Comparison of the 2003 and 2002 Periods and Quarters
Net sales.Net sales increased $218.5 million, or 18.7%, to $1.39 billion in the 2003 quarter from net sales of $1.17 billion in the 2002 quarter. Net sales increased $789.5 million, or 24.4%, to $4.02 billion in the 2003 period from net sales of $3.23 billion in the 2002 period. Net sales in our existing operations for the 2003 quarter comprised 16.6% and 14.0% of our total sales growth for the 2003 quarter and period, respectively, while acquisitions contributed the remaining 2.1% and 10.4% of our total sales growth for the 2003 quarter and period, respectively. Net sales in existing operations exclude the net sales of an acquired business for the first 12 months following the acquisition date of that business. We estimate food price inflation was approximately 2.5% and 1.0% for the 2003 quarter and period, respectively.
Broadline net sales increased $89.5 million, or 14.5%, to $707.6 million in the 2003 quarter from $618.2 million in the 2002 quarter. Net sales in the 2003 period increased $468.8 million, or 29.9%, to $2.04 billion, from $1.57 billion in the 2002 period. Net sales in our existing Broadline operations for the 2003 quarter and period comprised 10.6% and 8.5%, respectively, of total Broadline sales growth. Broadline sales growth in our existing operations in the 2003 quarter and period was driven by increased sales to existing and new customers as a result of pursuing our strategy of increasing sales to independent restaurants and generating incremental growth from existing customers and markets. Acquisitions contributed the remaining 3.9% and 21.4% of total Broadline sales growth for the 2003 quarter and period, respectively. Broadline acquisition sales growth was the result of our acquisition of Quality Foods, Inc. in the second quarter of 2002 and the acquisitions of Middendorf Meat Company and Thoms-Proestler Company and TPC Logistics, Inc., collectively TPC, in the third quarter of 2002, discussed in "Business Combinations." Our Broadline segment net sales represented 50.9% and 50.6% of our consolidated net sales in the 2003 quarter and period, respectively, compared to 52.8% and 48.5% of our consolidated net sales in the 2002 quarter and period, respectively. The decrease as a percentage of our consolidated net sales for the 2003 quarter is due primarily to increased sales in our Customized segment, discussed below. The increase as a percentage of our consolidated net sales for the 2003 period is due primarily to our 2002 acquisitions of Quality Foods, Middendorf Meat and TPC. We estimate that our Broadline segment experienced food price inflation of approximately 3.9% in the 2003 quarter and 2.0% in the 2003 period. Our Broadline segment expects to stop servicing certain Wendy's quick-service restaurant locations in the first quarter of fiscal 2004, a portion of which we expect to replace with new business. The estimated annual sales to these Wendy's locations totals approximately $120 million.
Customized net sales increased $103.9 million, or 29.9%, to $450.9 million in the 2003 quarter from $347.0 million in the 2002 quarter. Net sales increased $267.8 million, or 25.8%, to $1.31 billion in the 2003 period from $1.04 billion in the 2002 period. The increase in net sales is primarily due to sales to approximately 200 additional Ruby Tuesday casual-dining chain restaurants beginning in the third quarter of 2002, sales to approximately 265 additional T.G.I. Friday's casual-dining restaurants beginning in the fourth quarter of 2002, sales to approximately 70 Mimi's Café casual-dining restaurants beginning in the first quarter of 2003, sales to approximately 100 additional Ruby Tuesday locations beginning in the second quarter of 2003, and the continued growth in sales to existing customers. Customized net sales represented 32.5% of our consolidated net sales in both the 2003 quarter and period, up from 29.7% and 32.1% of our consolidated net sales in the 2002 quarter and period, respectively. The increase as a percentage of our consolidated net sales is due primarily to sales to new customers. We estimate that our Customized segment experienced approximately 1% food price inflation in the 2003 quarter and nominal food price deflation in the 2003 period.
Fresh-cut net sales increased $26.1 million, or 12.6%, to $234.2 million in the 2003 quarter from $208.1 million in the 2002 quarter. Net sales increased 9.0%, or $57.0 million, to $692.7 million in the 2003 period from $635.6 million in the 2002 period. This increase in net sales is due primarily to increased sales of "Tender Leaf" premium salad products to quick-service restaurants and retail customers. Our Tender Leaf salad products include Baby Spinach, Spring Mix Blends, Blends Plus and foodservice premium salad products. Fresh-cut net sales represented 16.6% and 16.9% of our consolidated net sales in the 2003 quarter and period, respectively, down from 17.5% and 19.4% of our consolidated net sales in the 2002 quarter and period, respectively. The decrease as a percentage of our consolidated net sales is due primarily to increased sales in our Customized segment in the 2003 quarter, combined with additional sales from our 2002 Broadline segment acquisitions. We estimate that our Fresh-cut segment experienced approximately 2% food price inflation in the 2003 quarter and nominal food price inflation in the 2003 period.
Cost of goods sold.Cost of goods sold increased $191.8 million, or 19.5%, to $1.17 billion in the 2003 quarter from $981.1 million in the 2002 quarter. Cost of goods sold in the 2003 period increased $683.9 million, or 25.2%, to $3.39 billion from $2.71 billion in the 2002 period. As a percentage of net sales, cost of goods sold increased to 84.5% and 84.4% in the 2003 quarter and period, respectively, from 83.9% and 83.8% in the 2002 quarter and period, respectively. The increase in cost of goods sold as a percentage of net sales is due to increased production costs in our Fresh-cut segment related to the growth of our Tender Leaf premium salad products in the 2003 period and increased lettuce costs in the second quarter of 2003. The growth in sales of our Tender Leaf salad products, discussed in "Net Sales," created inefficiencies in our processing and warehousing activities due to the slower speeds of the Tender Leaf processing equipment and the related physical capacity co nsumed by these processing lines. We are making improvements to a number of our existing production lines and will be installing two new Tender Leaf production lines to increase production capacity throughout the first and second quarters of 2004. In the second quarter of 2003, the cost of lettuce was affected by industry-wide increased demand from quick-service restaurants for new premium salad products supplied by our Fresh-cut segment. This level of demand was not anticipated when growers made their planting decisions, which resulted in a significant increase in market prices for lettuce. While we routinely contract for the vast majority of our lettuce needs, the success of these products meant that we had to make additional market purchases at higher prices to satisfy increased customer demand. We recouped some of these increased costs in the 2003 quarter. Cost of goods sold in the 2003 quarter and period included costs related to our Fresh-cut segment's retail consumer test of our fresh-cut fruit product line, as discussed in "Operating profit." These fruit test costs were minimal in the 2002 quarter and period. Furthermore, the 2002 quarter and period included $3.3 million of expenses attributable to damaged inventory as a result of an ammonia leak in July 2002 at our Springfield, Massachusetts Broadline facility. For further discussion of the ammonia leak, refer to our 2002 Annual Report on Form 10-K.
Gross profit.Gross profit increased $26.7 million, or 14.1%, to $215.4 million in the 2003 quarter from $188.7 million in the 2002 quarter. Gross profit in the 2003 period increased $105.6 million, or 20.1%, to $629.7 million from $524.1 million in the 2002 period. The increase in gross profit in the 2003 quarter and period was primarily due to additional sales in our Broadline and Customized segments, as discussed in "Net Sales." Gross profit margin, which we define as gross profit as a percentage of net sales, decreased to 15.5% and 15.6% in the 2003 quarter and period, respectively, from 16.1% and 16.2% in the 2002 quarter and period, respectively. The decrease in gross profit margin in the 2003 quarter and period was due primarily to increased production costs for Tender Leaf products, the impact of lettuce costs and costs related to our retail consumer test of fresh-cut fruit in our Fresh-cut segment, as discussed in "Cost of goods sold."
Operating expenses.Operating expenses increased $17.3 million, or 11.0%, to $175.6 million in the 2003 quarter, compared to $158.2 million in the 2002 quarter. Operating expenses increased $83.8 million, or 19.4%, to $515.8 million in the 2003 period, compared to $432.0 million in the 2002 period. As a percentage of net sales, operating expenses were 12.6% and 12.8% in the 2003 quarter and period, respectively, compared to 13.5% and 13.4% in the 2002 quarter and period, respectively. The decrease in operating expenses as a percentage of net sales was driven primarily by improved efficiencies in our Broadline segment and reduced overhead costs in our Fresh-cut segment. In the 2002 quarter and period, operating expenses included $1.5 million of costs directly attributable to the ammonia leak at our Springfield, Massachusetts Broadline facility.
Operating profit. Operating profitincreased $9.3 million, or 30.6%, to $39.8 million in the 2003 quarter from $30.5 million in the 2002 quarter. Operating profitincreased $21.8 million, or 23.7%, to $114.0 million in the 2003 period from $92.2 million in the 2002 period. Operating profit margin, which we define as operating profit as a percentage of net sales, increased to 2.9% in the 2003 quarter from 2.6% in the 2002 quarter and was 2.8% in both the 2003 and 2002 periods.
Operating profit margin in our Broadline segment increased to 2.8% in the 2003 quarter from 1.8% in the 2002 quarter, and increased to 2.6% in the 2003 period from 2.2% in the 2002 period. In the 2002 quarter and period, our Broadline segment operating profit margin was adversely affected by $4.8 million of costs attributable to the ammonia leak at our Springfield facility, discussed in "Cost of goods sold" and "Operating expenses."
Operating profit margin in our Customized segment was 1.3% in both the 2003 and 2002 quarters and increased to 1.3% in the 2003 period from 1.2% in the 2002 period. This improvement in operating profit margin resulted primarily from changes in pricing and improved operating efficiencies. Subsequent to the end of the 2003 quarter, our Customized distribution facility in Elkton, Maryland has been affected by a work stoppage by certain of its drivers. Currently, approximately 42% of the 90 drivers who are represented by the union have returned to work. In our fiscal 2003 fourth quarter, we will incur incremental costs to engage replacement drivers to maintain the service level to our customers and to provide additional security at the facility.
Operating profit margin in our Fresh-cut segment decreased to 7.7% in the 2003 quarter from 8.8% in the 2002 quarter, and decreased to 8.3% in the 2003 period from 8.7% in the 2002 period. The decrease in operating profit margin in the 2003 quarter and period is due mainly to increased production costs for Tender Leaf premium salad products, the increase in lettuce costs as a result of increased demand from quick-service restaurants for new premium salad products in the second quarter of 2003 and costs related to our retail consumer test of fresh-cut fruit, partially offset by reduced operating expenses due to improved efficiencies, all discussed in "Cost of goods sold" and "Operating expenses." As discussed in "Cost of goods sold," we are working to increase our production capacity for Tender Leaf premium salad products in the remainder of 2003 and the first half of 2004. In addition, as discussed in "Cost of goods sold," we recouped some of the increased lettuce costs created by incre ased demand for premium salad products at quick-service restaurants in the 2003 quarter. Finally, we had net costs of $2.7 million and $9.3 million in the 2003 quarter and period, respectively, related to our retail consumer test of fresh-cut fruit. We expect the impact of these start-up costs to continue to decline in the fourth quarter of 2003 as we introduce this fresh-cut fruit into more retail locations. In addition, we added fruit processing capacity to our Midwest operations in the 2003 quarter.
Other expense, net.Other expense, net,increased to $5.0 million in the 2003 quarter from $4.9 million in the 2002 quarter, and to $14.0 million in the 2003 period from $13.7 million in the 2002 period. Interest expense was $4.7 million in the 2003 quarter, compared to $4.6 million in the 2002 quarter, and $14.5 million in the 2003 period, compared to $13.4 million in the 2002 period. Interest expense was higher in the 2003 quarter and period because of higher average borrowing levels as a result of our acquisitions in 2002, partially offset by lower interest rates. The loss on the sale of the undivided interest in receivables increased to $478,000 in the 2003 quarter from $444,000 in the 2002 quarter, and decreased to $1.2 million in the 2003 period from $1.4 million in the 2002 period. The increase in the loss for the 2003 quarter was due to higher levels of accounts receivable securitized than in the 2002 quarter. The decrease in this loss for the 2003 period was du e to lower financing costs in the 2003 period. The loss on the sale of the undivided interest in receivables is related to the receivables purchase facility, referred to as the Receivables Facility, discussed in "Liquidity and Capital Resources." Other, net, in the 2003 period also included a gain of $956,000 on the sale of our investment in a fresh-cut produce facility sold in the first quarter of 2003.
Income tax expense.Income tax expense increased to $13.2 million in the 2003 quarter from $9.6 million in the 2002 quarter, and to $38.0 million in the 2003 period from $29.4 million in the 2002 period. As a percentage of earnings before income taxes, the provision for income taxes was 38.0% for the 2003 quarter and period and 37.5% for the 2002 quarter and period. The increase in the effective tax rate in 2003 is the result of increased state income taxes due to acquisitions completed in previous years.
Net earnings.Net earnings increased $5.6 million, or 35.1%, to $21.6 million in the 2003 quarter, compared to $16.0 million in the 2002 quarter. In the 2003 period, net earnings increased $12.9 million, or 26.4%, to $62.0 million from $49.0 million in the 2002 period. As a percentage of net sales, net earnings increased to 1.6% in the 2003 quarter from 1.4% in the 2002 quarter, and were 1.5% in both the 2003 and 2002 periods.
Diluted net earnings per common share.Diluted net earnings per common share, or EPS, is computed by dividing net income available to common shareholders plus dilutive after-tax interest on the 5½% convertible subordinated notes due in 2008, the Convertible Notes, by the weighted-average number of common shares and dilutive potential common shares outstanding during the period. Diluted EPS increased 29.4% to $0.44 in the 2003 quarter, compared to $0.34 in the 2002 quarter. In the 2003 period, diluted EPS increased 21.9% to $1.28 from $1.05 in the 2002 period. After-tax interest expense of $1.9 million and $5.6 million for the 2003 and 2002 quarters and periods, respectively, and common share equivalents of 6.1 million related to the Convertible Notes are included in the computation of diluted EPS in the 2003 and 2002 quarters and periods, because of the Convertible Notes' dilutive effect on EPS.
Liquidity and Capital Resources
We have historically financed our operations and growth primarily with cash flows from operations, borrowings under our credit facilities, the issuance of long-term debt, operating leases, normal trade credit terms and the sale of our common stock. Despite our growth in net sales, we have reduced our working capital needs by financing our investment in inventory principally with accounts payable and outstanding checks in excess of deposits. We typically fund our acquisitions and expect to fund future acquisitions with our existing cash, additional borrowings under our credit facility and the issuance of debt or equity securities.
Cash and cash equivalents totaled $36.1 million at September 27, 2003, an increase of $2.4 million from December 28, 2002. The increase was comprised of cash provided by operating activities of $140.7 million, partially offset by net cash used in investing activities of $75.8 million and net cash used in financing activities of $62.5 million.
Cash flows from operating activities. Cash provided by operating activities was $140.7 million in the 2003 period. In the 2003 period, the primary sources of cash from operating activities were net earnings and increased levels of trade accounts payable and accrued expenses and decreased levels of deferred income taxes, partially offset by increased levels of inventories and prepaid expenses. The change in operating assets and liabilities, net, includes proceeds received of $32.0 million in the 2003 quarter from the sale of an additional undivided interest in our Receivables Facility, discussed in "Off Balance Sheet Financing Activities." Cash provided by operating activities was $107.1 million in the 2002 period. In the 2002 period, the primary sources of cash from operations were net earnings and increased levels of income taxes payable, trade payables, accrued expenses and decreased levels of other current assets, partially offset by increased levels of trade receivables, de ferred tax assets and prepaid expenses.
Cash used in investing activities. Cash used in investing activities was $75.8 million in the 2003 period. Capital expenditures were $69.5 million in the 2003 period. Capital expenditures in the 2003 period included the purchase of two distribution centers from our master operating lease facilities totaling $15.3 million, discussed in "Off Balance Sheet Financing Activities." Capital expenditures in the 2003 period also included the purchase of additional fresh-cut processing equipment and an expansion of our Customized facility in Maryland. We anticipate that total capital expenditures, excluding acquisitions, for fiscal 2003 will be between $95 million and $105 million. Net cash paid for acquisitions in the 2003 period included $11.0 million paid to the former shareholders of Fresh International Corp. and its subsidiaries, collectively "Fresh Express," related to certain contractual obligations in the purchase agreement for Fresh Express, which we acquired in 2001. Also in the 2003 period, net cash paid for acquisitions included $1.9 million related to contractual obligations in the purchase agreements for companies acquired in 2001 and 2000. In the 2003 period, net cash paid for acquisitions also included $2.2 million received related to the closing net worth adjustment and certain related claims in connection with our 2002 acquisition of Middendorf Meat. In the 2003 period, we received proceeds of $4.5 million from the sale of our investment in a fresh-cut produce facility and recorded a gain on the sale of $956,000. Cash used in investing activities in the 2002 period was $241.7 million. Capital expenditures, excluding acquisitions of other businesses, for the 2002 period were $42.6 million. Cash used in investing activities in the 2002 period also included $199.5 million of cash paid for acquisitions, consisting of $84.1 million, $22.2 million and $90.3 million paid for the acquisitions of TPC, Middendorf Meat and Quality Foods, respectively, net of cash acquired, and $2 .9 million paid to the former shareholders of Carroll County Foods, Inc. and AFFLINK Incorporated (formerly Affiliated Paper Companies, Inc.), which were acquired in 2000 and 1998, respectively, as a result of certain contractual obligations under the purchase agreements relating to those acquisitions.
Cash used in financing activities. Cash used in financing activities was $62.5 million in the 2003 period, consisting primarily of net payments of $65.5 million on our revolving credit facility and a decrease in outstanding checks in excess of deposits of $4.8 million. We paid $732,000 in the 2003 period for debt issuance costs related to the revolving credit facility, discussed in "Financing Activities." In the 2003 period, cash flows from financing activities consisted of $10.7 million of proceeds from the exercise of stock options and purchases under our employee stock purchase plan. Cash provided by financing activities was $97.0 million in the 2002 period. Cash flows from financing activities included net borrowings of $97.0 million on our revolving credit facility and proceeds of $7.4 million from the exercise of stock options and purchases under our employee stock purchase plan. Cash used in financing activities in the 2002 period included a decrease in outstanding checks in excess of deposits of $5.4 million.
Financing Activities
In April 2003, we amended and restated our credit facility, referred to as the Credit Facility, which, among other things, increased the facility to $350.0 million from $200.0 million. The Credit Facility expires in 2006 and bears interest at a floating rate equal to, at our election, the agent bank's prime rate or a spread over LIBOR, which varies based upon our leverage ratio, as defined in the credit agreement. The Credit Facility has an annual commitment fee, ranging from 0.20% to 0.25% of the average daily unused portion of the total facility, based on our leverage ratio, as defined in the credit agreement. The Credit Facility also requires the maintenance of certain financial ratios, as defined in the credit agreement, and contains customary events of default. Under the Credit Facility, our subsidiaries are no longer required to guarantee borrowings, letters of credit or any other obligations, as had previously been required. The Credit Facility allows for the issuance of up to $90.0 million of standby letters of credit, which reduce borrowings available under the Credit Facility. At September 27, 2003, we had $32.5 million of borrowings outstanding, $41.7 million of letters of credit outstanding and $275.8 million available under the Credit Facility, subject to compliance with customary borrowing conditions. At September 27, 2003, our borrowings under the Credit Facility bore interest at a rate of 1.62% per annum. Interest is payable monthly.
We believe that our cash flows from operations, borrowings under our credit facilities and the sale of the undivided interest in receivables under the Receivables Facility, discussed below, will be sufficient to fund our operations and capital expenditures for the foreseeable future. However, we will likely require additional sources of financing to the extent that we make acquisitions in the future.
Off Balance Sheet Financing Activities
We have a Receivables Facility, which is generally described as off balance sheet financing. The Receivables Facility represents off balance sheet financing because the transaction and the financial institution's ownership interest in certain of our accounts receivable results in assets being removed from our consolidated balance sheet to the extent that the transaction qualifies for sale treatment under generally accepted accounting principles. This treatment requires us to account for the transaction with the financial institution as a sale of the undivided interest in the accounts receivable instead of reflecting the financial institution's net investment of $110.0 million as debt.
In July 2001, we entered into the Receivables Facility, under which PFG Receivables Corporation, a wholly owned, special-purpose subsidiary, sold an undivided interest in certain of our trade receivables. PFG Receivables Corporation was formed for the sole purpose of buying receivables generated by certain of our operating units and selling an undivided interest in those receivables to a financial institution. Under the Receivables Facility, certain of our operating units sell a portion of their accounts receivable to PFG Receivables Corporation, which in turn, subject to certain conditions, may from time to time sell an undivided interest in these receivables to the financial institution. Our operating units continue to service the receivables on behalf of the financial institution at estimated market rates. Accordingly, we have not recognized a servicing asset or liability.
We received $78.0 million of proceeds from the sale of the undivided interest in receivables under the Receivables Facility in 2001, and we continue to securitize our accounts receivable. Under the original terms of the Receivables Facility, the amount of the undivided interest in the receivables owned by the financial institution could not exceed $90.0 million at any one time. On June 30, 2003, we extended the term of the Receivables Facility through June 28, 2004, and increased the amount of the undivided interest in the receivables that can be owned by the financial institution to $165.0 million. On July 24, 2003, we sold an incremental undivided interest in receivables under the Receivables Facility and received an additional $32.0 million in proceeds. We used these proceeds to repay borrowings under our Credit Facility and to fund working capital needs.
At September 27, 2003, securitized accounts receivable totaled $175.9 million, including $110.0 million sold to the financial institution and derecognized from the consolidated balance sheet and including our residual interest in accounts receivable of $65.9 million. The Residual Interest represents our retained interest in receivables held by PFG Receivables Corporation and is included in accounts receivable on our consolidated balance sheet. We measure the Residual Interest using the estimated discounted cash flows of the underlying accounts receivable, based on estimated collections and a discount rate approximately equivalent to our incremental borrowing rate. The loss on sale of the undivided interest in receivables of $478,000 and $444,000 in the 2003 and 2002 quarters, respectively, and $1.2 million and $1.4 million in the 2003 and 2002 periods, respectively, is included in other expense, net, in our consolidated statements of earnings and represents our cost of securitizing thos e receivables with the financial institution.
We record the sale of the undivided interest in accounts receivable to the financial institution according to Statement of Financial Accounting Standards, or SFAS, No. 140,Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. Accordingly, at the time the undivided interest in receivables is sold, the receivables are removed from our consolidated balance sheet. We record a loss on the sale of the undivided interest in these receivables, which includes a discount, based upon the receivables' credit quality and a financing cost for the financial institution, based upon a 30-day commercial paper rate. At September 27, 2003, the rate under the Receivables Facility was 1.58% per annum.
In June 2003, we terminated our two master operating lease facilities. In June 2003, the lessor sold two of the three distribution centers included in the first master operating lease facility (the "First Facility") to third parties unaffiliated with us. We concurrently entered into operating leases with those unaffiliated third parties for these distribution centers. The operating leases have initial terms of 22 years, plus five renewal options of five years each. In addition, we purchased the remaining distribution center in the First Facility from the lessor for $10.4 million. This distribution center is recorded on our consolidated balance sheet at September 27, 2003, in our Customized segment.
In June 2003, the lessor sold one of the distribution centers and the office building included in our other master operating lease facility (the "Second Facility") to third parties unaffiliated with us. We also sold land and a building under construction to a third party unaffiliated with us. We concurrently entered into operating leases with those unaffiliated third parties for all of these properties. The operating leases have initial terms of 22 years, plus five renewal options of five years each. In addition, we purchased the remaining distribution center in the Second Facility from the lessor for $4.9 million. This distribution center is recorded on our consolidated balance sheet at September 27, 2003, in our Broadline segment.
As a result of our termination of the two master operating lease facilities, our four new operating leases and our purchase of two distribution centers previously included in these facilities, our future minimum lease payments increased by $79.5 million, net. As of September 27, 2003, these remaining payments totaled $79.3 million, net: $195,000 in the remainder of 2003; $1.4 million in 2004; $2.9 million in 2005; $3.8 million in each of 2006, 2007 and 2008; and $63.4 million thereafter. The four new operating leases discussed above do not contain residual value guarantees.
Contractual Obligations
At September 27, 2003, our Fresh-cut segment had contracts to purchase produce totaling $67.2 million, of which $33.3 million expire in 2003 and $33.9 million expire in 2004. Amounts due under these contracts are not included on our consolidated balance sheets, in accordance with generally accepted accounting principles.
In connection with certain acquisitions, we have entered into earnout agreements with certain of the former owners of the businesses that we have acquired. These agreements are based upon certain net earnings and other targets, as defined in each agreement, and discussed in more detail below in "Business Combinations." These earnout payments are for companies acquired from 2000 through 2002, and may include payments in cash and/or shares of our common stock. As of September 27,2003, the maximum potential earnout obligation, assuming all future earnout targets are met in their earliest possible years, totaled $38.3 million: $3.3 million in the remainder of 2003; $21.2 million in 2004; $12.2 million in 2005; and $1.6 million in 2006. These contingent payments are not recorded on our consolidated balance sheets in accordance with generally accepted accounting principles. If paid, these earnout payments would increase the goodwill of the companies acquired. If the fu ture earnout targets are not met, these maximum amounts will be lower, or we may not be required to make any payments.
We have entered into numerous operating leases, including leases for buildings, equipment, tractors and trailers. In certain of these leases, we have provided residual value guarantees to the lessors. As of September 27, 2003, the undiscounted maximum amount of potential future payments under these guarantees is approximately $5.9 million, which would be mitigated by the fair value of the leased assets at lease expiration. These leases have expiration dates ranging from 2003 to 2010.
Business Combinations
In the 2003 period, we paid $11.0 million to the former shareholders of Fresh Express. These payments were related to certain contractual obligations in the purchase agreement for Fresh Express, which we acquired in 2001. Also in the 2003 period, we paid $1.9 million and issued approximately 19,000 shares of our common stock, valued at $625,000, related to contractual obligations in the purchase agreements for companies acquired in 2001 and 2000. We recorded these payments to Fresh Express and other companies as additional purchase price, with corresponding increases in goodwill.
In connection with the acquisition of Fresh Express, we adopted a plan for integration of the business. We initially established an accrual of $8.9 million to provide for certain costs of this plan. This accrual was recorded as a part of the initial allocation of the purchase price of Fresh Express. The plan was to combine our Franklin Park, Illinois, and our Chicago, Illinois, processing plants into one facility, convert our Greencastle, Pennsylvania, and our Chicago facilities into distribution centers, dispose of certain processing equipment at the Chicago and Greencastle plants and eliminate approximately 500 processing-related jobs at the affected facilities. In the first quarter of 2003, we converted the Greencastle facility into a distribution center and eliminated approximately 300 processing-related jobs at that facility. In the second quarter of 2003, we decided not to convert the Chicago facility into a distribution center and will continue to use it for processing operatio ns. As a result, in the second quarter of 2003, we reduced our accrual for the integration plan by $2.2 million, with a corresponding decrease in Fresh Express' goodwill. In the third quarter of 2003, we completed the integration plan. Through September 27, 2003, $2.6 million of employee separation costs and $1.4 million of professional fees, lease and related costs and dismantling costs have been charged against the accrual.
In the 2002 period, in addition to the acquisitions of Quality Foods completed in the second quarter of 2002, and TPC and Middendorf Meat completed in the third quarter of 2002, discussed below, we paid a total of $2.9 million in cash and issued approximately 15,000 shares of our common stock, valued at approximately $500,000, to the former shareholders of Carroll County Foods and AFFLINK Incorporated, which we acquired in 2000 and 1998, respectively, as a result of certain contractual obligations in the purchase agreements related to those acquisitions. We recorded these payments to Carroll County Foods and AFFLINK as additional purchase price, with corresponding increases in goodwill.
In October 2002, a wholly owned subsidiary of our Pocahontas Foods USA subsidiary acquired all of the assets of All Kitchens, Inc., a privately owned procurement and merchandising firm based in Boise, Idaho. All Kitchens provides procurement and merchandising services to its distributors. We believe that this acquisition increases our services to existing Pocahontas and All Kitchens' distributors and expands our geographic base of independent foodservice distributors. In connection with the acquisition of All Kitchens, we will be required to pay the prior owner of the acquired assets up to $3.0 million in cash, if certain affiliate distributor targets are achieved through September 2005. We will record any earnout payments as additional purchase price, resulting in a corresponding increase in goodwill.
In July 2002, we acquired all of the outstanding common stock of TPC, a privately owned, broadline foodservice distributor based in Rock Island, Illinois. TPC services customers located throughout the states of Illinois, Indiana, Iowa and Wisconsin, including the major metropolitan area of Chicago. We believe that our acquisition of TPC extends our Broadline service area in the Midwest region. In connection with the acquisition of TPC, we entered into an earnout agreement whereby we will be required to pay the former shareholders of TPC up to $7.0 million, consisting of cash and additional common shares, if TPC achieves certain targeted levels of growth in sales and operating profit margin, as defined, through July 2004. We will record any earnout payments as additional purchase price, resulting in a corresponding increase in goodwill.
In July 2002, we also acquired all of the outstanding common stock of Middendorf Meat, a privately owned, broadline foodservice distributor based in St. Louis, Missouri, through the merger of Middendorf Meat with a wholly owned subsidiary of ours. Middendorf Meat distributes custom-cut steaks and other foodservice items to independent restaurants, private clubs, hotels and other foodservice establishments in St. Louis and surrounding areas. We believe that our acquisition of Middendorf Meat extends our service area to a region that is geographically contiguous to our other Broadline businesses. In connection with the acquisition of Middendorf Meat, we entered into an earnout agreement whereby we will be required to pay the former shareholders of Middendorf Meat up to $5.0 million, consisting of cash and additional common shares, if Middendorf Meat achieves certain targeted levels of growth in operating profit, as defined, over a period of up to six years following the acquisition. We w ill record any earnout payments as additional purchase price, resulting in a corresponding increase in goodwill. In the 2003 period, we finalized the purchase price of Middendorf Meat, resulting in the return of $2.2 million in cash and $1.4 million in our common stock from the former owners of Middendorf Meat, related to the closing net worth adjustment and certain related claims. We recorded this adjustment to the purchase price as a reduction of goodwill.
In May 2002, we acquired all of the outstanding stock of Quality Foods, a privately owned, broadline foodservice distributor based in Little Rock, Arkansas, with distribution centers in Little Rock and Batesville and Magee, Mississippi. Quality Foods provides products and services to traditional foodservice accounts in a region covering Arkansas, Louisiana, Mississippi, Missouri, Oklahoma, Tennessee and Texas. We believe that our acquisition of Quality Foods extends our service area to a region that is geographically contiguous to our other Broadline businesses. We paid $90.3 million, net of cash acquired, for Quality Foods. In connection with the acquisition of Quality Foods, we entered into an earnout agreement whereby we will be required to pay the former shareholders of Quality Foods up to $24.0 million in cash if Quality Foods achieves certain targeted levels of growth in operating profit, as defined, over a three-year period following the acquisition. We will record any earnout payments as additional purchase price, resulting in a corresponding increase in goodwill.
Critical Accounting Policies
Our condensed consolidated financial statements and accompanying notes have been prepared in accordance with generally accepted accounting principles applied on a consistent basis. The preparation of financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. We continually evaluate the accounting policies and estimates we use to prepare our financial statements. Management's estimates are generally based upon historical experience and various other assumptions that we determine to be reasonable in light of the relevant facts and circumstances. Because of the uncertainty inherent in such estimates, actual results may differ. We believe that our critical accounting policies and estimates include accounting for business combinations, off balanc e sheet financing activities, allowance for doubtful accounts, incurred but not reported insurance claims, reserve for inventories, sales incentives and vendor rebates and other promotional incentives.
Accounting for Business Combinations. Our goodwill and other intangible assets include the cost of acquired subsidiaries in excess of the fair value of the tangible net assets recorded in connection with acquisitions. Other intangible assets include trade names, trademarks, patents, non-compete agreements and customer relationships. We use estimates and assumptions in determining the fair value of assets acquired and liabilities assumed, assigning lives to acquired intangibles and evaluating those assets for impairment after acquisition. These estimates and assumptions include indicators that would trigger an impairment of assets and whether those indicators are temporary and economic or competitive factors that affect valuation, discount rates and cash flow estimates. When the carrying value of such assets are not expected to be recoverable or the estimated lives assigned to such assets are determined to be improper, we must reduce the carrying value of the assets to the net r ealizable value or adjust the amortization period of the asset, recording any adjustment in our consolidated statements of earnings. As of September 27, 2003, our unamortized goodwill was $582.4 million and other intangible assets totaled $199.2 million, net.
Accounting for Off Balance Sheet Financing Activities.We have a source of funding that is generally described as an off balance sheet financing activity - the Receivables Facility, described in "Off Balance Sheet Financing Activities." The sale of the undivided interest in our accounts receivable qualifies for sale treatment under generally accepted accounting principles; therefore, these receivables have been removed from our consolidated balance sheets. We measure the Residual Interest in the undivided interest in receivables sold under our Receivables Facility using the estimated discounted cash flows of the underlying accounts receivable, based on estimated collections and a discount rate approximately equivalent to our incremental borrowing rate. Significant changes in our estimates and assumptions could result in a change in earnings. See Note 6 to the condensed consolidated financial statements for further discussion of the Receivables Facility.
Allowance For Doubtful Accounts.We evaluate the collectibility of our accounts receivable based on a combination of factors. We regularly analyze our significant customer accounts, and when we become aware of a specific customer's inability to meet its financial obligations to us, such as in the case of bankruptcy filings or deterioration in the customer's operating results or financial position, we record a specific reserve for bad debt to reduce the related receivable to the amount we reasonably believe is collectible. We also record reserves for bad debt for all other customers based on a variety of factors, including the length of time the receivables are past due, the financial health of the customer, macroeconomic considerations and historical experience. If circumstances related to specific customers change, our estimates of the recoverability of receivables could be further adjusted. In the 2003 and 2002 periods, we wrote off unc ollectible accounts receivable of $3.8 and $4.5 million, respectively, against the allowance for doubtful accounts. In both the 2003 and 2002 periods, we charged estimates of $2.4 million to operating expenses to increase our allowance for doubtful accounts.
Incurred But Not Reported Insurance Claims. We maintain a self-insurance program covering portions of our general liability, vehicle liability and damage, workers' compensation and group medical insurance. The amounts in excess of the self-insured levels are fully insured, subject to certain limitations and exclusions. We accrue an estimated liability for these self-insured programs, including an estimate for incurred but not reported claims based on known claims and past claims history. These accruals are included in other current liabilities on the condensed consolidated balance sheets. The provisions for insurance claims include estimates of the frequency and timing of claim occurrences, as well as the ultimate amounts to be paid. These estimates could be significantly affected if paid claims differ from past claims history.
Reserve for Inventories.We maintain reserves for slow-moving and obsolete inventories. These reserves are based upon inventory category, age of inventory, specifically identified items and overall economic conditions. A sudden and unexpected change in consumer preferences could result in a significant change in the reserve balance and a corresponding charge to earnings.
Sales Incentives.We, primarily through our Fresh-cut segment, offer sales incentives and promotions to our customers(resellers) and to consumers. These incentives primarily include volume and growth rebates, exclusivity and placement fees (fees paid to retailers for product display), consumer coupons and promotional discounts. We follow the requirements of Emerging Issues Task Force, or EITF, No. 01-9,Accounting for Consideration Given by a Vendor to a Customer (including a Reseller of the Vendor's Products). Consideration given to customers and consumers related to sales incentives is recorded as a reduction of sales. Changes in the estimated amount of incentives to be paid are treated as changes in estimates and are recognized in the period of change. The cost of volume and growth rebates and exclusivity and placement fees is recorded using a systematic and rational allocation of the cost of the incentives to each of the underlying revenue transactions that resulted in progress by the customer toward earning the incentives to be paid. If we cannot reasonably estimate the amount of future incentives to be paid to the customer, we record the maximum potential amount. We use a customer's prior purchasing volume, as well as other factors, to assist in estimating the total incentives to be paid, if any. The cost of consumer coupons is recorded at either the date the coupon is offered or the date the related revenue is recognized by us. The amount recorded is based on the estimated amount of refunds or rebates that will be redeemed by consumers. We primarily use historical coupon redemption data and forecasted sales volumes to estimate the amount to be redeemed. If we cannot reasonably and reliably estimate the amount to be redeemed, we record the maximum potential amount. Promotional discounts are primarily recorded as a reduction to the customer's invoice for goods purchased based on an underlying agreement with the customer. A change in our estimates and a ssumptions related to consumer coupon redemption rates and customer purchase volumes, among other factors, may result in a change in our sales and earnings.
Vendor Rebates and other Promotional Incentives.We participate in various rebate and promotional incentives with our suppliers, primarily including volume and growth rebates, annual and multi-year incentives and promotional programs. Consideration received under these incentives is generally recorded as a reduction of cost of goods sold. However, in certain circumstances the consideration is recorded as a reduction of costs incurred by us. Consideration received may be in the form of cash and/or invoice deductions. Changes in the estimated amount of incentives to be received are treated as changes in estimates and are recognized in the period of change.
Consideration received for incentives that contain volume and growth rebates and annual and multi-year incentives is recorded as a reduction of cost of goods sold. The consideration is recorded by us based upon a systematic and rational allocation of these incentives to each of the underlying transactions that results in progress by us toward earning the incentives, provided the amounts are probable and reasonably estimable. If the incentives are not probable and reasonably estimable, we record the incentives as the underlying objectives or milestones are achieved. We record annual and multi-year incentives when earned, which is generally over the agreement period. We use current and historical purchasing data, forecasted purchasing volumes and other factors in estimating whether the underlying objectives or milestones will be achieved. Consideration received to promote and sell the supplier's products is typically a reimbursement of costs incurred by us and is then recorded as a redu ction of our costs. If the amount of consideration received from the suppliers exceeds our costs, any excess is recorded as a reduction of cost of goods sold. A change to our estimates and assumptions of future purchasing volumes and the amount of promotional costs, among other factors, may result in a change in our earnings.
In January 2003, the EITF reached a final consensus on EITF Issue No. 02-16,Accounting by a Customer (Including a Reseller) for Certain Consideration Received from a Vendor.EITF No. 02-16 clarifies certain aspects for accounting and recording by customers of consideration received from suppliers. The adoption of EITF No. 02-16 in the 2003 period did not have a material impact on our consolidated financial position or results of operations. Note 2 to the condensed consolidated financial statements discusses EITF No. 02-16 in more detail.
Management has discussed the development and selection of these critical accounting estimates with the audit committee of the board of directors and the audit committee has reviewed the above disclosure. In addition, our financial statements contain other items that require estimation, but are not as critical as those discussed above. These include our calculations for bonus accruals, depreciation, amortization and tax liabilities. Changes in estimates and assumptions used in these and other items could have an effect on our financial position or results of operations.
Forward-Looking Statements
This Form 10-Q and the documents incorporated by reference herein contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements, which are based on assumptions and estimates and describe our future plans, strategies and expectations, are generally identifiable by the use of the words "anticipate," "will," "believe," "estimate," "expect," "intend," "seek," "should," "could," "may," "would," or similar expressions. These forward-looking statements may address, among other things, our anticipated earnings, capital expenditures, contributions to our net sales by acquired companies, sales momentum, customer and product sales mix, expected efficiencies in our business and our ability to realize expected synergies from acquisitions. These forward-looking statements are subject to risks, uncertainties and assumptions, all as detailed from time to time in the reports we fil e with the Securities and Exchange Commission.
If one or more of these risks or uncertainties materialize, or if any underlying assumptions prove incorrect, our actual results, performance or achievements may vary materially from future results, performance or achievements expressed or implied by these forward-looking statements. All forward-looking statements attributable to us, or persons acting on our behalf, are expressly qualified in their entirety by the cautionary statements in this section. We undertake no obligation to publicly update or revise any forward-looking statements to reflect future events or developments.
Item 3. Quantitative and Qualitative Disclosures About Market Risks
Our primary market risks are related to fluctuations in interest rates. Our primary interest rate risk is from changing interest rates related to our outstanding debt. We currently manage this risk through a combination of fixed and floating rates on these obligations. At September 27, 2003, our total debt of $304.9 million consisted of fixed and floating-rate debt of $257.1 million and $47.8 million, respectively. In addition, the rate on our Receivables Facility is a floating rate. Substantially all of our floating rates are based on LIBOR, with the exception of the rate on the Receivables Facility, which is based upon a 30-day commercial-paper rate. A 100 basis-point increase in market interest rates on all of our floating-rate debt and our Receivables Facility would result in a decrease in net earnings and cash flow of approximately $1.0 million per annum, holding other variables constant.
Item 4. Controls and Procedures
We maintain disclosure controls and procedures, as defined in Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934 (the "Exchange Act"), that are designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission's rules and forms and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. We carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief 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 the evaluation of these disclosure co ntrols and procedures, the Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective.
PART II - OTHER INFORMATION
Item 1. Legal Proceedings
We announced in March 2002 that we had identified certain accounting errors at one of our Broadline operating subsidiaries, as more fully described in our 2002 Annual Report on Form 10-K. While no claims have been made to date, it is possible that claims may be brought by shareholders against us in connection with the accounting errors and costs related to the claims, including defense costs, could have an adverse effect on our financial condition or results of operations. In addition, at the time of the announcement of the identification of the accounting errors, we contacted the staff of the Securities and Exchange Commission, or SEC, to inform them of our identification of the errors and of our intention to cooperate with the staff of the SEC with respect to any review or inquiry they may conduct. Since that time, we have provided and continue to provide, updates to the staff of the SEC as well as certain documents and testimony requested by the staff. We have conducted an inquiry i nto the accounting errors and have taken appropriate remedial actions in connection with the investigation. Although we believe that we have fully cooperated with the SEC, the SEC could bring enforcement or other action against us. The costs associated with an SEC enforcement action or inquiry or an adverse outcome of any such enforcement action or inquiry could have a material adverse effect on our financial condition or results of operations.
From time to time, we are involved in legal proceedings and litigation arising in the ordinary course of business. In the opinion of management, the outcome of such proceedings and litigation currently pending will not have a material adverse effect on our results of operations or financial condition.
Item 4. Submission of Matters to a Vote of Security Holders.
