Senior Credit Agreement
On March 30, 2009, Physicians entered into a senior credit agreement with Union Bank, N.A. ("Union Bank") which converted the entire previously outstanding facility into an asset-based revolving credit facility, and the previously outstanding term loan was replaced with borrowings under the revolving credit facility of the senior credit agreement. On July 29, 2009, Physicians entered into an amendment to the senior credit agreement whereby the lender reduced its revolving loan commitment from $25.0 million to $20.0 million.
The senior credit agreement required the Company to comply with a minimum interest coverage ratio, a minimum EBITDA (as defined in the senior credit agreement) covenant and a minimum tangible net worth covenant. The senior credit agreement contained certain additional negative covenants, including limitations on the Company's ability to: incur other indebtedness and liens; fundamentally change its business through a merger, consolidation, amalgamation or liquidation; sell assets; make restricted payments; pay cash dividends from Physicians Formula, Inc. or pay for expenses of Physicians Formula Holdings, Inc., unless certain conditions are satisfied; make certain acquisitions, investments, loans and advances; engage in transactions with its affiliates; enter into certain agreements; engage in sale-leaseback transactions; incur certain unfunded liabilities; change its line of business; and make capital expenditures in excess of $2.0 million per year. The senior credit agreement required the Company to make mandatory prepayments with the proceeds of certain asset dispositions and upon the receipt of insurance or condemnation proceeds to the extent the Company did not use the proceeds for the purchase of satisfactory replacement assets in accordance with the terms of the senior credit agreement.
Borrowings under the senior credit agreement were guaranteed by Physicians Formula Holdings, Inc. and the domestic subsidiaries of Physicians Formula, Inc. and borrowings under the senior credit agreement were secured by a pledge of the capital stock of Physicians Formula, Inc. and its equity interests in each of its subsidiaries and substantially all of the assets of Physicians Formula, Inc. and its domestic subsidiaries.
On November 6, 2009, the senior credit agreement with Union Bank was replaced with a New Senior Credit Agreement with Wells Fargo Bank, N.A. ("Wells Fargo") as described below.
Bridge Loan
On September 4, 2009, Physicians, as borrower, and Mill Road Capital, L.P. ("Mill Road"), as lender, entered into an agreement (the "Bridge Loan Agreement") for a second-priority senior bridge loan facility (the "Bridge Loan") in the amount of $4.2 million. The Company used borrowings under the Bridge Loan to repay $2.9 million of borrowings under the senior credit agreement with Union Bank, which included approximately $2.4 million of overadvances to Physicians, and to fund short-term wo rking capital requirements. The Bridge Loan was scheduled to mature on December 3, 2009 with interest accruing at a rate of 15% per annum payable upon maturity of the Bridge Loan.
The Bridge Loan Agreement required the Company to comply with the same financial covenants that the Company was required to comply with under its existing senior credit agreement with Union Bank. Borrowings under the Bridge Loan Agreement were guaranteed by the Company and the domestic subsidiaries of Physicians (the "Guarantors"), and borrowings under the Bridge Loan Agreement were secured by a second-priority pledge of the capital stock of Physicians and its equity interests in each of its subsidiaries and substantially all of the assets of Physicians and its subsidiaries.
On November 6, 2009, the Bridge Loan was repaid using the proceeds from the issuance of a new Senior Subordinated Note as described below.
New Senior Credit Agreement
On November 6, 2009, pursuant to a new senior credit agreement (the “New Senior Credit Agreement”) between Physicians and Wells Fargo, Physicians entered into a new asset-based revolving credit facility (the “new revolving credit facility”) and terminated its previous asset-based revolving credit facility (the “old revolving credit facility”) with Union Bank. Approximately $9.3 million of the proceeds of the new revolving credit facility were used to repay outstanding borrowings under Physicians’ old revolving credit facility. The new revolvi ng credit facility is scheduled to mature on November 6, 2012.
The maximum amount available for borrowing under the new revolving credit facility is equal to the lesser of $25.0 million and a borrowing base formula equal to: (i) 65% or such lesser percentage of eligible accounts receivable as Wells Fargo in its discretion as an asset-based lender may deem appropriate; plus (ii) the least of (1) $14.0 million and (2) the sum of specified percentages (or such lesser percentages as Wells Fargo in its discretion as an asset-based lender may deem appropriate) of each of the following items of eligible inventory (as defined in the New Senior Credit Agreement): (A) of eligible inventory consisting of finished goods that are fully packaged, labeled and ready for shipping, not to exceed 65% of such eligible inventory, (B) eligible inventory consisting of semi-finished goods which are ready for packaging and shi pping, not to exceed $4.0 million, (C) eligible inventory consisting of raw materials, not to exceed $1.5 million, (D) eligible inventory consisting of blank components, not to exceed $1.0 million and (E) eligible inventory consisting of returned items, not to exceed $0.75 million; plus (iii) the cash balance in a certain Canadian concentration account; less (iv) a working capital reserve of $1.0 million as such amount may be adjusted by Wells Fargo from time to time and a borrowing base reserve that Wells Fargo establishes from time to time in its discretion as a secured asset-based lender; less (v) indebtedness owed to Wells Fargo other than indebtedness outstanding under the new revolving credit facility. Availability under the new revolving credit facility is reduced by outstanding letters of credit.
Floating rate borrowings under the new revolving credit facility accrue interest at a daily rate equal to the three-month LIBOR plus 3.5% and fixed rate borrowings accrue interest at a fixed rate equal to the three-month LIBOR plus 3.5% on the date of borrowing. Interest on floating rate borrowings is payable monthly in arrears and interest on fixed rate borrowings are payable upon the expiration of the fixed rate term, subject to minimum monthly interest payments in the amount of $25,000. Under the New Senior Credit Agreement, Physicians is required to pay to Wells Fargo an unused credit line fee equal to 0.5% per annum and various other fees associated with cash management and other related services. Physicians may reduce the maximum amount available for borrowing or terminate the facility prior to the scheduled maturity date at any time by paying breakage fees equal to 3% of the maximum amount of the new revolving credit facility or amount of the reduction in the credit facility, as applicable, decreasing to 1.5% after November 6, 2010 and decreasing to 0.5% after November 6, 2011.
Under the New Senior Credit Agreement, all payments to Physicians and its subsidiaries are required to be deposited into a lockbox account provided by Wells Fargo, except that payments in connection with the Company’s Canadian operations may be deposited into a lockbox account with Royal Bank of Canada. Any amounts deposited into a lockbox account with Wells Fargo will be swept to a collection account to be applied to repay the outstanding borrowings under the new revolving credit facility. If the balance in Physicians’ Canadian account exceeds Canadian $2.0 million at any time, Physicians must within 10 days after such occurrence transfer the excess amount to the collection account to repay borrowings under the new revolving credit facility. In addition, at any time, Physicians may transfer amounts out of the restricted Canadian accounts to repay borrowings under the revolving credit facility or, so long as no event of default exists, pay costs and expenses incurred in connection with the Company’s Canadian operations from its Canadian operating account.
The New Senior Credit Agreement requires the Company to comply with a monthly minimum book net worth covenant and a quarterly minimum adjusted EBITDA (as defined in the agreement) covenant. In addition, the Company is required to comply with certain negative covenants, including limitations on its ability to: incur other indebtedness and liens; make certain investments, loans or advances; guaranty indebtedness; pay cash dividends from Physicians, except in an amount up to $100,000 to allow the Company to pay ordinary course expenses; sell assets; suspend operations; consolidate or merge with another entity; enter into sale-leaseback arrangements; or enter into unrelated lines of business or acquire assets not related to our business; and make capital expenditures in excess of $5.5 million for the year ending December 31, 2010 (subject to up to a $600,000 carryforward from the prior year). As of June 30, 2010, the Company held no assets aside from its investment in Physicians. The financial covenants for the periods after December 31, 2010 will be agreed upon between Physicians and Wells Fargo at a later date. The New Senior Credit Agreement also contains customary events of default, including a change of control of Physicians. As of June 30, 2010, the Company was in compliance with the covenants contained in the New Senior Credit Agreement (see further details below).
The New Senior Credit Agreement defines “book net worth” as the Company’s stockholders’ equity, determined in accordance with GAAP and calculated without regard to any change in the valuation of goodwill and intangible assets made in accordance with ASC 350, Intangibles-Goodwill and Other. The New Senior Credit Agreement requires that the Company has a minimum book net worth of $48.75 million as of June 30, 2010. As of June 30, 2010, the Company was in compliance with such covenant. The New S enior Credit Agreement defines “Adjusted EBITDA” as the Company’s consolidated net income, calculated before (i) interest expense, (ii) provision (benefit) for income taxes, (iii) depreciation and amortization expense, (iv) gains arising from the write-up of assets, (v) any extraordinary gains, (vi) stock-based compensation expenses, (vii) changes resulting from the valuation of goodwill and intangible assets made in accordance with ASC 350, and (viii) changes resulting from foreign exchange adjustments arising from a revaluation of assets subject to foreign currency revaluation, and (ix) provisions arising from adjustments to the Company’s inventory reserves for obsolete, excess, or slow moving inventory. On June 29, 2010, Physicians entered into the First Amendment to the New Senior Credit Agreement (the "First Amendment") with Wells Fargo which reduced the minimum adjusted EBITDA covenant for the 12 months ended June 30, 2010 by $850,000 to $11.0 million from $11.85 million. A s of June 30, 2010, the Company was in compliance with such covenant. All other covenants, including the book net worth covenant, the maximum capital expenditure covenant and the other 2010 minimum adjusted EBITDA covenants were not modified. In connection with the First Amendment, the Company paid Wells Fargo a fee of $10,000 and related expenses.
The New Senior Credit Agreement and the Note Agreement with respect to the Company's Senior Subordinated Note (discussed below under “New Senior Subordinated Note”) contain provisions that could result in the acceleration of maturity of the indebtedness and entitle the lenders to exercise remedies upon an event of default, including a default of the financial covenants. There is no assurance that the Company would receive waivers should it not meet its financial covenant requirements. Even if the Company is able to obtain a waiver, in co nnection with negotiating a waiver, it may be required to agree to other changes in the senior credit agreement including increased interest rates, tighter covenants or lower availability thresholds or pay a fee for such waiver. If the Company is not able to comply with the new financial covenants in the senior credit agreement and it is unable to obtain waivers, the Company would need to obtain additional sources of liquidity; however, given the current state of the worldwide credit markets, there can be no assurance that the Company will be able to obtain additional sources of liquidity on terms acceptable to it, or at all.
Borrowings under the new revolving credit facility are guaranteed by the Company and the domestic subsidiaries of Physicians and are secured by a pledge of the capital stock of Physicians and its subsidiaries and substantially all of the assets of the Company and its subsidiaries.
Physicians paid a closing fee to Wells Fargo equal to $250,000 and agreed to pay all expenses incurred by Wells Fargo in connection with the new revolving credit facility.
As of June 30, 2010 and December 31, 2009, there was $7.9 million and $9.9 million outstanding under the new revolving credit facility, respectively, at interest rates of 4.03% and 3.75%, respectively. As of June 30, 2010 and December 31, 2009, there were no outstanding letters of credit and $5.9 million and $12.2 million available under the new revolving credit facility, respectively. The new revolving credit facility contains a lock-box feature, whereby remittances made by customers to the lock-box repays the outstanding obligation under the new revolving credit facility. As such, in accordance with ASC 470-10-45, the Company classified the above outstanding amount under the new revolving credit facility as a current liability in the accompanying condensed consolidated balance sheets.
New Senior Subordinated Note
On November 6, 2009, pursuant to a Senior Subordinated Note Purchase and Security Agreement between Physicians, the guarantors named therein and Mill Road (the “Note Agreement” or "Senior Subordinated Note"), reported as Related Party Long-Term Debt on the accompanying condensed consolidated balance sheets, Physicians issued a new Senior Subordinated Note to Mill Road in an aggregate principal amount eq ual to $8.0 million. Physicians used $4.3 million of the proceeds to repay in full the principal of $4.2 million and interest of $107,000 outstanding under its Bridge Loan from Mill Road. The Company used the remaining proceeds for capital expenditures and general corporate purposes. Prior to an amendment entered into during April 2010 as described below, the Senior Subordinated Note was scheduled to mature on May 6, 2013 and accrue interest at 19% per annum, with 15% per annum payable in cash monthly in arrears on the first day of each calendar month and 4% payable in kind with quarterly compounding on the first day of each calendar quarter. Interest expense related to the new Senior Subordinated Note totaled approximately $322,000 and $704,000 for the three and six months ended June 30, 2010, respectively, of which $82,000 was included in accrued expenses in the accompanying condensed consolidated balance sheet as of June 30, 2010.
Subject to the terms of the new revolving credit facility, the Senior Subordinated Note may be redeemed in whole or in part prior to November 6, 2010 at an amount equal to 105% of the aggregate principal amount of the outstanding Notes, decreasing to 104% if redeemed on or after November 6, 2010 and prior to November 6, 2011, decreasing to 102% if redeemed on or after November 6, 2011 and prior to November 6, 2012, and decreasing to 101% if redeemed on or after November 6, 2012. In addition, Physicians must make an offer to redeem the Senior Subordinated Notes upon a change of control of Physicians at the then applicable redemption price. The Company is required to comply with substantially the same covenants under the Note Agreement that it is required to comply with under the New Senior Credit Agreement. However, the Company is not required to comply with the minimum adjusted EBITDA covenant beginning in 2010. In addition, the events of default under the Note Agreement are substantially the same as the events of default under the New Senior Credit Agreement. The Senior Subordinated Note is guaranteed by the Company and Physicians’ subsidiaries and is se cured by a first lien on certain intellectual property and a second lien on substantially all of the other assets of the Company and its subsidiaries and pledges of the stock of Physicians and its subsidiaries. The value of the collateral subject to these liens is limited to the lesser of 10% of the value of the assets of Physicians Formula Holdings, Inc. and its subsidiaries and 10% of the value of all outstanding common stock of Physicians Formula Holdings, Inc. as of November 6, 2009 (the “10% Cap”). Pursuant to an intercreditor agreement entered into between Physicians, Mill Road and Wells Fargo in connection with the New Senior Credit Agreement and Note Agreement (the "New Intercreditor Agreement"), the Senior Subordinated Note is subordinate in right of payment to the prior paying of all obligations under the New Senior Credit Agreement and the liens securing the obligations under the Note Agreement are junior and subordinate to the liens securing the obligations under the New Senior Credit Agreement (except for first liens on certain intellectual property). In addition, the New Intercreditor Agreement prohibits certain amendments to the Note Agreement without the consent of Wells Fargo and prohibits certain amendments to the New Senior Credit Agreement without the consent of Mill Road.
In connection with the issuance of the Senior Subordinated Note, Mill Road agreed that, until September 30, 2012, it would not acquire more than 35% of the Company’s common stock or seek to elect any directors to the Board (other than the one director it is entitled to nominate while the Senior Subordinated Note is outstanding), in each case, without obtaining the prior written consent of the Board. These restrictions will be released if the Company receives a bid for the acquisition of the Company (other than from Mill R oad or its affiliates).
As required under the Note Agreement, the Company sought stockholder approval in order to comply with the Nasdaq shareholder approval requirements and to satisfy certain sections of the Delaware General Corporation Law, because Mill Road is an “interested stockholder” for purposes of the statute. Because Mill Road is an interested stockholder, the Company was required to obtain the vote of 66 2/3% of the outstanding common stock not owned by Mill Road to approve the transactions. At the special meeting of the stockholders held on April 28, 2010, the s tockholders approved, by the requisite margin, a Second Amendment to the Senior Subordinated Note (the "Second Amendment") and the issuance of warrants to Mill Road.
On April 30, 2010, Physicians, the Company, the subsidiaries of Physicians and Mill Road entered into the Second Amendment. Under the Second Amendment, Mill Road agreed to reduce the interest rate on the Senior Subordinated Note from 19% per annum (15% payable in cash monthly and 4% payable in kind with quarterly compounding) to 14% per annum (10% payable in cash monthly and 4% payable in kind with annual compounding), and to extend the maturity of the Senior Subordinated Note by 18 months to November 6, 2014. The prepayment premium for an optional redemption was also amended so that if the Senior Subordinated Note is redeemed on or after November 6, 2011 and prior to November 6, 2012, the prepayment premium would be 102%, decreasing to 101% if redeemed on or after November 6, 2012 and prior to November 6, 2013, and decreasing to 100% if redeemed on or after November 6, 2013. In addition, the existing limit on the amount of collateral securing the Senior Subordinated Note was removed.
In addition, as required by the Note Purchase Agreement and as consideration for the reduction in interest payments, on April 30, 2010, the Company entered into a Common Stock Purchase Warrant agreement with Mill Road pursuant to which warrants have been issued entitling Mill Road to purchase 650,000 shares of the Company's common stock. The warrants have an exercise price equal to $0.25 per share and expire on April 30, 2017. As a result of the issuance of the warrants, Mill Road beneficially owns 2,516,943 shares of the Company's common stock and warrants to purchase 650,000 shares of common stock, representing aggregate beneficial ownership of 3,166,943 shares (approximately 22%) of the Company's common stock. The Company filed a registration statement under the Securities Act of 1933, as amended, to register the resale of the shares underlying the warrants pursuant to a registrati on rights agreement entered into with Mill Road. Nothing in the preceding sentence shall be construed as an offering of securities for sale.
On June 3, 2010, Physicians, the Company, the subsidiaries of Physicians and Mill Road entered into a Third Amendment to the Senior Subordinated Note (the "Third Amendment"). Pursuant to the Third Amendment, Mill Road has the right to nominate one individual to serve as a member of the Company's board of directors (the "Board") so long as (A) the outstanding principal amount under the Senior Subordinated Note is no less than $2.0 million and Mill Road owns shares of, or securities convertible into, or exercisable for, capital stock of the Company, or (B) Mill Road owns no less than 5% of the issued and outstanding capital stock of the Company (on a fully diluted basis) and any part of the Senior Subordinated Note is outstanding. In addition, in the Third Amendment, the Company agrees to (i) increase the size of the Board and appoint Mill Road's nominee to the Board, and (ii) recommend to t he Company's stockholders that Mill Road's nominee to the Board be elected to the Board at the annual meetings of stockholders (clauses (i) and (ii) together, the "Company Obligations"), in each case so long as the conditions in clauses (A) or (B) of the immediately preceding sentence are met. Prior to the Third Amendment, Mill Road had the right to nominate one individual to serve as a member of the Board and the Company had an obligation to perform the Company Obligations, in each case so long as the Senior Subordinated Note was outstanding.
In connection with the new revolving credit facility and Senior Subordinated Note, and the amendments thereto, the Company incurred total costs of $2.3 million associated with these agreements, which included $250,000 and $222,000 of closing fees paid to Wells Fargo and Mill Road, respectively.
The issuance of the warrants and reduction in interest payments has been accounted for as a partial conversion of the required payments under the Note Purchase Agreement for equity interests under ASC 470-20, Debt with Conversion and Other Options. ASC 470-20 requires the issuer of convertible debt instruments to separately account for the liability and equity components of the convertible debt instrument in a manner that reflects the issuers borrowing rate at the date of issuance for a similar debt instrument without the conversion feature. ASC 470-20 requires bifurcation of a component of the convertible debt instrument, classification of that component in equity and the accretion of the resulting discount on the debt to be recognized as interest expense.
The equity component of the Senior Subordinated Note was $940,000 at the time of issuance and was applied as debt discount and as additional paid-in capital. The unamortized discount for the Senior Subordinated Note will be amortized through the debt maturity date of November 6, 2014. The effective interest rate on the liability component of the Senior Subordinated Note is 17.5%. Interest expense related to the contractual coupon rate was $322,000 and $704,000 for the three and six months ended June 30, 2010, respectively. Interest expense related to amortization of the debt discount was $21,000 for each of the three and six months ended June 30, 2010.
Long-term debt and the equity component of the Senior Subordinated Note as of June 30, 2010 is as follows:
| Senior Subordinated Note | | $ | 8,130 | |
| Unamortized discount | | | (919 | ) |
| Net carrying value of Senior Subordinated Note | | $ | 7,211 | |
| | | | | |
| Equity component of Senior Subordinated Note | | $ | 940 | |
The estimated fair value of the Senior Subordinated Note, based on publicly traded debt of comparable companies with similar features, was approximately $7.1 million compared to its carrying value of $7.2 million at June 30, 2010.
8. COMMITMENTS AND CONTINGENCIES
Litigation
The Company is involved in various lawsuits in the ordinary course of business. In management's opinion, the ultimate resolution of these matters will not result in a material impact to the Company's condensed consolidated interim financial statements.
Environmental
The Company is subject to a broad range of frequently changing federal, state and local environmental, health and safety laws and regulations, including those governing discharges to air, soil and water, the handling and disposal of, and exposure to, hazardous substances and the investigation and remediation of any contamination resulting from the release of any hazardous substances. The Company believes that its business, operations and facilities are in material compliance with all applicable environmental, health and safety laws and regulations, and future expenditures will be necessary in order to maintain such compliance.
The shallow soils and groundwater below the Company's City of Industry facilities were contaminated by the former operator of the property. The former operator performed onsite cleanup, and the Company anticipates that it will receive written confirmation from the State of California that no further onsite cleanup is necessary. Such confirmation would not rule out potential liability for regional groundwater contamination or alleged potable water supply contamination discussed below. If further onsite cleanup is required, the Company believes the co st, which the Company is not able to estimate, would be indemnified, without contest or material limitation, by companies that have fulfilled similar indemnity obligations to the Company in the past, and which the Company believes remain financially able to do so.
The facilities are located within an area of regional groundwater contamination known as the Puente Valley “operable unit” (“PVOU”) of the San Gabriel Valley Superfund Site. The Company, along with many others, was named a potentially responsible party (“PRP”) for the regional contamination by the United States Environmental Protection Agency (“EPA”). The Company entered into a settlement with another PVOU PRP, pursuant to which, in return for a payment the Company had already made and had been fully indemnified for by a third pa rty, the other PRP indemnified the Company against most claims for PVOU contamination. A court approved and entered a consent decree among the other PRP, the Company and the EPA that resolves the Company's liability for cleanup of regional groundwater contamination without any payment by the Company to the EPA. Depending on the scope and duration of the cleanup, the Company may be required to make further payments to the other PRP for regional groundwater remediation costs. The Company estimates the amount of such additional payments, if any, would not exceed approximately $130,000. The estimate is based on component estimates for two distinct contaminants that may requir e remediation. Those estimates in turn are based on a number of assumptions concerning the likelihood that remediation will be required, the cost of remediation if required and other matters. Uncertainty in predicting these matters limits the reliability and precision of the estimates. The Company expects any such additional payments by the Company to be covered by indemnities given to the Company by other companies. Those companies may contest their indemnity obligation for these payments. The Company believes the companies are financially able to pay the liability. Because the Company believes it is not probable that it will be held liable for any of these expenses, the Company has not recorded a liability for such potential claims.
The Company believes its liability for these contamination matters and related claims is substantially covered by third-party indemnities, has been resolved by prior agreements and settlements, and any costs or expenses associated therewith will be borne by prior operators of the facilities, their successors and their insurers. The Company is attempting to recoup approximately $760,000 in defense costs from one of these indemnitors. These costs have been expensed as paid by the Company and are not recorded in the accompanying condensed consolidated balance sheets.
