 1, 2005.
The Company accounts for income taxes under SFAS No. 109, “Accounting for Income Taxes.” This statement requires that the Company recognize a current tax liability or asset for current taxes payable or refundable and a deferred tax liability or asset for the estimated future tax effects of temporary differences and carryforwards to the extent they are realizable. A valuation allowance is recorded to reduce the Company’s deferred tax assets to the amount that is more likely than not to be realized. While management has considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for the valuation allowance, in the event management were to determine that the Company would be able to realize deferred tax assets in the future in excess of the net recorded amount, an adjustment to the deferred tax asset would increase income in the period such determination was made. Likewise, should management determine that the Company would not be able to realize all or part of its net deferred tax asset in the future, an adjustment to the deferred tax asset would be charged to income in the period such determination was made. The Company does not provide for United States income taxes on earnings of subsidiaries outside of the United States. The Company’s intention is to reinvest these earnings permanently. Management believes that United States foreign tax credits would largely eliminate any United States taxes or offset any foreign withholding taxes.
The Company determines its periodic income tax expense based upon the current period income and the estimated annual effective tax rate for the Company. The rate is revised, if necessary, as of the end of each successive interim period during the fiscal year to the Company’s best current estimate of its annual effective tax rate.
During the second quarter of 2005, the Company settled tax assessments from the Massachusetts Department of Revenue (MDOR) for the years 1993-1998. In addition, the Company settled refund claims from amended tax returns filed with the MDOR claiming approximately $1,400 of research and development tax credits for the years 1993-2001 and additional credits of $700 claimed on the originally filed tax returns for 2002 and 2003. Settlement of these claims allowed the Company to record a tax benefit during the second quarter of $1,800, or $1,167, net of applicable federal taxes.
The Company maintains a deferred compensation plan for certain senior executives of the Company. Benefits payable upon retirement are grossed up by the Company’s marginal tax rate. During the first quarter of 2005, the Company reduced Other Long-term Liabilities and Selling, General, and Administrative expenses by approximately $575, primarily due to four executives contractually waiving their rights to have their benefit grossed up by the marginal tax rate.
In March 2005, the FASB issued Interpretation No. 47, “Accounting for Conditional Asset Retirement Obligations,” (FIN 47). FIN 47 clarifies that the term “conditional asset retirement obligation” as used in SFAS No. 143, “Accounting for
Asset Retirement Obligations,” refers to a legal obligation to perform an asset retirement activity in which the timing and (or) method of settlement are conditional on a future event that may or may not be within the control of the entity. FIN 47 is effective no later than the end of fiscal years ending after December 15, 2005 and will be effective for the Company on December 31, 2005. The Company does not expect there to be any material effect on its consolidated financial statements upon adoption of the new standard.
In December 2004, the FASB issued SFAS No. 123 (revised), “Share-Based Payment.” Statement 123 (revised) replaces SFAS No. 123, “Accounting for Stock-Based Compensation,” and supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees.” Statement 123 (revised) covers a wide range of share-based compensation arrangements and requires that the compensation cost related to these types of payment transactions be recognized in financial statements. Cost will be measured based on the fair value of the equity or liability instruments issued. Statement 123 (revised) becomes effective for years beginning after June 15, 2005 and will be effective for the Company beginning in the first quarter of 2006. The Company is currently assessing the impact of SFAS 123 (revised) on its consolidated financial statements.
In November 2004, the FASB issued SFAS No. 151, “Inventory Costs,” which amends the guidance in ARB No. 43, Chapter 4, “Inventory Pricing.” This amendment clarifies the accounting for abnormal amounts of idle facility expense, freight, handling costs and wasted material (spoilage). SFAS No. 151 requires that those items be recognized as current-period charges regardless of whether they meet the criteria specified in ARB 43 of “so abnormal.” In addition, SFAS No. 151 requires that allocation of fixed production overheads to the costs of conversion be based on normal capacity of the production facilities. SFAS No. 151 is effective for financial statements for fiscal years beginning after June 15, 2005. The Company is currently assessing the impact of SFAS No. 151 on its consolidated financial statements.
In December 2004, the FASB issued FASB Staff Position No. FAS 109-1, “Application of FASB Statement No. 109, Accounting for Income Taxes, to the Tax Deduction on Qualified Production Activities Provided by the American Jobs Creation Act of 2004,” indicating that this deduction should be accounted for as a special deduction in accordance with the provisions of SFAS No. 109. Beginning in 2005, as qualifying activity occurs the Company will recognize allowable deductions through timely adjustments in its effective tax rate.
In December 2004, the FASB issued Staff Position No. FAS 109-2, “Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004,” which provides a practical exception to the SFAS No. 109 requirement to reflect the effect of a new tax law in the period of enactment by allowing additional time beyond the financial reporting period to evaluate the effects on plans for reinvestment or repatriation of unremitted foreign earnings. The adoption of FAS 109-2 does not have any material effect on the Company’s consolidated financial statements.
Item 2. | MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS |
The Company’s fiscal year is a 52 or 53 week period ending on the Saturday closest to January 1. “Fiscal 2004” was a 52 week period ended January 1, 2005 and “Fiscal 2005” will be a 52 week period ending December 31, 2005. The first nine months of Fiscal 2004 and Fiscal 2005 ended October 2, 2004 and October 1, 2005, respectively.
Critical Accounting Policies
The Company considered the disclosure requirements of Financial Reporting Release No. 60 regarding critical accounting policies and Financial Reporting Release No. 61 regarding liquidity and capital resources, certain trading activities and related party/certain other disclosures, and concluded that there were no material changes during the first nine months of 2005 that would warrant further disclosure beyond those matters previously disclosed in the Company’s Annual Report on Form 10-K for the year ended January 1, 2005.
Recently Issued Statements of Financial Accounting Standards, Accounting Guidance and Disclosure Requirements
In March 2005, the FASB issued Interpretation No. 47, “Accounting for Conditional Asset Retirement Obligations,” (FIN 47). FIN 47 clarifies that the term “conditional asset retirement obligation” as used in SFAS No. 143, “Accounting for Asset Retirement Obligations,” refers to a legal obligation to perform an asset retirement activity in which the timing and (or) method of settlement are conditional on a future event that may or may not be within the control of the entity. FIN 47 is effective no later than the end of fiscal years ending after December 15, 2005 and will be effective for the Company on December 31, 2005. The Company does not expect there to be any material effect on its consolidated financial statements upon adoption of the new standard.
In December 2004, the FASB issued SFAS No. 123 (revised), “Share-Based Payment.” Statement 123 (revised) replaces SFAS No. 123, “Accounting for Stock-Based Compensation,” and supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees.” Statement 123 (revised) covers a wide range of share-based compensation arrangements and
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requires that the compensation cost related to these types of payment transactions be recognized in financial statements. Cost will be measured based on the fair value of the equity or liability instruments issued. Statement 123 (revised) becomes effective for years beginning after June 15, 2005. The Company is currently assessing the impact of SFAS 123 (revised) on its consolidated financial statements.
In November 2004, the FASB issued SFAS No. 151, “Inventory Costs,” which amends the guidance in ARB No. 43, Chapter 4, “Inventory Pricing.” This amendment clarifies the accounting for abnormal amounts of idle facility expense, freight, handling costs and wasted material (spoilage). SFAS No. 151 requires that those items be recognized as current-period charges regardless of whether they meet the criteria specified in ARB 43 of “so abnormal.” In addition, SFAS No. 151 requires that allocation of fixed production overheads to the costs of conversion be based on normal capacity of the production facilities. SFAS No. 151 is effective for financial statements for fiscal years beginning after June 15, 2005 and will be effective for the Company beginning in the first quarter of 2006. The Company is currently assessing the impact of SFAS No. 151 on its consolidated financial statements.
In December 2004, the FASB issued FASB Staff Position No. FAS 109-1, “Application of FASB Statement No. 109, Accounting for Income Taxes, to the Tax Deduction on Qualified Production Activities Provided by the American Jobs Creation Act of 2004,” indicating that this deduction should be accounted for as a special deduction in accordance with the provisions of SFAS No. 109. Beginning in 2005, as qualifying activity occurs the Company will recognize allowable deductions through timely adjustments in its effective tax.
In December 2004, the FASB issued Staff Position No. FAS 109-2, “Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004,” which provides a practical exception to the SFAS No. 109 requirement to reflect the effect of a new tax law in the period of enactment by allowing additional time beyond the financial reporting period to evaluate the effects on plans for reinvestment or repatriation of unremitted foreign earnings. The adoption of FAS 109-2 does not have any material effect on the Company’s consolidated financial statements.
General
Quaker is a leading designer, manufacturer and worldwide marketer of a broad range of woven upholstery fabrics which it sells at various price points primarily to manufacturers of residential furniture. The Company is also a leading developer and manufacturer of specialty yarns. Approximately 14.3% of the Company’s net revenues during the first nine months of 2005 were attributable to fabrics sold outside the United States and approximately 60.0% of Quaker’s fabrics are manufactured to customer order.
Competition in the industry is intense, from both domestic fabric mills and fabric mills located outside the U.S. manufacturing products for sale into the U.S. market. In addition, there has been a recent and significant increase in imports of both furniture coverings and fully upholstered furniture into the U.S. market, with industry data indicating that sales of imported fabrics in both roll and “kit” form represented approximately 42% of total U.S. fabric sales during 2004, up from 29% in 2003 and 11% in 2002. Competition in the U.S. domestic market has intensified as a result of the January 1, 2005 expiration of the quotas imposed under the Uruguay Round Agreement on Textiles and Clothing on textile and apparel products coming into the U.S.
The Company’s fabric products compete with other furniture coverings, including leather, suede, microdenier “faux suede,” prints, tufts, flocks and velvets, for consumer acceptance. Consumer tastes in upholstered furniture coverings are somewhat cyclical and do change over time, with various coverings gaining or losing share depending on changes in home furnishing trends and the amount of retail floor space allocated to various upholstered furniture product categories at any given time. For example, leather furniture and furniture covered with microdenier faux suede products, primarily imported in roll and “kit” form from low labor cost countries, particularly China, have enjoyed growing popularity over the past few years, primarily at the expense of woven fabrics, such as the Jacquards and other woven fabrics Quaker manufactures, and in some retail furniture stores, these products may occupy as much as 50% of the floor space allocated to upholstered furniture products.
Competitive factors in the industry include product design, product pricing, customer service and quality. Competition from lower cost imported products has increased, particularly from those products coming into the United States from China. Management considers such factors as incoming customer order rates, size of production backlog, manufacturing efficiencies, product mix and price points in evaluating the Company’s financial condition and operating performance. Incoming orders during the first nine months of 2005 were down approximately 21.9% compared to the first nine months of 2004. The total backlog of fabric and yarn products at the end of the first nine months of 2005 was down $3.8 million compared to that of a year ago, with the dollar value of the yarn backlog up $0.3 million or 30.2% and the dollar value of the fabric backlog down $4.1 million or 22.1%.
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Results of Operations - Quarterly Comparison
Net Sales. Net sales for the third quarter of 2005 decreased $17.1 million, or 26.9%, to $46.5 million from $63.6 million in the third quarter of 2004. Net fabric sales within the United States decreased 30.7%, to $35.8 million in the third quarter of 2005 from $51.7 million in the third quarter of 2004, as a result of continued competition from leather, microdenier faux suede and other furniture coverings being imported into the U.S. in roll and “kit” form, primarily from low labor cost countries in Asia. Net foreign sales of fabric decreased 14.8%, to $6.3 million in the third quarter of 2005 from $7.4 million in the third quarter of 2004. This decrease in foreign sales was due primarily to lower sales in Mexico, Canada, Europe and the Middle East. In Mexico, the Company competes primarily with Mexican weavers which typically offer their products at prices lower than the Company’s. The Company has lost some additional market share to these lower cost local mills. Sales in Europe declined primarily due to general economic weakness. In Canada, where furniture manufacturers sell furniture into both the United States and Canadian markets, strong competition from imported faux suede fabrics and leather continued during the third quarter of 2005 and contributed to a more difficult competitive environment. The political climate in the Middle East, as well as increased competition from Turkish and Chinese fabric manufacturers, negatively impacted sales into that region during the third quarter of 2005. Net yarn sales decreased to $4.4 million in the third quarter of 2005 from $4.5 million in the third quarter of 2004, with the decrease in the third quarter of 2005 principally due to lower craft yarn sales to a single customer. Sales to this customer accounted for 70.2% of third quarter 2005 and 48.2% of third quarter 2004 yarn sales. While the fourth quarter outlook is for significantly lower yarn sales, management believes the Company’s yarn sales have potential for future growth beginning during the first quarter of 2006.
The gross volume of fabric sold decreased 31.6%, to 7.0 million yards in the third quarter of 2005 from 10.2 million yards in the third quarter of 2004. The weighted average gross sales price per yard increased 4.0%, to $6.04 in the third quarter of 2005 from $5.81 in the third quarter of 2004, as a result of a general price increase effective April 2005 and product mix changes. The Company sold 32.5% fewer yards of middle to better-end fabrics and 30.2% fewer yards of promotional-end fabrics in the third quarter of 2005 than in the third quarter of 2004. The average gross sales price per yard of middle to better-end fabrics increased by 5.7%, to $7.29 in the third quarter of 2005 from $6.90 in the third quarter of 2004. The average gross sales price per yard of promotional-end fabrics increased by 0.7%, to $4.12 in third quarter of 2005 from $4.09 in the third quarter of 2004.
Gross Margin. The gross margin percentage for the third quarter of 2005 decreased to 13.1%, as compared to 18.4% for the third quarter of 2004. The decline in sales volume in the third quarter of 2005 as compared to the third quarter of 2004 resulted in an increase in fixed costs per unit, contributing 230 basis points to the gross margin decline. In addition, higher energy costs and higher raw material costs each contributed 150 basis points to the gross margin decline.
As part of the consolidation of manufacturing and warehousing facilities, the Company incurred $430,000 of moving and duplicate occupancy costs during the third quarter of 2005. These costs are included in cost of goods sold.
Restructuring and Asset Impairment Charges. During the three month period ended October 1, 2005, the Company reported a restructuring and asset impairment charge of $6.0 million. During the third quarter of 2005, the Company decided to close its manufacturing facility located at 763 Quequechan Street in Fall River, Massachusetts and offer the building for sale. As a result of this change in use, the building and certain of the equipment in it were evaluated for impairment in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” Based on the projected gross cash flows expected from this equipment and facility, the Company determined that these assets were impaired and recorded a charge of $5.3 million. In addition, due to recent weakness in upholstery fabric orders, the Company evaluated its prepaid marketing materials for impairment. As a result of this analysis, the Company determined that a portion of this asset had been impaired and recorded a charge of $707,000.
Selling, General and Administrative Expenses. Selling, general and administrative expenses decreased to $10.5 million in the third quarter of 2005 as compared to $14.2 million in the third quarter of 2004, primarily due to lower sales commissions as a result of lower sales and a decrease in payroll costs attributable to staffing reductions. Selling, general and administrative expenses as a percentage of net sales were 22.7% and 22.3% in the third quarters of 2005 and 2004, respectively. Selling, general and administrative expenses were higher as a percentage of net sales due to lower sales.
Interest Expense. Interest expense decreased to $0.8 million in the third quarter of 2005 from $0.9 million in the third quarter of 2004, primarily due to the repayment of senior debt with higher interest rates.
Effective Tax Rate. The Company’s effective tax rate was a benefit of 36.2% in the third quarter of 2005 compared to a benefit of 35.5% in the third quarter of 2004. The effective tax rate in the third quarter of 2005 was higher due to certain federal and state tax credits.
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Results of Operations - Nine-Month Comparison
Net Sales. Net sales for the first nine months of 2005 decreased $46.5 million, or 21.1%, to $174.6 million from $221.1 million in the first nine months of 2004. Net fabric sales within the United States decreased 26.0%, to $132.4 million in the first nine months of 2005 from $179.0 million in the first nine months of 2004, as a result of increased competition from leather, microdenier faux suede and other furniture coverings being imported into the U.S. in roll and “kit” form, primarily from low labor cost countries in Asia. Net foreign sales of fabric decreased 13.8%, to $21.9 million in the first nine months of 2005 from $25.4 million in the first nine months of 2004. This decrease in foreign sales of fabric was due primarily to lower sales in Mexico, Canada, Europe and the Middle East. In Mexico, the Company competes primarily with Mexican weavers which typically offer their products at prices lower than the Company’s. The Company has lost some additional market share to these lower cost local mills. Sales in Europe declined primarily due to general economic weakness. In Canada, where furniture manufacturers sell furniture into both the United States and Canadian markets, competition from imported faux suede fabrics and leather increased during the first nine months of 2005 and contributed to a more difficult competitive environment. The political climate in the Middle East, as well as increased competition from Turkish and Chinese fabric manufacturers, negatively impacted sales into that region during the first nine months of 2005. Net yarn sales increased to $20.2 million in the first nine months of 2005 from $16.7 million in the first nine months of 2004, with the increase in 2005 principally due to craft yarn sales to a single customer. Sales to this customer accounted for 81.1% of the Company’s yarn sales in the first nine months of 2005 and 48.2% in the first nine months of 2004 yarn sales. While the fourth quarter outlook is for significantly lower yarn sales, management believes the Company’s yarn sales have significant potential for future growth, beginning during the first quarter of 2006.
The gross volume of fabric sold decreased 26.4%, to 26.4 million yards in the first nine months of 2005 from 35.9 million yards in the first nine months of 2004. The weighted average gross sales price per yard increased 2.4%, to $5.87 in the first nine months of 2005 from $5.73 in the first nine months of 2004 as a result of product mix changes. The Company sold 29.6% fewer yards of middle to better-end fabrics and 21.2% fewer yards of promotional-end fabrics in the first nine months of 2005 than in the first nine months of 2004. The average gross sales price per yard of middle to better-end fabrics increased by 5.3%, to $7.12 in the first nine months of 2005 from $6.76 in the first nine months of 2004. The average gross sales price per yard of promotional-end fabrics decreased by 0.2%, to $4.06 in first nine months of 2005 from $4.07 in the first nine months of 2004.
Gross Margin. The gross margin percentage for the first nine months of 2005 decreased to 13.7% as compared to 19.8% for the first nine months of 2004. The 21.1% drop in net sales in the first nine months of 2005 compared to the first nine months of 2004 caused fixed manufacturing costs as a percentage of net sales to increase, leading to a decline in the gross margin of approximately 260 basis points. The balance of the gross margin decline was caused by a general increase in Quaker’s raw material costs driven by rising oil prices, and unusual costs of approximately $1.7 million incurred during the first half of 2005 related to a key supplier decision to exit the acrylic fiber business and the liquidation of a second important supplier. These increases contributed approximately 250 basis points to the gross margin decline. Higher energy costs resulted in approximately 100 basis points at the gross margin level.
As part of the consolidation of manufacturing and warehousing facilities, the Company incurred $801,000 of moving and duplicate occupancy costs during the first nine months of 2005. These costs are included in cost of goods sold.
Restructuring and Asset Impairment Charges. During the nine month period ended October 1, 2005, the Company reported restructuring and asset impairment charges of $9.7 million. This consisted of $9.4 million of asset impairment charges and $243,000 of employee termination costs. During the first nine months of 2005, the Company reduced its production capacity by idling certain manufacturing equipment and also decided to close a manufacturing facility. As a result of these changes and in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” the Company evaluated these assets impairment. Asset impairments of $3.4 million and $5.3 million were reported in the second and third quarters of 2005, respectively. In addition, due to recent weakness in upholstery fabric orders, the Company evaluated its prepaid marketing materials for impairment and determined that a portion of this asset had been impaired and recorded a charge of $707,000 in the third quarter of 2005. The Company also reduced its workforce during the second quarter of 2005 and recorded $243,000 of employee termination costs consisting of severance costs payable to affected employees.
Goodwill Impairment. The Company determined that goodwill should be tested for impairment at July 2, 2005 in accordance with the provisions of SFAS No. 142, “Goodwill and Other Intangible Assets,” due to lower than anticipated orders and a related reduction in the Company’s backlog position. As a result of this testing, the Company determined that goodwill had been impaired. Accordingly, a goodwill impairment charge of $5.4 million, or $0.32 per share, was recorded in the three month period ended July 2, 2005.
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Selling, General and Administrative Expenses. Selling, general and administrative expenses decreased to $35.2 million in the first nine months of 2005 as compared to $41.6 for the first nine months of 2004, primarily due to lower sales commissions as a result of lower sales, a decrease in payroll costs attributable to staffing reductions and an adjustment during the first quarter in certain assumptions used to value benefits due to the Company’s executives under the terms of its non-qualified deferred compensation plan. Selling, general and administrative expenses as a percentage of net sales were 20.2% and 18.8% in the first nine months of 2005 and 2004, respectively. Selling, general and administrative expenses were higher as a percentage of net sales due to lower sales.
Interest Expense. Interest expense decreased to $2.2 million in the first nine months of 2005 from $2.6 million in the first nine months of 2004, primarily due to the repayment of senior debt with higher interest rates.
Effective Tax Rate. The Company’s effective tax rate was a benefit of 33.6% in the first nine months of 2005 compared to a benefit of 35.3% in the first nine months of 2004. The effective tax rate in the first nine months was affected by two events. First, as discussed in Note 2, the Company reported a goodwill impairment charge of $5.4 million. The goodwill had no tax basis, and therefore, no tax benefit related to this expense is realized. Second, the Company recorded the settlement of certain state tax assessments and claims during the second quarter of 2005, which resulted in a tax benefit in the quarter of $1.2 million.
During the second quarter of 2005, the Company settled tax assessments from the Massachusetts Department of Revenue (MDOR) for the years 1993-1998. In addition, the Company settled refund claims from amended tax returns filed with the MDOR claiming approximately $1.4 million of research and development tax credits for the years 1993-2001 and additional credits of $0.7 million claimed on the originally filed tax returns for 2002 and 2003. Settlement of these claims allowed the Company to record a tax benefit of $1.8 million or $1.2 million, net of applicable federal taxes.
Liquidity and Capital Resources
The Company historically has financed its operations and capital requirements through a combination of internally generated funds and borrowings under the Credit Agreement and the 2005 Credit Agreement (as hereinafter defined). The Company’s capital requirements have arisen principally in connection with (i) the purchase of equipment to expand production capacity, add new technologies to broaden and differentiate the Company’s products, and improve the Company’s quality and productivity performance, (ii) increases in the Company’s working capital needs, and (iii) investments in the Company’s information technology systems.
The primary source of the Company’s liquidity and capital resources in recent years has been operating cash flow. The Company’s net cash provided by operating activities was $4.0 million and $15.2 million in the first nine months of 2005 and 2004, respectively. Cash provided by operating activities decreased during the first nine months of 2005 due principally to a $20.4 million reduction in net income and an $8.5 million reduction in deferred income tax liabilities, offset to some extent by $14.8 million of non-cash charges, consisting of $5.4 million of goodwill impairment and $9.4 million of asset impairments, and a net reduction in operating assets and liabilities of $1.6 million.
In January 2005, Solutia, the Company’s supplier of acrylic fiber, announced that it would be exiting the acrylic business, with operations at Solutia’s acrylic manufacturing facilities expected to cease in April 2005. Approximately 36% of the Company’s filling yarns are acrylic and are purchased from spinners that have historically used acrylic fiber purchased from Solutia. As a result of this, the Company took steps to build a safety stock of fiber during the first quarter of 2005, resulting in an overall increase in inventory. This safety stock is meant to facilitate the Company’s transition from Solutia to other sources of acrylic fiber and the Company expects to use most of it before the end of 2005.
Capital expenditures for the first nine months of 2005 and 2004 were $4.5 million, and $12.1 million, respectively. Capital expenditures during 2005 were funded by operating cash flow and borrowings under the Company’s Credit Agreements. Management anticipates that capital expenditures for new projects will not exceed $6.0 million in 2005 consisting principally of facilities maintenance expenditures, and facility modifications at the 540,000 square foot manufacturing and warehousing facility leased by the Company in December 2004.
As of October 1, 2005, the Company had $41.0 million outstanding under the 2005 Credit Agreement, $4.6 million of letters of credit and unused availability of approximately $2.1 million, net of the Availability Reserve. As of January 1, 2005, the Company had no loans outstanding under the Second Amended and Restated Credit Agreement, dated as of February 14, 2002 and unused availability of $35.3 million, net of outstanding letters of credit of $4.7 million.
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Debt consists of the following:
| | October 1,
2005 | | January 1,
2005 | |
| | (In thousands) | |
| | | |
Senior Secured Revolving Credit Facility | | $ | 21,022 | | $ | – | |
Term Loan payable in quarterly principal installments plus interest over a 5 year period, beginning November 1, 2005 | | | 20,000 | | | – | |
7.18% Senior Notes | | | – | | | 30,000 | |
7.09% Senior Notes | | | – | | | 5,000 | |
7.56% Series A Notes | | | – | | | 5,000 | |
Total Debt | | $ | 41,022 | | $ | 40,000 | |
Less: Current Portion of Term Loan | | | 4,000 | | | – | |
Current Portion of Senior Secured Revolving Credit Facility | | | 16,022 | | | – | |
Current Long-Term Debt | | | – | | | 40,000 | |
Total Long-Term Debt | | $ | 21,000 | | $ | – | |
On May 18, 2005, Quaker Fabric Corporation of Fall River (“QFR”), a wholly-owned subsidiary of Quaker Fabric Corporation (the “Company”), entered into a five-year, $70.0 million senior secured revolving credit and term loan agreement with Bank of America, N.A. and two other lenders (the “2005 Credit Agreement”). The 2005 Credit Agreement provides for a $20.0 million term loan (the “Term Loan”) and a $50.0 million revolving credit and letter of credit facility (the “Revolving Credit Facility”). QFR’s obligations under the 2005 Credit Agreement are guaranteed by the Company and two QFR subsidiaries (the “Guaranty”). Pursuant to a Security Agreement (also dated as of May 18, 2005) executed by QFR, the Company, and two subsidiaries of QFR, all of QFR’s obligations under the 2005 Credit Agreement are secured by first priority liens upon all of QFR’s and the Company’s assets and on the assets of the two QFR subsidiaries acting as guarantors (the “Security Agreement”).
Advances to QFR under the Revolving Credit Facility are limited by a formula based on Quaker’s accounts receivable and inventory, minus an “Availability Reserve” (and such other reserves as the Bank may establish from time to time in its reasonable credit judgment.) Advances made under the Revolving Credit Facility bear interest at either the prime rate plus Applicable Margin or the LIBOR rate plus Applicable Margin. Until October 21, 2005, the Applicable Margin was 2.25% for LIBOR advances and 0.75% for prime rate advances. Thereafter, the Applicable Margin is to be determined quarterly based upon the Company’s ratio of Consolidated Total Funded Debt to EBITDA, as defined in the 2005 Credit Agreement, with the Applicable Margin ranging from 1.75% to 2.50% for LIBOR advances and from 0.25% to 1.0% for prime rate advances. As of October 1, 2005, the weighted average interest rates of the advances outstanding was 5.84%.
The Revolving Credit Facility has a term of five years. The outstanding balance of the Revolving Credit Facility is classified in the balance sheet as a short term liability, except for a maximum of $5.0 million, as required by Emerging Issues Task Force (EITF) No. 95-22, “Balance Sheet Classification of Borrowings Outstanding under Revolving Credit Agreements that include both a Subjective Acceleration Clause and a LockBox Arrangement.” The 2005 Credit Agreement requires that the Company limit funds in its cash operating account to not more than $5.0 million, and any cash balances exceeding $5.0 million must be applied to the payment of outstanding advances under the Revolving Credit Facility. In accordance with EITF 95-22, this covenant restricting the Company’s ability to allow cash balances in the operating account to exceed $5.0 million, coupled with other terms in the 2005 Credit Agreement, allows no more than $5.0 million of the Revolving Credit Facility to be classified as long-term debt.
The Term Loan bears interest at either the prime rate plus Applicable Margin or the LIBOR rate plus Applicable Margin. Until October 21, 2005, the Applicable Margin was 3.00% for LIBOR advances and 1.50% for prime rate advances. Thereafter, the Applicable Margin is to be determined quarterly based upon the Company’s ratio of Consolidated Total Funded Debt to EBITDA, as defined, in the 2005 Credit Agreement. The Applicable Margin for LIBOR advances ranges from 2.50% to 3.25% and for prime rate advances from 1.00% to 1.75%. As of October 1, 2005, the weighted average interest rate of the Term Loan was 6.62%. Amortization of the Term Loan is over a five-year period beginning November 1, 2005, with payments of principal to be made on a quarterly basis and the principal payment due November 1, 2005 timely made. In certain events, such as the sale of assets, proceeds must be used to prepay the Term Loan. Annual aggregate principal payments under the Term Loan are as follows:
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Fiscal Year | | (In thousands) | |
| | | | | | |
2005 | | | $ | 1,000 | | |
2006 | | | | 4,000 | | |
2007 | | | | 4,000 | | |
2008 | | | | 4,250 | | |
2009 | | | | 4,500 | | |
2010 | | | | 2,250 | | |
| | | $ | 20,000 | | |
The 2005 Credit Agreement includes customary financial covenants (including fixed charge coverage ratios and, until the first quarter of 2006 minimum consolidated EBITDA requirements), reporting obligations, and affirmative and negative covenants including, but not limited to, limitations on certain business activities of the Company and QFR and restrictions on the Company’s and/or QFR’s ability to declare and pay dividends, incur additional indebtedness, create certain liens, make capital expenditures, incur capital lease obligations, make certain investments, engage in certain transactions with stockholders and affiliates, and purchase, merge, or consolidate with or into any other corporation.
QFR’s initial borrowing under the 2005 Credit Agreement was approximately $46.0 million, of which approximately $42.3 million, was used to repay, in full, all of QFR’s outstanding obligations under Senior Notes due October 2005 and 2007 that QFR issued to an insurance company during 1997 and Series A Notes due February 2009 that QFR issued to the same insurance company during 2002, with such repayment including a yield maintenance premium of approximately $2.0 million. The balance of the initial borrowing was used to cover approximately $1.0 million of closing costs and to repay, in full, all of QFR’s outstanding obligations to Fleet National Bank (“Fleet”) under the Second Amended and Restated Credit Agreement dated February 14, 2002 by and between Fleet and QFR. The Company recorded a charge in the second quarter of 2005 of $2.2 million for “Early Extinguishment of Debt” which includes the $2.0 million yield maintenance premium plus the write off of previously capitalized deferred financing costs.
On July 26, 2005, the Company and the other parties to the 2005 Credit Agreement entered into Amendment No. 1, effective as of July 1, 2005, to the 2005 Credit Agreement to: (i) increase the Availability Reserve from $5.0 million to $7.5 million effective August 20, 2005 and from $7.5 million to $10.0 million effective September 24, 2005, (ii) reduce the minimum consolidated EBITDA and fixed charge coverage ratio requirements in the financial covenants, (iii) reduce the limits on the Company’s annual capital expenditure programs, and (iv) under certain circumstances, require the Company to retain a consultant.
As of October 1, 2005, there were $41.0 million of loans outstanding under the 2005 Credit Agreement, including the $20.0 million term loan component, approximately $4.6 million of letters of credit and unused availability of approximately $2.1 million, net of the Availability Reserve, as defined in the 2005 Credit Agreement.
On October 25, 2005, the Company and the other parties to the 2005 Credit Agreement entered into Amendment No. 2, effective as of October 21, 2005, to the 2005 Credit Agreement (“Amendment No. 2”) to: (i) reduce the Availability Reserve, (ii) reduce the minimum consolidated EBITDA requirement for the fourth quarter of fiscal 2005 in the financial covenants, (iii) eliminate the minimum consolidated EBITDA requirement in its entirety for all periods after the fourth quarter of fiscal 2005, (iv) add a new “Two Quarter Fixed Charge Coverage Ratio” requirement to the financial covenants applicable to the five fiscal quarters beginning with the first quarter of fiscal 2006 and ending with the first quarter of fiscal 2007, (v) reduce the Minimum Fixed Charge Coverage Ratio in the financial covenants for the first fiscal quarter of 2006, (vi) increase the Applicable Margin by 0.25% with respect to the Term Loan and all Revolving Credit Facility advances until March 1, 2006, when all subsequent changes in Applicable Margins will be determined solely based upon the Company’s ratio of Consolidated Total Funded Debt to EBITDA. The Company paid an amendment fee of $175, which will be capitalized and amortized over the remaining term of the 2005 Credit Agreement.
As of November 8, 2005, there were $39.5 million of loans outstanding under the 2005 Credit Agreement, including the $19.0 million term loan component, approximately $4.6 million of letters of credit and unused availability of $4.5 million, net of the $7.5 million Availability Reserve required following the effective date of Amendment No. 2
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The Company’s ability to meet its current obligations is dependent on: (i) its access to trade credit, (ii) its operating cash flow and (iii) its Availability under the 2005 Credit Agreement, which is a function of Eligible Accounts Receivable, Eligible Inventory, and the Availability Reserve as those terms are defined in the 2005 Credit Agreement. Availability is typically lowest during the third quarter of each fiscal year principally due to: (i) the seasonality of the Company’s business and (ii) the negative effects of the Company’s annual two-week July shutdown period on sales and cash. Increases in the Availability Reserve such as those reflected in Amendments No. 1 to the 2005 Credit Agreement, discussed above, reduce Availability and thus the Company’s ability to borrow. In like manner, decreases in the Availability Reserve such as those reflected in Amendment No. 2 to the 2005 Credit Agreement discussed above increase Availability and thus the Company’s ability to borrow. The Company manages its inventory levels, accounts receivable, accounts payable and capital expenditures to provide adequate resources to meet its operating needs, maximize its cash flow and reduce the need to borrow under the 2005 Credit Agreement. However, its cash position may be adversely affected by factors it cannot completely control, including but not limited to, a reduction in incoming order rates, production rates, sales, and accounts receivable, as well as delays in receipt of payment of accounts receivable and limitations of trade credit. The Company has implemented a plan to reduce its investment in inventory and is seeking to dispose of certain manufacturing and warehousing facilities no longer needed as a result of the consolidation of some of its facilities. In addition, management adjusts the Company’s cost structure on a continuing basis to reflect changes in demand. Management believes that the 2005 Credit Agreement, as amended, together with the Company’s operating cash flow are adequate to meet the Company’s foreseeable liquidity needs.
No dividends were paid on the Company’s common stock prior to 2003. During the first quarter of 2003, the Board of Directors adopted a new dividend policy. This policy provides for future dividends to be declared at the discretion of the Board of Directors, based on the Board’s quarterly evaluation of the Company’s results of operations, cash requirements, financial condition and other factors deemed relevant by the Board. In 2004 and 2003, the Company paid cash dividends of $1.5 million or $0.09 per common share and $1.7 million or $0.10 per common share, respectively. As noted above, the terms of the 2005 Credit Agreement prohibit the payment of dividends. The Company had previously agreed with its prior lenders not to declare or pay any dividends or distributions, and in accordance with those agreements, the Company suspended dividend payments during the third quarter of 2004 and no dividends have been declared or paid since that time. Restricted net assets of the Company as of October 1, 2005 equal 100% of the net assets of the Company. All operations of the Company are conducted by QFR. This restriction has no impact on the Company’s operations, except for the prohibition on the payment of dividends.
Inflation
The Company does not believe that inflation has had a significant impact on the Company’s results of operations for the periods presented. Historically, the Company believes it has been able to minimize the effects of inflation by improving its manufacturing and purchasing efficiency, by increasing employee productivity, and by reflecting the effects of inflation in the selling prices of the new products it introduces each year. However, recent increases in oil prices have resulted in significant increases in the Company’s energy and raw material costs, primarily as a result of the substantial number of raw materials used by the Company that are derived from petroleum, and despite an across the board price increase effected by the Company during the first half of 2005, and a $0.15 per yard temporary surcharge effected in October, 2005, intense competition in the industry has impaired the Company’s ability to pass all of these cost increases along to its customers.
Cautionary Statement Regarding Forward-Looking Information
Statements contained in this report, as well as oral statements made by the Company that are prefaced with the words “may,” “will,” “expect,” “anticipate,” “continue,” “estimate,” “project,” “intend,” “designed” and similar expressions, are intended to identify forward-looking statements regarding events, conditions and financial trends that may affect the Company’s future plans of operations, business strategy, results of operations and financial position. These statements are based on the Company’s current expectations and estimates as to prospective events and circumstances about which the Company can give no firm assurance. Further, any forward-looking statement speaks only as of the date on which such statement is made, and the Company undertakes no obligation to update any forward-looking statement to reflect events or circumstances after the date on which such statement is made. As it is not possible to predict every new factor that may emerge, forward-looking statements should not be relied upon as a prediction of the Company’s actual future financial condition or results. These forward-looking statements like any forward-looking statements, involve risks and uncertainties that could cause actual results to differ materially from those projected or anticipated. Such risks and uncertainties include: the Company’s ability to comply with the terms of the financing documents to which it is a party, the Company’s ability to generate sufficient Eligible Accounts Receivable and Eligible Inventory, net of the Availability Reserve (all as defined in the 2005 Credit Agreement) to maintain adequate Availability to meet its liquidity needs, product demand and market acceptance of the Company’s products, regulatory uncertainties, the effect of economic conditions, the impact of competitive products and pricing, including, but not limited to, imported furniture and furniture coverings sold into the U.S. domestic market,
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foreign currency exchange rates, changes in customers’ ordering patterns, and the effect of uncertainties in markets outside the U.S. (including Mexico and South America) in which the Company operates.
Item 3. | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK |
Derivative Financial Instruments, Other Financial Instruments, and Derivative Commodity Instruments
Quantitative and Qualitative Disclosures About Market Risk
The Company’s exposures relative to market risk are due to foreign exchange risk and interest rate risk.
Foreign currency risk
Approximately 3.2% of the Company’s revenues are generated outside the U.S. from sales which are not denominated in U.S. dollars. Foreign currency risk arises because the Company engages in business in Mexico and Brazil in local currency. Accordingly, in the absence of hedging activities, whenever the U.S. dollar strengthens relative to the other major currencies, there is an adverse affect on the Company’s results of operations, and alternatively, whenever the U.S. dollar weakens relative to the other major currencies, there is a positive affect on the Company’s results of operations.
It is the Company’s policy to minimize, for a period of time, the unforeseen impact on its results of operations of fluctuations in foreign exchange rates by using derivative financial instruments to hedge the fair value of foreign currency denominated intercompany payables. The Company’s primary foreign currency exposures in relation to the U.S. dollar are the Mexican peso and the Brazilian real.
The Company also enters into forward exchange contracts to hedge the purchase of fixed assets denominated in foreign currencies. These hedges are designated as cash flow hedges intended to reduce the risk of currency fluctuations from the time of order through delivery of the equipment. Gains or losses on these derivative instruments are reported as a component of “other comprehensive income.”
At October 1, 2005, the Company had the following derivative financial instruments outstanding:
Type of
Instrument | | Currency | | Notional
Amount in
Local
Currency | | Weighted
Average
Contract
Rate | | Notional
Amount in
U.S. Dollars | | Fair Value
Gain
(Losses) | | Maturity | |
| | | | | | | | | | | | | | |
Forward Contracts | | Mexican Peso | | 30.0 million | | 11.54 | | | $2.6 million | | $(136,000) | | Jun. 2006 | |
| | | | | | | | | | | | | | |
Forward Contracts | | Brazilian Real | | 0.9 million | | 2.44 | | | $0.4 million | | $ (24,000) | | Mar. 2006 | |
| | | | | | | | | | | | | | |
Forward Contracts | | Euro | | 0.1 million | | 0.79 | | | $0.1 million | | $ (8,000) | | Nov. 2005 | |
The Company estimated the change in the fair value of all derivative financial instruments assuming both a 10% strengthening and weakening of the U.S. dollar relative to all other major currencies. In the event of a 10% strengthening of the U.S. dollar, the change in fair value of all derivative financial instruments would result in an unrealized loss of approximately $0.3 million; whereas a 10% weakening of the U.S. dollar would result in an unrealized gain of approximately $0.3 million.
Interest Rate Risk
The Company is exposed to market risk from changes in interest rates on debt. The Company’s exposure to interest rate risk consists of floating rate debt based on the London Interbank Offered Rate (LIBOR) or Prime rate plus an “Applicable Margin” under the Company’s 2005 Credit Agreement. As of October 1, 2005, there was $41.0 million of borrowings outstanding under the Credit Agreement at floating rates. Increases in short-term interest rates will increase the Company’s interest expense. The Company mitigates this risk in the short term by locking in a portion of its outstanding borrowings at LIBOR rates for up to six months.
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Item 4. | CONTROLS AND PROCEDURES |
The Company’s management, under the supervision and with the participation of the 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 Rule 13a-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, management has concluded that, as of the end of the period covered by this report, the Company’s disclosure controls and procedures are effective in alerting them on a timely basis to material information relating to the Company (including its consolidated subsidiaries) required to be included in the Company’s periodic filings under the Exchange Act and in ensuring that the information required to be disclosed by the Company in the reports it files or submits under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the rules of the Securities and Exchange Commission. In addition, management has evaluated and concluded that during the most recent fiscal quarter covered by this report, there has not been any change in the Company’s internal control over financial reporting that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.
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QUAKER FABRIC CORPORATION AND SUBSIDIARIES
PART II - OTHER INFORMATION
Item 6. Exhibits
(A) Exhibits
31.1 Certification by the Chief Executive Officer pursuant to section 302 of the Sarbanes-Oxley Act of 2002.
31.2 Certification by the Chief Financial Officer pursuant to section 302 of the Sarbanes-Oxley Act of 2002.
32.1 Certification by the Chief Executive Officer pursuant to section 906 of the Sarbanes-Oxley Act of 2002.
32.2 Certification by the Chief Financial Officer pursuant to section 906 of the Sarbanes-Oxley Act of 2002.
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QUAKER FABRIC CORPORATION AND SUBSIDIARIES
SIGNATURES
Pursuant to the requirements 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.
| | | QUAKER FABRIC CORPORATION |
Date: November 10, 2005
| | |
By: /s/ Paul J. Kelly
|
| | | Paul J. Kelly
Vice President - Finance
and Treasurer (Principal Financial Officer) |
| | | | |
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