On August 1, 2004, the Company and ID Security Systems Canada Inc. entered into a settlement agreement effective July 30, 2004, pursuant to which the Company agreed to pay $19.95 million, in full and final settlement of the claims covered by the litigation. This settlement was accrued in the second quarter of 2004. Payment in full was made on August 5, 2004.
On June 22, 2006, the Company settled the follow-on purported class action suits that were filed in connection with the ID Security Systems Canada Inc. litigation. The purported class action complaints generally alleged a claim of monopolization and were substantially based upon the same allegations as contained in the ID Security Systems Canada Inc. case as discussed above. The settlement was for $1.45 million in cash and credits for the purchase of 90 million radio frequency label tags. As a result, we recorded a pre-tax charge to earnings of $2.3 million. As a portion of the settlement is in the form of vouchers for the future purchases of tags, the settlement is anticipated to impact revenue and margin over the term of the redemption period for the vouchers.
The Company originally filed suit on May 1, 2001, alleging that the disposable, deactivatable radio frequency security tag manufactured by All-Tag Security S.A. and All-Tag Security Americas, Inc.’s (jointly “All-Tag”) and sold by Sensormatic Electronics Corporation (Sensormatic) infringed on a U.S. Patent No. 4,876,555 (Patent) owned by the Company. On April 22, 2004, the United States District Court for the Eastern District of Pennsylvania granted summary judgment to defendants All-Tag and Sensormatic Electronics Corporation on the ground that the Company’s Patent is invalid for incorrect inventorship. The Company appealed this decision. On June 20, 2005, the Company won an appeal when the Federal Circuit reversed the grant of summary judgment and remanded the case to the District Court for further proceedings. The case is now in the discovery phase and trial is set for January 2007. The original U.S. application was filed in March 1988 and is scheduled to expire on March 17, 2007. The Company acquired the patent in 1995 when it acquired Actron AG.
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Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Information Relating to Forward-Looking Statements
This report includes forward-looking statements made pursuant to the safe harbor provision of the Private Securities Litigation Reform Act of 1995. Except for historical matters, the matters discussed are forward-looking statements, within the meaning of Section 27A of the Securities Act of 1933, as amended, that reflect our current views with respect to future events and financial performance. These forward-looking statements are subject to certain risks and uncertainties which could cause actual results to differ materially from historical results or those anticipated. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of their dates. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. Information about potential factors that could affect our business and financial results is included in our Annual Report on Form 10-K for the year ended December 25, 2005, and our other Securities and Exchange Commission filings.
Overview
Checkpoint Systems, Inc. is a multinational manufacturer and marketer of integrated system solutions for retail security, labeling, and merchandising. We provide technology-driven integrated supply chain solutions to brand, track, and secure goods for retailers and consumer product manufacturers worldwide. We are a leading provider and earn revenues primarily from the sale of electronic article surveillance (EAS), closed-circuit television (CCTV), hand-held labeling systems (HLS), retail merchandising systems (RMS), and radio frequency identification (RFID) systems. Applications include automatic identification, retail security, and pricing and promotional labels and signage. Operating directly in 32 countries, we have a global network of subsidiaries and distributors, and provide customer service and technical support around the world.
Our results are heavily dependent upon sales to the retail market. Our customers are dependent upon retail sales which are susceptible to economic cycles and seasonal fluctuations. Furthermore, as approximately two-thirds of our revenues and operations are located outside the U.S., fluctuations in foreign currency exchange rates have a significant impact on reported results.
Our business plan is to generate sustained revenue growth through selected investments in product development and marketing. We intend to offset the cost of these investments through product cost and operating expense reductions.
On January 30, 2006, we completed the sale transaction for our barcode systems (BCS) businesses and U.S. hand-held labeling and Turn-O-Matic® businesses (“disposal group”) and as a result recorded, in the first quarter of 2006, a pre-tax gain on sale of $2.8 million. The businesses included in the disposal group were highly integrated into our operations in many of the countries in which we operate. In accordance with the guidance of SFAS 144, discontinued operations only includes revenues and expenses that are directly attributable to the businesses included in the disposal group. As a result, discontinued operations do not include any allocations for general and administrative expenses. It also does not include selling and marketing expenses for shared staff that will continue with the Company after the sale of the business.
To respond to the lower revenue base resulting from the sale of the disposal group and improve our operating margins, we have been taking action and are continuing to develop plans to rationalize the selling, general, and administrative structure that is not part of the disposal group. The two major cost savings initiatives are focused on our European region, where the BCS businesses were highly integrated into 14 countries, and on our global supply chain.
European cost reduction initiatives are focused on improving sales productivity by making better use of indirect sales channels and streamlining our field service operations. In certain regions of Europe, we are also using shared service centers to centralize our accounting and customer service operations.
For the global supply chain, we are currently conducting an evaluation to improve manufacturing operations, supply chain operations, and sourcing of materials. As a result, we have initiated the move of our EAS electronics manufacturing from Puerto Rico to the Dominican Republic and anticipate the completion by the second half of 2006. We have also closed our UK labeling plant and consolidated those operations into our main Service Bureau in Terborg, Netherlands.
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We continue to evaluate additional changes in our supply chain to improve manufacturing utilization, and optimize freight and delivery time. These changes to our supply chain could affect our ability to recover the value of certain fixed assets within our manufacturing facilities, which may result in a future impairment as the evaluation is finalized and plans are approved.
As a direct result of these detailed plans first initiated in the second quarter of 2005, employee headcount is down by 822 or 20% compared to the end of the first quarter 2005. This was accomplished through restructuring and attrition. We would expect these actions to generate approximately $20 million to $23 million in annual cost savings, with a substantial portion of these cost savings being realized in 2006. Included in the employee headcount reduction are 374 employees who left the company as part of the sale of the disposal group. While the actions we are taking may negatively impact sales and profits in the short term, we believe they will yield a positive, long-term impact on operating margins.
We expect to implement changes in the fourth quarter of 2006 that will streamline our management structure as well as focus our RFID strategy on our core retail customers and our existing library business. As a result, we expect to incur additional restructuring expense in the fourth quarter 2006 related to these actions.
During the second quarter 2006, we settled the class action lawsuit that arose in connection with the antitrust litigation with ID Security Systems Canada, Inc. The settlement was for $1.45 million in cash and credits for the purchase of 90 million radio frequency label tags. As a result, we recorded a pre-tax charge to earnings of $2.3 million. As a portion of the settlement is in the form of vouchers for the future purchases of tags, the settlement is anticipated to impact revenue and margin over the term of the redemption period for the vouchers.
Future financial results will be dependent upon our ability to expand the functionality of our existing product lines, develop or acquire new products for sale through our global distribution channels, convert new large chain retailers to RF-EAS, and reduce the cost of our products and infrastructure to respond to competitive pricing pressures.
Our strong base of recurring revenue (revenues from the sale of consumables into the installed base of security systems, and hand-held labeling tools), repeat customer business, and our borrowing capacity should provide us with adequate cash flow and liquidity to execute our business plan.
Results of Operations
(All comparisons are with the previous year, unless otherwise stated.)
Net Revenues
Our unit volume is driven by product offerings, number of direct sales personnel, recurring sales and, to some extent, pricing. Our base of installed systems provides a source of recurring revenues from the sale of disposable tags, labels and service revenues.
Our customers are substantially dependent on retail sales, which are seasonal, subject to significant fluctuations, and difficult to predict. Such seasonality and fluctuations impact our sales. Historically, we have experienced lower sales in the first half of each year.
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Analysis of Statement of Operations
Thirteen Weeks Ended September 24, 2006 Compared to Thirteen Weeks Ended September 25, 2005
The following table presents for the periods indicated certain items in the consolidated statement of operations as a percentage of total revenues and the percentage change in dollar amounts of such items compared to the indicated prior period:
| | Percentage of Total Revenues | | Percentage Change
In Dollar Amount | |
| |
| |
| |
Quarter ended | | September 24,
2006
(Fiscal 2006) | | September 25,
2005
(Fiscal 2005) | | Fiscal 2006 vs.
Fiscal 2005 | |
| |
| |
| |
| |
Net Revenues | | | | | | | |
Security | | 73.8 | % | 79.2 | % | (15.7) | % |
Labeling Services | | 14.1 | | 9.8 | | 30.5 | |
Retail Merchandising | | 12.1 | | 11.0 | | (0.9) | |
| |
| |
| |
| |
Net revenues | | 100.0 | | 100.0 | | (9.6) | |
Cost of revenues | | 57.1 | | 56.9 | | (9.2) | |
| |
| |
| |
| |
Total gross profit | | 42.9 | | 43.1 | | (10.1) | |
Selling, general, and administrative expenses | | 32.4 | | 30.1 | | (2.6) | |
Research and development | | 2.9 | | 2.4 | | 9.3 | |
Restructuring | | 1.0 | | 1.9 | | (53.9) | |
Legal settlement | | — | | — | | — | |
| |
| |
| |
| |
Operating income | | 6.6 | | 8.8 | | (31.7) | |
Interest income | | 0.7 | | 0.3 | | N/A | |
Interest expense | | 0.3 | | 0.4 | | (37.7) | |
Other gain, net | | 0.2 | | — | | N/A | |
| |
| |
| |
| |
Earnings before income taxes and minority interest | | 7.2 | | 8.7 | | (24.5) | |
Income taxes | | — | | 1.7 | | N/A | |
Minority interest | | — | | — | | 33.3 | |
| |
| |
| |
| |
Earnings from continuing operations | | 7.2 | | 7.0 | | (6.0) | |
(Loss) earnings from discontinued operations, net of tax | | — | | 0.7 | | N/A | |
Net earnings | | 7.2 | % | 7.7 | % | (14.8) | % |
| |
| |
| |
| |
N/A – Comparative percentages are not meaningful.
Net Revenues
Revenues for the third quarter 2006 compared to the third quarter 2005 decreased by $17.7 million or 9.6% from $185.5 million to $167.8 million. Foreign currency translation had a positive impact on revenues of approximately $3.5 million or 1.9% in 2006 as compared to 2005.
(dollar amounts in millions) | | | | | | | | | |
Quarter ended | | September 24,
2006
(Fiscal 2006) | | September 25,
2005
(Fiscal 2005) | | Dollar Amount
Change
Fiscal 2006
vs. Fiscal 2005 | | Percentage
Change
Fiscal 2006
vs. Fiscal 2005 | |
| |
| |
| |
| |
| |
Net Revenues: | | | | | | | | | | | | |
Security | | $ | 123.9 | | $ | 147.0 | | $ | (23.1 | ) | (15.7 | )% |
Labeling Services | | | 23.7 | | | 18.1 | | | 5.6 | | 30.5 | |
Retail Merchandising | | | 20.2 | | | 20.4 | | | (0.2 | ) | (0.9 | ) |
| |
|
| |
|
| |
|
| |
| |
Net Revenues | | $ | 167.8 | | $ | 185.5 | | $ | (17.7 | ) | 9.6 | % |
| |
|
| |
|
| |
|
| |
| |
Security revenues decreased by $23.1 million or 15.7% in the third quarter 2006 as compared to the third quarter 2005. Foreign currency translation had a positive impact of approximately $2.2 million or 1.5% over prior year’s comparable quarter. The decrease in Security was primarily due to lower EAS revenues of $21.1 million coupled with lower CCTV revenues of $3.3 million. The decline in EAS was primarily due to decreases in the U.S. and Europe of $15.5 million and $6.4 million, respectively partially offset by an increase in Asia Pacific EAS revenues of $1.0 million. The decrease in the U.S. and European EAS revenues can be primarily attributed to large account chain-wide installations during 2005 that did not continue in 2006, and the effects of restructuring on European sales operations. The Asia Pacific increase is a result of new chain-wide installations in 2006. The decrease in CCTV was a result of slower store roll-outs in 2006 compared to 2005.
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Labeling Services revenues increased by $5.6 million or 30.5% over last year’s comparable quarter. Foreign currency translation had a positive impact of approximately $0.6 million or 3.1% over prior year’s comparable quarter. The increase was primarily due to increased Check-Net® revenues in Europe and Asia Pacific of $2.9 million and $0.4 million, respectively coupled with increased Intelligent Library Systems revenue of $0.9 million. The increase in Check-Net® revenues resulted from the increased focus on expanding our customer base attributable to our integrated apparel source tag labels. The increase in Intelligent Library Systems revenue was attributable to an increase in installation activity in the U.S.
Retail Merchandising revenues decreased by $0.2 million or 0.9% in the third quarter of 2006 compared to prior year’s identical period. Foreign currency translation had a positive impact of approximately $0.7 million or 3.7% over prior year’s comparable quarter. The decrease primarily resulted from the generalized decline of HLS revenues of $2.0 million offset by an increase in our Retail Merchandising Systems revenue of $1.1 million. The HLS decline of $2.0 million is due primarily to the continued transition from hand-held price labeling to automated bar-coding and scanning by retailers. The Retail Merchandising Systems increase was due to higher demand particularly in Europe.
Gross Profit
Gross profit for the third quarter of 2006 was $72.0 million, or 42.9% of revenues, compared to $80.0 million, or 43.1% of revenues, for the third quarter 2005. Foreign currency translation had a positive impact on gross profit of approximately $1.2 million or 1.5% in 2006 as compared to 2005.
Security gross profit, as a percentage of Security revenues, increased to 44.3% in the third quarter of 2006 from 43.9% in the third quarter of 2005. The increase in Security gross profit margin percentage was attributed to improved product margins compared to 2005 partially offset by an increase in inventory reserves of $4.7 million. The improvement in product margins was due to lower margins in 2005 from the large-chain wide roll-outs. The increase in inventory reserves was due to aging customer specific inventory and production issues with new label manufacturing processes.
Labeling Services gross profit, as a percentage of Labeling Services revenues, increased to 32.8% in the third quarter of 2006 from 27.3% in the third quarter of 2005. The increase in Labeling gross profit, as a percentage of Labeling revenues, resulted from higher gross margins in our Intelligent Library System (ILS) product line in the U.S. and improved margins in our CheckNet® business.
The Retail Merchandising gross profit, as a percentage of Retail Merchandising revenues, decreased to 45.8% in the third quarter of 2006 from 51.8% in the third quarter of 2005. This decrease was primarily due to lower margins in Europe resulting from the shift in HLS to franchising.
Field service and installation costs for 2006 and 2005 were 11.2% and 11.8% of net revenues, respectively. The decrease was due primarily to the restructuring initiatives and fewer large account chain wide installations of our EAS products in the third quarter of 2006.
Selling, General, and Administrative Expenses
Selling, general and administrative expenses decreased $1.4 million, or 2.6% over the third quarter 2005. Foreign currency increased selling, general, and administrative expenses by approximately $1.0 million or 1.8% in 2006 as compared to 2005. The selling, general, and administrative expenses decrease was due primarily to reductions associated with our restructuring initiatives, partially offset by stock compensation expense of $1.7 million in the third quarter of 2006 with no such comparable charge in 2005. As a percentage of revenues, selling, general, and administrative expenses increased to 32.4% in the third quarter of 2006 from 30.1% in the third quarter of 2005.
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Research and Development Expenses
Research and development (R&D) costs were $4.9 million, or 2.9% of revenues in the third quarter of 2006, as compared to $4.5 million, or 2.4% in the third quarter of 2005.
Restructuring Expenses
Restructuring expenses were $1.6 million in the third quarter 2006 compared to $3.5 million in the third quarter 2005. Restructuring expenses in 2006 were a result of additional cost reductions initiatives to improve our future operating performance.
Interest Income and Interest Expense
Interest expense decreased, in the third quarter of 2006, $0.3 million due to lower debt levels in 2006 compared to 2005. Interest income increased $0.7 million due to more cash invested and higher interest rates in 2006 compared to 2005.
Income Taxes
The continuing operations effective tax rate for the third quarter 2006 was 0.4%, including a $3.7 million reduction in valuation allowances and tax reserves. The reduction of the valuation allowance was due to the reassessment of our plans to rationalize operations, which led to a change in expected future profitability. The release in tax reserves was due to the expiration of statues of limitations in certain tax jurisdictions. For the third quarter 2005, the continuing operations effective tax rate was 20.1%, including a $1.0 million reduction in tax reserves.
Earnings from Continuing Operations
Earnings from continuing operations for the third quarter 2006 decreased $0.8 million from $12.9 million in 2005 to $12.1 million in 2006.
Earnings from Discontinued Operations, Net of Tax
Earnings from discontinued operations, net of tax, for the third quarter 2005 were $1.3 million in 2005 with minimal activity in 2006. The 2005 earnings from discontinued operations were primarily due to the bar-code business being in operation in 2005.
Net Earnings
Net earnings were $12.1 million, or $.30 per diluted share, in the third quarter 2006 compared to a net earnings of $14.2 million, or $.36 per diluted share, in the third quarter 2005. The weighted average number of shares used in the diluted earnings per share computation was 40.1 million and 39.2 million for the third quarters of 2006 and 2005, respectively.
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Thirty-nine Weeks Ended September 24, 2006 Compared to Thirty-nine Weeks Ended September 25, 2005
The following table presents for the periods indicated certain items in the consolidated statement of operations as a percentage of total revenues and the percentage change in dollar amounts of such items compared to the indicated prior period:
| | Percentage of Total Revenues | | Percentage
Change
In Dollar Amount | |
| |
| |
| |
Thirty-nine weeks ended | | September 24,
2006
(Fiscal 2006) | | September 25,
2005
(Fiscal 2005) | | Fiscal 2006 vs.
Fiscal 2005 | |
| |
| |
| |
| |
Net Revenues | | | | | | | |
Security | | 72.2 | % | 77.0 | % | (15.5) | % |
Labeling Services | | 15.2 | | 10.4 | | 31.6 | |
Retail Merchandising | | 12.6 | | 12.6 | | (10.3) | |
| |
| |
| |
| |
Net revenues | | 100.0 | | 100.0 | | (10.0) | |
Cost of revenues | | 58.0 | | 56.4 | | (7.3) | |
| |
| |
| |
| |
Total gross profit | | 42.0 | | 43.6 | | (13.4) | |
Selling, general, and administrative expenses | | 34.4 | | 33.5 | | (7.4) | |
Research and development | | 2.9 | | 2.6 | | (2.4) | |
Restructuring expense | | 0.5 | | 1.9 | | (74.7) | |
Legal settlement | | 0.5 | | — | | N/A | |
| |
| |
| |
| |
Operating income | | 3.7 | | 5.6 | | (41.6) | |
Interest income | | 0.7 | | 0.3 | | N/A | |
Interest expense | | 0.3 | | 0.4 | | (46.0) | |
Other gain, net | | 0.1 | | — | | N/A | |
| |
| |
| |
| |
Earnings before income taxes and minority interest | | 4.2 | | 5.5 | | (30.3) | |
Income taxes | | 0.4 | | 1.3 | | N/A | |
Minority interest | | — | | — | | 21.6 | |
| |
| |
| |
| |
Earnings from continuing operations | | 3.8 | | 4.2 | | (17.7) | |
Earnings from discontinued operations, net of tax | | 0.3 | | 1.0 | | N/A | |
Net earnings | | 4.1 | % | 5.2 | % | (28.2) | % |
| |
| |
| |
| |
N/A – Comparative percentages are not meaningful.
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Net Revenues
Revenues for the first nine months of 2006 compared to the same period in 2005 decreased by $52.6 million or 10.0% from $527.6 million to $475.0 million. Foreign currency translation had a negative impact on revenues of approximately $4.8 million or 0.9% in the first nine months of 2006 as compared to the first nine months of 2005.
(dollar amounts in millions)
Thirty-nine weeks ended | | September 26,
2006
(Fiscal 2006) | | September 25,
2005
(Fiscal 2005) | | Dollar Amount
Change
Fiscal 2006
vs. Fiscal 2005 | | Percentage
Change
Fiscal 2006
vs. Fiscal 2005 | |
| |
| |
| |
| |
| |
Net Revenues: | | | | | | | | | | | | |
Security | | $ | 342.8 | | $ | 405.9 | | $ | (63.1 | ) | (15.5 | )% |
Labeling Services | | | 72.4 | | | 55.1 | | | 17.3 | | 31.6 | |
Retail Merchandising | | | 59.8 | | | 66.6 | | | (6.8 | ) | (10.3 | ) |
| |
|
| |
|
| |
|
| |
| |
Net Revenues | | $ | 475.0 | | $ | 527.6 | | $ | (52.6 | ) | (10.0 | )% |
| |
|
| |
|
| |
|
| |
| |
Security revenues decreased by $63.1 million or 15.5% in the first nine months of 2006 as compared to the first nine months of 2005. Foreign currency translation had a negative impact of approximately $3.2 million or 0.8% over the first nine months of 2006. The remaining decline in security revenue was attributable to decreases in EAS revenues of $48.1 million and CCTV revenues of $8.6 million. The decrease of EAS revenue was primarily due to decreases in the U.S. and Europe of $33.8 million and $17.2 million, respectively which was partially offset by an increase in Asia Pacific EAS revenues of $3.6 million. The decrease in the U.S. and European EAS revenues can be primarily attributed to large account chain-wide installations during 2005 that did not continue in 2006 and the effects of the restructuring of European sales operations. The Asia Pacific increase is a result of new chain-wide installations in 2006. The CCTV decline was due primarily to decreases in the U.S. and Europe of $5.3 million and $3.2 million, respectively. The decrease in CCTV was due to fewer large account chain-wide roll-outs this year compared to the prior year.
Labeling Services revenues increased by $17.3 million or 31.6% over last year’s comparable period. Foreign currency translation had a negative impact of approximately $0.7 million or 1.3% over the first nine months of 2006. The increase in revenues was primarily due to an increase in Check-Net® and Intelligent Library System revenues of $13.7 million and $4.4 million, respectively.
Retail Merchandising revenues decreased by $6.8 million or 10.3%. The negative impact of foreign currency translation was approximately $0.9 million or 1.4%. The remaining decrease was primarily resulting from the decline of HLS revenues in Europe of $6.0 million. The transition to an indirect sales model in parts of Europe plus the ongoing transition from hand-held price labeling to automated bar-coding and scanning by retailers contributed to the decline in HLS.
Gross Profit
Gross profit for the first nine months of 2006 was $199.3 million, or 42.0% of revenues, compared to $230.2 million, or 43.6% of revenues, for the first nine months of 2005. Foreign currency translation had a negative impact of approximately $1.5 million or 0.7%.
Security gross profit, as a percentage of Security revenues, decreased to 42.6% in the first nine months of 2006 from 43.8% in the first nine months of 2005. Security gross profit percentage was negatively impacted by unfavorable manufacturing variances due to higher raw material costs, the implementation of a new manufacturing process for our RF labels, and costs to move our systems assembly operations from Puerto Rico to the Dominican Republic coupled with an increase in our inventory reserves. The increase in our inventory reserves were due to aging customer specific inventory and production issues with new label manufacturing processes.
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Labeling gross profit, as a percentage of Labeling revenues, increased to 34.0% in the first nine months of 2006 from 32.0% in the first nine months of 2005. The improved margin was due primarily to higher margins in our library business.
Retail Merchandising gross profit, as a percentage of Retail Merchandising revenues, decreased to 48.1% in the first nine months of 2006 from 52.0% in the first nine months of 2005. This decrease, as a percentage of Retail Merchandise revenues, was due primarily to the transition to an indirect sales model in parts of Europe.
Field service and installation costs for the first nine months of 2006 and 2005 were 10.9% and 11.9% of net revenues, respectively. The decrease was due primarily to cost reductions and fewer large account chain-wide installations of our EAS products in the first nine months of 2006 than in the first nine months of 2005.
Selling, General, and Administrative Expenses
Selling, general, and administrative expenses decreased $13.1 million, or 7.4% over the first nine months of 2006. Foreign currency translation decreased selling, general, and administrative expenses by approximately $1.6 million. The remaining decrease was due primarily to the impact of our restructuring initiatives coupled with consulting costs and the write-off of unamortized bank fees associated with the term loan and secured revolving credit facility resulting from the repayment of the term loan and refinancing of the revolving credit facility that did not re-occur in 2006. This was offset by stock compensation expense of $4.6 million in 2006 with no such comparable charge in 2005.
Research and Development Expenses
Research and development costs were $13.6 million, or 2.9% of revenues in the first nine months of 2006 and $14.0 million, or 2.6% in the first nine months of 2005.
Restructuring Expenses
Restructuring expenses were $2.5 million, or 0.5% of revenues for the first nine months of 2006, compared to $9.8 million, or 1.9% of revenues for the first nine months of 2005. The decrease was due primarily to the initial cost savings initiatives designed to improve sales productivity and the overhead structure in Europe that took place in 2005, which decreased in 2006.
Litigation Settlement
Litigation expense was $2.3 million for the first nine months of 2006. This was a result of the settlement of a class action suit arising from the anti-trust litigation with ID Security Systems Canada, Inc.
Interest Income
Interest income for the first nine months of 2006 increased $1.9 million from the comparable period in 2005 due primarily to an increase in cash associated with the sale of our bar-code business to SATO.
Interest Expense
Interest expense for the first nine months of 2006 decreased $1.2 million from the comparable period in 2005 due primarily to lower overall debt levels.
Income Taxes
The effective tax rate for the thirty-nine weeks ended September 24, 2006 was 9.0%. For the thirty-nine weeks ended September 25, 2005, the effective tax rate was 23.1%. The 2006 effective tax rate is positively impacted by a reduction of valuation allowances and tax reserves of $3.7 million. The reduction of the valuation allowance was due to the reassessment of our plans to rationalize operations, which led to a change in expected future profitability. The release in tax reserves was due to the expiration of statues of limitations in certain tax jurisdictions. For 2005, the continuing operations effective tax rate included a $1.0 million reduction in tax reserves.
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Earnings from Continuing Operations
Earnings from continuing operations for the first nine months of 2006 decreased $3.9 million from $22.2 million in 2005 to $18.3 million in 2006.
Earnings from Discontinued Operations, Net of Tax
Earnings from discontinued operations, net of tax, for the first nine months of 2006 decreased $3.8 million from $5.3 million in 2005 to $1.5 million in 2006. The 2005 earnings from discontinued operations were primarily due to the bar-code business being in operation in 2005. The 2006 earnings were due primarily to the $1.3 million gain on the sale of the bar-code business.
Net Earnings
Net earnings were $19.8 million, or $0.49 per diluted share, in the first nine months 2006 compared to $27.6 million, or $0.71 per diluted share, in the first nine months 2005. The weighted average number of shares used in the diluted earnings per share computation were 40.3 million and 38.9 million for the first nine months of 2006 and 2005, respectively.
Financial Condition
Liquidity and Capital Resources
Our liquidity needs have related to, and are expected to continue to relate to, capital investments, product development costs, future restructurings related to the rationalization of the business, acquisitions, and working capital requirements. We believe that cash provided from operating activities and funding available under our current credit agreement should be adequate for the foreseeable future to service debt and meet our anticipated cash requirements.
As of September 24, 2006, our cash and cash equivalents were $121.4 million compared to $113.2 million as of December 25, 2005. Our operating activities during the first nine months of 2006 used approximately $16.8 million compared to a use of $2.9 million during the first nine months of 2005. In comparison, our 2006 cash from operating activities was impacted negatively by lower net earnings, payment of restructuring liabilities and an increase in inventory levels due to lower than anticipated sales levels partially offset by the receipt of a $10.9 million tax refund. In addition, the 2005 cash from operating activities was negatively impacted by an increase in accounts receivable due to large chain-wide installations without such installations in 2006.
On January 30, 2006, we completed the sale transaction for our barcode systems (BCS) businesses and U.S. hand-held labeling and Turn-O-Matic® businesses for gross cash proceeds of $37 million ($32.1 million net of costs to sell and restricted cash) plus the assumption of $5 million in liabilities.
We continue to reinvest in the Company through spending in technology and process improvement. In the first nine months of 2006, our expenditures in research and development amounted to $13.6 million. We estimate our expenditures in research and development during the remainder of 2006 will be approximately $4.5 million.
Our capital expenditures for the first nine months of 2006 totaled $8.3 million, compared to $7.8 million during the first nine months of 2005. We anticipate our capital expenditures, used primarily to upgrade technology and improve our production capabilities, to approximate $3.0 million for the remainder of 2006.
As of September 24, 2006, our working capital was $244.6 million compared to $207.3 million as of December 25, 2005. At the end of the third quarter 2006, our percentage of total debt to total stockholders’ equity decreased to 6.0% from 9.3% as of December 25, 2005. As of September 24, 2006, we had available lines of credit totaling approximately $136.5 million.
In October 2006, the Company’s Board of Directors authorized the repurchase of up to 2 million shares of the Company’s Common Stock. Shares will be repurchased at the times and amounts determined by management based on its evaluation of market conditions and other factors. Repurchases will be made from time to time in the open market.
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We do not anticipate paying any cash dividends on our common stock in the near future.
Provisions for Restructuring
2005 Restructuring Plan
In the second quarter of 2005, we initiated actions focused on reducing our overall operating expenses in Europe. These actions included the implementation of a cost reduction plan designed to consolidate certain administrative functions in Europe. In addition, we have committed to a plan to restructure a portion of our supply chain staff as we transition our manufacturing to lower cost areas. A net charge of $3.1 million was recorded in the nine months ended 2006 in connection with these plans. The total employees affected by the restructuring were 742 of which 486 have been terminated. The anticipated total cost is expected to approximate $19 million to $21 million of which $19.0 million has been incurred. These terminations are anticipated to be complete by the end of 2006. Termination benefits are planned to be paid 1 month to 24 months after termination. Upon completion, the annual savings are anticipated to be approximately $20 million to $23 million.
Restructuring accrual activity was as follows:
(dollar amounts are in thousands)
| | Accrual at
Beginning of
Year | | Charged
to
Earnings | | Charge
Reversed
to
Earnings | | Cash
Payments | | Exchange
Rate
Changes | | Accrual
at 9/24/06 | |
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| |
| |
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| |
Severance and other employee-related charges | | $ | 10,121 | | $ | 3,780 | | $ | 725 | | $ | 10,347 | | $ | 486 | | $ | 3,315 | |
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2003 Restructuring Plan
In the first quarter 2006, we reversed $0.4 million of our lease reserve to income as we have obtained a sublease for the property previously reserved.
In the third quarter 2006, we reversed $0.2 million of previous severance accruals under the 2003 plan.
Exposure to Foreign Currency
We manufacture products in the USA, the Caribbean, Europe, and the Asia Pacific region for both the local marketplace, as well as for export to our foreign subsidiaries. The subsidiaries, in turn, sell these products to customers in their respective geographic areas of operation, generally in local currencies. This method of sale and resale gives rise to the risk of gains or losses as a result of currency exchange rate fluctuations on the inter-company receivables and payables. Additionally, the sourcing of product in one currency and the sales of product in a different currency can cause gross margin fluctuations due to changes in currency exchange rates.
We have historically not used financial instruments to minimize our exposure to currency fluctuations on our net investments in and cash flows derived from our foreign subsidiaries. We have used third party borrowings in foreign currencies to hedge a portion of our net investments in and cash flows derived from our foreign subsidiaries. As we reduce our third party foreign currency borrowings, the effect of foreign currency fluctuations on our net investments in and cash flows derived from our foreign subsidiaries increases.
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We selectively purchase currency forward exchange contracts to reduce the risks of currency fluctuations on short-term inter-company receivables and payables. These contracts guarantee a predetermined exchange rate at the time the contract is purchased. This allows us to shift the effect of positive or negative currency fluctuations to a third party. As of September 24, 2006, we had currency forward exchange contracts totaling approximately $16.7 million. The contracts are in the various local currencies covering primarily our Western European, Canadian, and Australian operations. Historically, we have not purchased currency forward exchange contracts where it is not economically efficient, specifically for our operations in South America and Asia.
Critical Accounting Policies and Estimates
Except as noted below, there has been no change to our critical accounting policies and estimates, contained in Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of our Annual Report on Form 10-K filed for the year ended December 25, 2005.
Effective December 26, 2005, we adopted the fair value recognition provision of Statement of Financial Accounting Standards (SFAS) 123R “Share-based Payment”, using the modified prospective transition method, and therefore have not restated prior period results. Under this method we recognize compensation expense for all share-based payments granted either after December 25, 2005 or prior to December 26, 2005 but not vested as of that date. Under the fair value recognition provisions of SFAS 123R, we recognize share-based compensation net of an estimated forfeiture rate and only recognize compensation cost for those shares expected to vest. For awards granted after the adoption date we recognize the expense on a straight-line basis over the requisite service period of the award. For non-vested awards granted prior to the adoption date, we continue to use the ratable expense allocation method. Prior to SFAS 123R adoption, we accounted for share-based payments under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) and accordingly, generally recognized compensation expense only when we granted options with a discounted exercise price. Pro forma net earnings and earnings per share stated as if we applied the fair value method, were previously disclosed in our consolidated financial statement footnotes in accordance with SFAS 148 “Accounting for Stock-based Compensation – Transition and Disclosures.”
Determining the appropriate fair value model and calculating the fair value of share-based payment awards requires the input of highly subjective assumptions, including the expected life of the share-based payment awards and stock price volatility. The assumptions used in calculating the fair value of share-based payment awards represent management’s best estimates, but these estimates involve inherent uncertainties and the application of management judgment. As a result, if factors change and we use different assumptions, our share-based compensation expense could be materially different in the future. In addition, we are required to estimate the expected forfeiture rate and only recognize expense for those shares expected to vest. If our actual forfeiture rate is materially different from our estimate, the share-based compensation expense could be significantly different from what we have recorded in the current period. See Note 2 to the Consolidated Condensed Financial Statements for a further discussion on share-based compensation.
Off-balance Sheet Arrangements and Contractual Obligations
Our significant contractual obligations and off-balance sheet arrangements have not changed materially from those disclosed in our Annual Report on Form 10-K for the year ended December 25, 2005.
New Accounting Pronouncements and Other Standards
In June 2006, the FASB ratified Emerging Issues Task Force (EITF) issued Issue 06-3, “How Sales Taxes Collected From Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement”. EITF 06-3 requires a company to disclose its accounting policy (i.e., gross or net presentation) regarding the presentation of taxes within the scope of EITF 06-3. If taxes are significant, a company should disclose the amount of such taxes for each period for which an income statement is presented. The guidance is effective for periods beginning after December 15, 2006. We are currently evaluating the effect that the adoption of EITF 06-3 will have on our results of operations.
In July 2006, the FASB issued Interpretation (FIN) No. 48, “Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109” which prescribes a recognition threshold and measurement attribute, as well as criteria for subsequently recognizing, derecognizing and measuring uncertain tax positions for financial statement purposes. FIN 48 also requires expanded disclosure with respect to the uncertainty in income tax assets and liabilities. FIN 48 is effective for fiscal years beginning after December 15, 2006 and is required to be recognized as a change in accounting principle through a cumulative-effect adjustment to retained earnings as of the beginning of the year of adoption. We are currently evaluating the effect that the adoption of FIN 48 will have on our financial position and results of operations.
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In September 2006, the FASB issued SFAS 157, “Fair Value Measurements”. This Standard defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. The adoption of SFAS 157 is not expected to have a material impact on our financial position, results of operations or cash flows.
The FASB also issued in September 2006 SFAS 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans — an amendment of FASB Statement No. 87, 88, 106 and 132(R)”. This Standard requires recognition of the funded status of a benefit plan in the statement of financial position. The Standard also requires recognition in other comprehensive income certain gains and losses that arise during the period but are deferred under pension accounting rules, as well as modifies the timing of reporting and adds certain disclosures. SFAS 158 provides recognition and disclosure elements to be effective as of the end of the fiscal year after December 15, 2006 and measurement elements to be effective for fiscal years ending after December 15, 2008. We are currently evaluating the effect that the adoption of SFAS 158 will have on our financial position and results of operations
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Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
There have been no significant changes to the market risks as disclosed in Item 7a. “Quantitative And Qualitative Disclosures About Market Risk” of our Annual Report on Form 10-K filed for the year ended December 25, 2005.
Item 4. CONTROLS AND PROCEDURES
We carried out an evaluation, under the supervision and with the participation of our principal executive officer and principal financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this report. Based on this evaluation, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures are effective.
There has been no change in our internal control over financial reporting that occurred during the period ended September 24, 2006 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
PART II. OTHER INFORMATION
Item 1. LEGAL PROCEEDINGS
We are involved in certain legal and regulatory actions, all of which have arisen in the ordinary course of business, except for the matters described in the following paragraphs. Management believes it is remotely possible that the ultimate resolution of such matters will have a material adverse effect on our consolidated results of operations and/or financial condition, except as described below.
ID Security Systems Canada Inc. versus Checkpoint Systems, Inc.
On August 1, 2004, the Company and ID Security Systems Canada Inc. entered into a settlement agreement effective July 30, 2004, pursuant to which the Company agreed to pay $19.95 million, in full and final settlement of the claims covered by the litigation. This settlement was accrued in the second quarter of 2004. Payment in full was made on August 5, 2004.
Matters related to ID Security Systems Canada Inc. versus Checkpoint Systems, Inc.
On June 22, 2006, the Company settled the follow-on purported class action suits that were filed in connection with the ID Security Systems Canada Inc. litigation. The purported class action complaints generally alleged a claim of monopolization and were substantially based upon the same allegations as contained in the ID Security Systems Canada Inc. case as discussed above. The settlement was for $1.45 million in cash and credits for the purchase of 90 million radio frequency label tags. As a result, we recorded a pre-tax charge to earnings of $2.3 million. As a portion of the settlement is in the form of vouchers for the future purchases of tags, the settlement is anticipated to impact revenue and margin over the term of the redemption period for the vouchers.
All-Tag Security S.A., et al
The Company originally filed suit on May 1, 2001, alleging that the disposable, deactivatable radio frequency security tag manufactured by All-Tag Security S.A. and All-Tag Security Americas, Inc.’s (jointly “All-Tag”) and sold by Sensormatic Electronics Corporation (Sensormatic) infringed on a U.S. Patent No. 4,876,555 (Patent) owned by the Company. On April 22, 2004, the United States District Court for the Eastern District of Pennsylvania granted summary judgment to defendants All-Tag and Sensormatic Electronics Corporation on the ground that the Company’s Patent is invalid for incorrect inventorship. The Company appealed this decision. On June 20, 2005, the Company won an appeal when the Federal Circuit reversed the grant of summary judgment and remanded the case to the District Court for further proceedings. The case is now in the discovery phase and trial is set for January 2007. The original U.S. application was filed in March 1988 and is scheduled to expire on March 17, 2007. The Company acquired the patent in 1995 when it acquired Actron AG.
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Item 1A. RISK FACTORS
There have been no material changes from December 25, 2005 to the significant risk factors and uncertainties known to the Company that, if they were to occur, could materially adversely affect the Company's business, financial condition, operating results and/or cash flow. For a discussion of the Company's risk factors, refer to Item 1A. "Risk Factors", contained in the Company's Annual Report on Form 10-K for the year ended December 25, 2005.
Item 6. EXHIBITS
Exhibit 3.1 | | Articles of Incorporation, as amended, are hereby incorporated by reference to Item 14(a), Exhibit 3(i) of the Registrant’s 1990 Form 10-K, filed with the SEC on March 14, 1991. |
Exhibit 3.2 | | By-Laws, as Amended and Restated, are hereby incorporated by reference to Item 15(c), Exhibit 3.2 of the Registrant’s 2004 10-K, filed with the SEC on March 11, 2005. |
Exhibit 31.1 | | Rule 13a-14(a) Certification of George W. Off, Chairman of the Board, President and Chief Executive Officer. |
Exhibit 31.2 | | Rule 13a-14(a) Certification of W. Craig Burns, Executive Vice President, Chief Financial Officer and Treasurer. |
Exhibit 32.1 | | Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
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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.
CHECKPOINT SYSTEMS, INC. | | | |
/s/ W. Craig Burns
| | |
November 3, 2006
|
| | | |
W. Craig Burns
Executive Vice President,
Chief Financial Officer and Treasurer | | | |
/s/ Raymond D. Andrews | | | November 3, 2006 |
| | | |
Raymond D. Andrews
Vice President
and Chief Accounting Officer | | | |
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INDEX TO EXHIBITS
EXHIBIT | | DESCRIPTION |
| |
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| | |
EXHIBIT 31.1 | | Rule 13a-14(a)/15d-14(a) Certification of George W. Off, Chairman of the Board, President and Chief Executive Officer |
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EXHIBIT 31.2 | | Rule 13a-14(a)/15d-14(a) Certification of W. Craig Burns, Executive Vice President, Chief Financial Officer and Treasurer |
| | |
EXHIBIT 32.1 | | Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 936 of the Sarbanes-Oxley Act of 2002 |
| | |
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)