UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
------------------------------------------------------------------
(Mark One)
|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2005
OR
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from____ ____ to ______
-----------------------------
Commission File Number 1-15345
GALAXY NUTRITIONAL FOODS, INC.
(Exact name of registrant as specified in its charter)
Delaware 25-1391475
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
2441 Viscount Row
Orlando, Florida 32809
(Address of principal executive offices) (Zip Code)
(407) 855-5500
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. YES |X| NO |_|
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). YES |_| NO |X|
Indicate by check mark whether the registrant is a shell company (as
defined in Rule 12b-2 of the Exchange Act). YES |_| NO |X|
On November 11, 2005, there were 20,051,327 shares of common stock, $.01
par value per share, outstanding.
1
GALAXY NUTRITIONAL FOODS, INC.
Index to Form 10-Q
For the Quarter Ended September 30, 2005
PAGE NO.
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Balance Sheets 4
Statements of Operations 5
Statement of Stockholders' Equity (Deficit) 6
Statements of Cash Flows 7
Notes to Financial Statements 8
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations 18
Item 3. Quantitative and Qualitative Disclosures About Market Risk 34
Item 4. Controls and Procedures 35
PART II. OTHER INFORMATION
Item 3. Defaults Upon Senior Securities 36
Item 6. Exhibits 37
SIGNATURES 41
2
PART I. FINANCIAL INFORMATION
GALAXY NUTRITIONAL FOODS, INC.
Balance Sheets
SEPTEMBER 30, MARCH 31,
Notes 2005 2005
-------- ------------------ ------------------
(Unaudited)
ASSETS
CURRENT ASSETS:
Cash $ -- $ 561,782
Trade receivables, net 12 6,026,258 4,644,364
Inventories 3,283,094 3,811,470
Prepaid expenses and other 371,547 219,592
------------------ ------------------
Total current assets 9,680,899 9,237,208
PROPERTY AND EQUIPMENT, NET 7 9,330,257 18,246,445
OTHER ASSETS 352,048 286,013
------------------ ------------------
TOTAL $ 19,363,204 $ 27,769,666
================== ==================
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
CURRENT LIABILITIES:
Line of credit 2 $ 4,275,221 $ 5,458,479
Book overdraft 130,834 --
Accounts payable 3,198,435 3,057,266
Accrued and other current liabilities 3 1,801,241 2,130,206
Current portion of accrued employment contracts 8,11 903,362 586,523
Current portion of term notes payable 2 8,670,985 1,320,000
Current portion of obligations under capital leases 114,792 194,042
------------------ ------------------
Total current liabilities 19,094,870 12,746,516
ACCRUED EMPLOYMENT CONTRACTS, less current portion 11 743,887 993,305
TERM NOTES PAYABLE, less current portion 2 -- 6,921,985
OBLIGATIONS UNDER CAPITAL LEASES, less current portion 68,258 85,337
------------------ ------------------
Total liabilities 19,907,015 20,747,143
------------------ ------------------
COMMITMENTS AND CONTINGENCIES 4 -- --
TEMPORARY EQUITY:
Common stock, subject to registration 4 2,680,590 2,220,590
STOCKHOLDERS' EQUITY (DEFICIT):
Common stock 175,511 164,115
Additional paid-in capital 68,360,749 65,838,227
Accumulated deficit (58,868,000) (48,307,748)
------------------ ------------------
9,668,260 17,694,594
Less: Notes receivable arising from the exercise of stock options 11 (12,772,200) (12,772,200)
Treasury stock (120,461) (120,461)
------------------ ------------------
Total stockholders' equity (deficit) (3,224,401) 4,801,933
------------------ ------------------
TOTAL $ 19,363,204 $ 27,769,666
================== ==================
See accompanying notes to financial statements
3
GALAXY NUTRITIONAL FOODS, INC.
Statements of Operations
(UNAUDITED)
THREE MONTHS ENDED SIX MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------------------------ -------------------------------------
Notes 2005 2004 2005 2004
------- ---------------- ----------------- ---------------- ------------------
5 RESTATED RESTATED
NET SALES $ 10,438,225 $ 11,900,553 $ 20,289,378 $ 23,092,231
COST OF GOODS SOLD 7,817,351 9,319,969 15,400,206 17,571,299
---------------- ----------------- ---------------- ------------------
Gross margin 2,620,874 2,580,584 4,889,172 5,520,932
---------------- ----------------- ---------------- ------------------
OPERATING EXPENSES:
Selling 1,557,547 1,572,470 2,493,792 3,032,870
Delivery 726,078 615,257 1,341,549 1,208,583
Employment contract expense - general
and administrative -- 444,883 -- 444,883
General and administrative, including
$3,319, ($121,172), $870,837 and
$41,202 non-cash compensation
related to stock based transactions 6 921,934 444,796 2,523,464 1,240,512
Research and development 89,052 78,932 180,094 151,618
Cost of disposal activities 8 499,556 -- 754,567 --
Impairment of property and equipment 7 -- -- 7,896,554 --
Loss on sale of assets 6,242 -- 5,606 --
---------------- ----------------- ---------------- ------------------
Total operating expenses 3,800,409 3,156,338 15,195,626 6,078,466
---------------- ----------------- ---------------- ------------------
INCOME (LOSS) FROM OPERATIONS (1,179,535) (575,754) (10,306,454) (557,534)
---------------- ----------------- ---------------- ------------------
OTHER INCOME (EXPENSE):
Interest expense (293,603) (264,008) (650,798) (523,824)
Derivative income 5 -- 442,606 -- 321,487
Gain/(loss) on fair value of warrants 57,000 620,247 397,000 461,351
---------------- ----------------- ---------------- ------------------
Total other income (expense) (236,603) 798,845 (253,798) 259,014
---------------- ----------------- ---------------- ------------------
NET INCOME (LOSS) $ (1,416,138) $ 223,091 $ (10,560,252) $ (298,520)
Less:
Preferred stock dividends 5 -- 38,006 -- 80,398
Preferred stock accretion to
redemption value 5 -- (225,304) -- 275,340
---------------- ----------------- ---------------- ------------------
NET INCOME (LOSS) TO COMMON
STOCKHOLDERS $ (1,416,138) $ 410,389 $ (10,560,252) $ (654,258)
================ ================= ================ ==================
BASIC AND DILUTED NET INCOME (LOSS)
PER COMMON SHARE 9 $ (0.07)$ 0.03 $ (0.55) $ (0.04)
================ ================= ================ ==================
See accompanying notes to financial statements.
4
GALAXY NUTRITIONAL FOODS, INC.
Statements of Stockholders' Equity (Deficit)
(UNAUDITED)
Common Stock Notes
--------------------------- Receivable
Shares Par Value Additional Accumulated for Common Treasury Total
Paid-In Capital Deficit Stock Stock
--------------------------------------------------------------------------------------------------------------
Balance at March 31, 16,411,474 $ 164,115 $ 65,838,227 $ (48,307,748) $ (12,772,200) $ (120,461) $ 4,801,933
2005
Exercise of warrants 1,130,000 11,300 1,257,700 -- -- -- 1,269,000
Exercise of options 2,000 20 2,540 -- -- -- 2,560
Issuance of common
stock under
employee stock
purchase plan 7,603 76 11,785 -- -- -- 11,861
Fair value of
stock-based
transactions -- -- 1,443,053 -- -- -- 1,443,053
Non-cash compensation
related to variable
securities -- -- (192,556) -- -- -- (192,556)
Net loss -- -- -- (10,560,252) -- -- (10,560,252)
--------------------------------------------------------------------------------------------------------------
Balance at September
30, 2005 17,551,077 $ 175,511 $ 68,360,749 $ (58,868,000) $ (12,772,200) $ (120,461) $ (3,224,401)
==============================================================================================================
See accompanying notes to financial statements.
5
GALAXY NUTRITIONAL FOODS, INC.
Statements of Cash Flows
(UNAUDITED)
Six Months Ended September 30, Notes 2005 2004
------- ----------------- ---------------
RESTATED
CASH FLOWS FROM OPERATING ACTIVITIES:
Net Loss $ (10,560,252) $ (298,520)
Adjustments to reconcile net loss to net cash from (used in)
operating activities:
Depreciation and amortization 1,075,852 1,092,086
Amortization of debt discount and financing costs 105,718 49,615
Provision for losses on trade receivables 754,451 164,000
Impairment of property and equipment and (gain)/loss on sale
of assets 7 7,902,161 --
Change in fair value of derivative instrument 5 -- (321,487)
(Gain) Loss on fair value of warrants (397,000) (461,351)
Non-cash compensation related to stock-based transactions 1,6 870,837 41,202
(Increase) decrease in:
Trade receivables (2,136,345) (2,019,628)
Inventories 528,376 (339,254)
Prepaid expenses and other (151,955) (47,802)
Increase (decrease) in:
Accounts payable 141,169 1,173,240
Accrued and other liabilities 301,456 343,691
----------------- ---------------
NET CASH FROM (USED IN) OPERATING ACTIVITIES (1,565,532) (624,208)
----------------- ---------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of property and equipment (82,525) (77,207)
Proceeds from sale of equipment 20,700 22,482
----------------- ---------------
NET CASH FROM (USED IN) INVESTING ACTIVITIES (61,825) (54,725)
----------------- ---------------
CASH FLOWS FROM FINANCING ACTIVITIES: 10
Increase in book overdrafts 130,834 --
Net borrowings (payments) on line of credit (1,183,258) 1,276,485
Borrowing on term notes payable 1,200,000 --
Repayments on term notes payable (550,000) (480,000)
Principal payments on capital lease obligations (96,329) (133,731)
Financing costs for long term debt (179,093) --
Costs associated with issuance of common stock -- (22,500)
Proceeds from issuance of common stock under employee stock
purchase plan 11,861 12,480
Proceeds from exercise of common stock options 2,560 --
Proceeds from exercise of common stock warrants 5 1,729,000 --
----------------- ---------------
NET CASH FROM (USED IN) FINANCING ACTIVITIES 1,065,575 652,734
----------------- ---------------
NET INCREASE (DECREASE) IN CASH (561,782) (26,199)
CASH, BEGINNING OF PERIOD 561,782 449,679
----------------- ---------------
CASH, END OF PERIOD $ -- $ 423,480
================= ===============
See accompanying notes to financial statements.
6
GALAXY NUTRITIONAL FOODS, INC.
Notes To Financial Statements
(UNAUDITED)
(1) Summary of Significant Accounting Policies
The unaudited financial statements have been prepared by Galaxy
Nutritional Foods, Inc. (the "Company"), in accordance with accounting
principles generally accepted in the United States of America ("GAAP") for
interim financial information and applicable rules and regulations of the
Securities and Exchange Commission. The accompanying financial statements
contain all normal recurring adjustments which are, in the opinion of
management, necessary for the fair presentation of such financial
statements. Certain information and disclosures normally included in the
financial statements prepared in accordance with GAAP have been omitted
under such rules and regulations although the Company believes that the
disclosures are adequate to make the information presented not misleading.
The March 31, 2005 balance sheet data was derived from the audited
financial statements, but does not include all disclosures required by
GAAP. These unaudited financial statements should be read in conjunction
with the financial statements and notes included on Form 10-K/A for the
fiscal year ended March 31, 2005. Interim results of operations for the
six-month period ended September 30, 2005 may not necessarily be
indicative of the results to be expected for the full year.
Impairment of Long-Lived Assets
In accordance with SFAS No. 144, "Accounting for the Impairment of
Disposal of Long-Lived Assets," the Company evaluates the carrying value
of long-lived assets when circumstances indicate the carrying value of
those assets may not be fully recoverable. The Company evaluates
recoverability of long-lived assets held for use by comparing the net
carrying value of an asset group to the estimated undiscounted cash flows
(excluding interest) during the remaining life of the asset group. If such
an evaluation indicates that the future undiscounted cash flows of certain
long-lived asset groups are not sufficient to recover the carrying value
of such asset groups, the assets are then adjusted to their fair values.
The Company recorded an impairment of property and equipment in the first
quarter of fiscal 2006 as discussed more fully in Note 7.
Disposal Costs
The Company has recorded significant accruals in connection with its
planned asset sale and outsourcing arrangement with Schreiber Foods, Inc.
These accruals include estimates pertaining to employee termination costs
and, in the future, may also include related abandonment of excess
equipment and facilities and other potential costs. Actual costs may
differ from these estimates or the Company's estimates may change. In
accordance with SFAS 146, "Accounting for Costs Associated with Exit or
Disposal Activities", costs associated with restructuring activities are
recognized when they are incurred rather than at the date of a commitment
to an exit or disposal plan. Given the significance and complexity of
these activities, and the timing of the execution of such activities, the
accrual process involves periodic reassessments of estimates made at the
time the original decisions were made, including evaluating estimated
employment terms and real estate market conditions for sub-lease rents.
The Company will continually evaluate the adequacy of the remaining
liabilities under its restructuring initiatives. Although the Company
believes that these estimates accurately reflect the costs of its
activities, actual results may differ, thereby requiring the Company to
record additional provisions or reverse a portion of such provisions.
Should the timing of employee terminations change, the Company's estimate
of restructuring expenses may have to be increased.
Stock Based Compensation
The Company has three stock-based employee compensation plans. Prior to
April 1, 2003, the Company accounted for those plans under the recognition
and measurement provisions of Accounting Principles Board Opinion No. 25,
"Accounting for Stock Issued to Employees," (APB No. 25), and related
Interpretations.
Effective April 1, 2003, the Company adopted the fair value recognition
provisions of Statement of Financial Accounting Standards ("SFAS") No.
123, "Accounting for Stock-Based Compensation," and applies SFAS No. 148,
"Accounting for Stock-Based Compensation - Transition and Disclosure,"
prospectively to all employee awards granted on or after April 1, 2003.
These standards require the Company to provide pro-forma information
regarding net income (loss) and earnings (loss) per share amounts as if
compensation cost for all the Company's employee and director stock-based
awards had been determined in accordance with the fair value method
prescribed in SFAS No. 123. Awards from the Company's plans vest over
periods ranging from immediate to five years. Therefore, the cost related
to stock-based compensation included in the determination of net income
for the periods is less than that which would have been recognized if the
fair value based method had been applied to all awards since the original
effective date of SFAS No. 123.
7
The Company estimated the fair value of each stock-based award during the
periods presented by using the Black-Scholes pricing model with the
following assumptions:
Six Months Ended: September 30, September 30,
2005 2004
------------------- --------------------
Dividend Yield None None
Volatility 24.9%-46.0% 44.0%-59.0%
Risk Free Interest Rate 3.35%-3.45% 1.46%-3.96%
Expected Lives in Months 1-36 6-120
Under the accounting provisions of SFAS No. 123, the Company's net loss
and net loss per basic and diluted share would have been reduced to the
pro forma amounts indicated below:
THREE MONTHS ENDED SIX MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
2005 2004 2005 2004
----------------- ---------------- ----------------- ------------------
RESTATED RESTATED
Net income (loss) to common
stockholders as reported $ (1,416,138) $ 410,389 $ (10,560,252) $ (654,258)
Add: Stock-based compensation
expense included in reported net
income (loss) 3,319 (121,172) 870,837 41,202
Deduct: Stock-based compensation
expense determined under fair value
based method for all awards (13,652) 91,263 (891,245) (101,317)
----------------- ---------------- ----------------- ------------------
Pro forma net income (loss) to
common stockholders $ (1,426,471) $ 380,480 $ (10,580,660) $ (714,373)
================= ================ ================= ==================
Net income (loss) per common share:
Basic & Diluted - as reported $ (0.07) $ 0.03 $ (0.55) $ (0.04)
================= ================ ================= ==================
Basic & Diluted - pro forma $ (0.07) $ 0.02 $ (0.55) $ (0.05)
================= ================ ================= ==================
Net Income (Loss) per Common Share
Net income (loss) per common share is computed by dividing net income or
loss by the weighted average shares outstanding. Diluted income (loss) per
common share is computed on the basis of weighted average shares
outstanding plus potential common shares which would arise from the
exercise of stock options, warrants and conversion of the Series A
convertible preferred stock.
Use of Estimates
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America requires
management to make estimates and assumptions that affect the reported
amounts of assets and liabilities and disclosure of contingent assets and
liabilities at the date of the financial statements and reported amounts
of revenues and expense during the reporting period. The Company's
significant estimates include the allowance for doubtful accounts
receivable, which is made up of reserves for promotions, discounts and bad
debts, provision for inventory obsolescence, valuation of deferred taxes,
and valuation of stock options and warrants. Actual results could differ
from those estimates.
Reclassifications
Certain items in the financial statements of the prior period have been
reclassified to conform to current period presentation.
Segment Information
The Company does not identify separate operating segments for management
reporting purposes. The results of operations are the basis on which
management evaluates operations and makes business decisions. The
Company's sales are generated primarily within the United States of
America.
8
Recent Accounting Pronouncements
In November 2004, the Financial Accounting Standards Board ("FASB") issued
SFAS No. 151, "Inventory Costs, an amendment of Accounting Research
Bulletin No. 43, Chapter 4." SFAS No. 151 requires that abnormal amounts
of idle facility expense, freight, handling costs and wasted materials
(spoilage) be recorded as current period charges and that the allocation
of fixed production overheads to inventory be based on the normal capacity
of the production facilities. SFAS No. 151 is effective during fiscal
years beginning after June 15, 2005, although earlier application is
permitted. The Company believes that the adoption of this Statement will
not have a significant impact on the financial position, results of
operations or cash flows of the Company.
In December 2004, the FASB issued SFAS No. 123 (revised 2004),
"Share-Based Payment" ("SFAS No. 123R"), which addresses the accounting
for share-based payment transactions in which a company receives employee
services in exchange for (a) equity instruments of the company or (b)
liabilities that are based on the fair value of the company's equity
instruments or that may be settled by the issuance of equity instruments.
SFAS No. 123R supercedes APB Opinion No. 25 and amends SFAS No. 95,
"Statement of Cash Flows." Under SFAS No. 123R, companies are required to
record compensation expense for all share-based payment award transactions
measured at fair value as determined by an option valuation model.
Currently, the Company uses the Black-Scholes pricing model to calculate
the fair value of its share-based transactions. This statement is
effective for fiscal years beginning after June 15, 2005. Since the
Company currently recognizes compensation expense at fair value for
share-based transactions in accordance with SFAS No. 123, it does not
anticipate adoption of this standard will have a significant impact on its
financial position, results of operations, or cash flows. However, the
Company is still evaluating all aspects of the revised standard.
In December 2004, the FASB issued SFAS No. 153, "Exchanges of Nonmonetary
Assets an Amendment of APB Opinion No. 29." SFAS No. 153 amends APB
Opinion No. 29 to eliminate the exception for nonmonetary exchanges of
similar productive assets from being measured based on the fair value of
the assets exchanged. SFAS No. 153 now provides a general exception for
exchanges of nonmonetary assets that do not have commercial substance.
SFAS No. 153 is effective for fiscal periods beginning after June 15,
2005. The Company believes that the adoption of this Statement will not
have a significant impact on its financial position, results of operations
or cash flows.
In May 2005, the FASB issued SFAS No. 154, "Accounting Changes and Error
Corrections - a replacement of APB Opinion No. 20 and SFAS No. 3." SFAS
No. 154 changes the requirements for the accounting for and reporting of a
change in accounting principle and a change required by an accounting
pronouncement when the pronouncement does not include specific transition
provisions. SFAS No. 154 requires retrospective application of changes as
if the new accounting principle had always been used. SFAS No. 154 is
effective for fiscal years beginning after December 15, 2005. The Company
is still evaluating all aspects of the revised standard in order to
evaluate the impact on its financial position and results of operations.
(2) Line of Credit, Notes Payable and Going Concern
On May 27, 2003, the Company obtained from Textron Financial Corporation
("Textron") a revolving credit facility (the "Textron Loan") with a
maximum principal amount of $7,500,000 pursuant to the terms and
conditions of a Loan and Security Agreement dated May 27, 2003 (the
"Textron Loan Agreement"). The Textron Loan is secured by the Company's
inventory, accounts receivable and all other assets. Generally, subject to
the maximum principal amount, which can be borrowed under the Textron Loan
and certain reserves that must be maintained during the term of the
Textron Loan, the amount available under the Textron Loan for borrowing by
the Company from time to time is equal to the sum of (i) 85% of the net
amount of its eligible accounts receivable plus (ii) 60% of the Company's
eligible inventory not to exceed $3,500,000. Advances under the Textron
Loan bear interest at a variable rate, adjusted on the first (1st) day of
each month, equal to the prime rate plus 1.75% per annum (8.5% at
September 30, 2005) calculated on the average cash borrowings for the
preceding month. The initial term of the Textron loan ends on May 26,
2006. As of September 30, 2005, the outstanding principal balance on the
Textron Loan was $4,275,221.
The Textron Loan Agreement contains certain financial and operating
covenants. On June 3, 2005, the Company executed a fourth amendment to the
Textron Loan Agreement that provided a waiver on all the existing defaults
for the fiscal quarters ended December 31, 2004 and March 31, 2005, and
amended the fixed charge coverage ratio and the adjusted tangible net
worth requirements for periods after March 31, 2005. Additionally, the
fourth amendment allowed the Textron Loan to be in an over-advance
position not to exceed $750,000 until July 31, 2005. In exchange for the
waiver and amendments, the Company's interest rate on the Textron Loan was
set at Prime plus 4.75% and the Company paid a fee of $50,000 in four
weekly installments of $12,500.
9
On June 16, 2005, the Company used a portion of the proceeds from the
warrant exercises described in Note 5 to satisfy the $750,000 over-advance
with Textron. In connection with the satisfaction of the over-advance, the
Company agreed to immediately terminate Textron's obligation to permit any
over-advances under the Textron Loan, which obligation was to expire on
July 31, 2005. With the termination of the over-advance facility, the
interest rate on the Textron Loan returned to its prior level of Prime
plus 1.75%.
Due to the cost of disposal activities and impairment of property and
equipment (as discussed in Notes 7 and 8), the Company fell below the
requirements in the fixed charge coverage ratio and the adjusted tangible
net worth calculation from June 30, 2005 through September 30, 2005.
Effective October 1, 2005, the Company executed a fifth amendment to the
Textron Loan Agreement that provided a waiver for the defaults in the
fixed charge coverage ratio and the adjusted tangible net worth
requirements, in addition to certain over-advances on the Textron Loan,
during the periods from June 2005 through September 2005. The fifth
amendment amends and replaces several financial covenants, allows
eligibility for borrowing on inventory until December 31, 2005 and
provides that the Textron Loan will expire at the end of the initial term
on May 26, 2006. Additionally, Textron has consented to the sale of the
Company's manufacturing equipment to Schreiber and the termination of
their liens on the assets being sold. In exchange for the waiver and
amendments, the Company paid a fee of $50,000, and has agreed to pay an
administration fee in the following installments if the Textron Loan has
not then been paid in full: 5,000 on February 1, 2006, $10,000 on March 1,
2006, $15,000 on April 1, 2006 and $20,000 May 1, 2006. The Company
anticipates that it will be in compliance with the amended covenants and
reporting requirements through the end of the term of the Textron Loan on
May 26, 2006.
Simultaneous with the closing of the Textron Loan in May 2003, Wachovia
Bank, N.A. successor by merger to SouthTrust Bank ("Wachovia") extended
the Company a new term loan in the principal amount of $2,000,000. This
term loan was consolidated with the Company's March 2000 term loan with
Wachovia, which had a then outstanding principal balance of $8,131,985 for
a total term loan amount of $10,131,985. This term loan is secured by all
of the Company's equipment and certain related assets. Additionally, the
term loan bears interest at Wachovia's Base Rate plus 1% (7.75% at
September 30, 2005).
On June 30, 2005, the Company entered into a Loan Modification Agreement
with Wachovia regarding its term loan. The agreement modified the
following terms of the loan: 1) the loan will mature and be payable in
full on July 31, 2006 instead of June 1, 2009; 2) the principal payments
will remain at $110,000 per month with accrued interest at Wachovia's Base
Rate plus 1% instead of increasing to $166,250 on July 1, 2005 as provided
by the terms of the promissory note evidencing the loan; and 3) all
covenants related to the Company's tangible net worth, total liabilities
to tangible net worth, and maximum funded debt to EBITDA ratios are waived
and compliance is not required by the Company through the maturity of the
loan on July 31, 2006. In connection with the agreement, the Company
agreed to pay $60,000, of which $30,000 was paid upon execution of the
agreement and $30,000 was paid on August 1, 2005. As required by the terms
of the agreement, if the Company sells the equipment securing the loan,
the loan will be due and payable in full at the time of sale. Therefore,
the proceeds from the sale of the Company's manufacturing equipment to
Schreiber will be used to pay the loan in full.
In September 2005, Wachovia assigned this term loan to Beltway Capital
Partners LLC. The balance outstanding on the term loan as of September 30,
2005 was $7,691,985.
Pursuant to a Note and Warrant Purchase Agreement dated September 12,
2005, the Company received $1,200,000 as a loan from Mr. Frederick A.
DeLuca, a greater than 10% shareholder, which loan was evidenced by an
unsecured promissory note (the "Note"). The Note requires monthly interest
only payments at 3% above the bank prime rate of interest per the Federal
Reserve Bank and matures on June 15, 2006. In consideration for the Note
and in accordance with an exemption from registration provided by Section
4(2) of the Securities Act of 1933, as amended, the Company issued to Mr.
DeLuca a warrant to purchase up to 300,000 shares of the Company's common
stock at an exercise price equal to $1.53 (95% of the lowest closing price
of the Company's common stock in the sixty calendar days immediately
preceding October 17, 2005). The warrant fully vested on October 17, 2005
and can be exercised on or before the expiration date of October 17, 2008.
Also in consideration for the Note, the Company granted Mr. DeLuca "piggy
back" registration rights with respect to the shares underlying the
warrant. In accordance with the accounting provisions of SFAS No. 123, the
Company recorded the $234,000 initial fair value of the warrant as a
discount to debt on September 12, 2005. This discount is being amortized
from September 2005 through June 2006. The Company amortized $13,000 in
the three months ended September 30, 2005. Since the exercise price for
the warrant was not fixed until October 17, 2005, the Company revalued the
warrant obligation on September 30, 2005 and calculated a fair value of
$177,000. The $57,000 difference between the initial value of the warrant
and the value of the warrant on September 30, 2005 was recorded as a gain
on fair value of warrants in the Statement of Operations.
10
If the Company is unable to refinance or renew the Company's existing
credit facilities, or if additional financing is not available on terms
acceptable to us, the Company will be unable to satisfy such facilities by
their maturity dates. In such an event, Textron, Beltway and the
shareholders (including Mr. DeLuca and those discussed in Note 13) could
exercise their respective rights under their loan documents, which could
include, among other things, declaring defaults under the loans and
pursuing foreclosure on the Company's assets that are pledged as
collateral for such loans. If such an event occurred, it would be
substantially more difficult for us to effectively continue the operation
of the Company's business, and it is unlikely that the Company would be
able to continue as a going concern.
(3) Accrued and Other Current Liabilities
Accrued and other current liabilities are summarized as follows:
September 30, 2005 March 31, 2005
---------------------- ---------------------
Tangible personal property taxes $ 1,227,683 $ 1,049,841
Warrant liability 177,000 740,000
Other 396,558 340,365
---------------------- ---------------------
Total $ 1,801,241 $ 2,130,206
====================== =====================
(4) Commitments and Contingencies
In accordance with a registration rights agreement dated October 6, 2004,
the Company agreed that within 180 days it would file with the Securities
and Exchange Commission ("SEC") and obtain effectiveness of a registration
statement that included 2,000,000 shares issued in a private placement and
500,000 shares related to a stock purchase warrant. Per the terms of the
agreement, if a registration statement was not filed, or did not become
effective within 180 days, then in addition to any other rights the
investor may have, the Company would be required to pay certain liquidated
damages. The Company filed a registration statement on Form S-3 on March
14, 2005. However, this registration statement has not yet been declared
effective. The investor granted an extension of time to have the
registration statement declared effective by the SEC and waived all
damages and remedies for failure to have an effective registration
statement until September 1, 2005. As of September 1, 2005, the Company is
accruing liquidated damages of $71,875 (2.5% times the product of
2,500,000 registerable shares and the share price of $1.15 per share)
every thirty days until the registration statement becomes effective. The
Company is in the process of completing a pre-effective amendment to the
registration statement and will request acceleration of the effectiveness
of the registration statement as soon after its filing as reasonably
practicable.
The Emerging Issues Task Force ("EITF") is currently reviewing the
accounting for securities with liquidated damages clauses as stated in
EITF 05-04, "The Effect of a Liquidated Damages Clause on a Freestanding
Financial Instrument Subject to EITF 00-19." There are currently several
views as to how the account for this type of transaction and the EITF has
not yet reached a consensus. In accordance with EITF 00-19 and 05-04,
because the maximum potential liquidated damages as described above may be
greater than the difference in fair values between registered and
unregistered shares, the value of the common stock subject to registration
should be classified as temporary equity until the registration statement
becomes effective. Based on the above determination, the Company has
recorded the $2,680,590 value of common stock subject to registration as
temporary equity. Upon effectiveness of the registration statement, the
amount will be reclassified into permanent equity.
(5) Capital Stock
Common Stock Issuances
In accordance with a warrant agreement dated April 10, 2003, the Company
issued to Mr. Frederick DeLuca, a greater than 10% shareholder, a warrant
to purchase up to 100,000 shares of common stock of the Company at an
exercise price of $1.70 per share. Additionally, in accordance with a
warrant agreement dated October 6, 2004, the Company issued to Mr. DeLuca
a warrant to purchase up to 500,000 shares of common stock of the Company
at an exercise price of $1.15 per share. Subsequently in June 2005, the
Company agreed to reduce the per-share exercise price on these warrants to
$1.36 and $0.92, respectively, in order to induce Mr. DeLuca to exercise
his warrants. All of the warrants were exercised on June 16, 2005 for
total proceeds of $596,000.
11
In accordance with EITF 00-19, "Accounting for Derivative Financial
Instruments Indexed To, and Potentially Settled in the Company's Own
Stock," and the terms of the above warrant for 500,000 shares of common
stock, the fair value of the warrant was accounted for as a liability,
with an offsetting reduction to the carrying value of the common stock. On
March 31, 2005, the fair value of the warrant was estimated using the
Black-Scholes pricing model to be $740,000 and on June 16, 2005, the fair
value was estimated to be $400,000. The $340,000 change in fair value was
reflected as a gain on the fair value of warrants line item in the
Statement of Operations during the three months ended June 30, 2005. The
warrant liability was moved to temporary equity upon the exercise of the
warrant as described above.
On each of April 24, 2003 and October 6, 2004, BH Capital Investments, LP
and Excalibur Limited Partnership each received warrants to purchase up to
250,000 shares of common stock at an exercise price of $2.00 per share.
Also, Excalibur Limited Partnership received a warrant to purchase up to
30,000 shares of common stock at an exercise price of $2.05 per share on
June 26, 2002. Subsequently in June 2005, the Company agreed to reduce the
per-share exercise price on all such warrants to $1.10 in order to induce
BH Capital Investments, LP and Excalibur Limited Partnership to exercise
their warrants. All of the warrants were exercised on June 16, 2005 for
total proceeds of $1,133,000.
The Company used a portion of the proceeds from the warrant exercises to
satisfy the $750,000 over-advance provided by Textron under the Fourth
Amendment and Waiver to the Textron Loan Agreement, as described in Note 2
and the remaining proceeds from the warrant exercises were used for
working capital purposes.
In accordance with the accounting provisions of SFAS No. 123, the Company
recorded $1,024,500 in non-cash compensation expense related to the
reduction in the exercise price of the warrants in June 2005.
Preferred Stock Issuances and Restatement
On April 6, 2001, the Company received from BH Capital Investments, LP and
Excalibur Limited Partnership (the "Series A Preferred Holders") proceeds
of approximately $3,082,000 less costs of $181,041 for the issuance of
72,646 shares of the Company's Series A convertible preferred stock with a
face value of $3,500,000 and warrants to purchase shares of the Company's
common stock. The shares were subject to certain designations, preferences
and rights including the right to convert such shares into shares of
common stock at any time. The per share conversion price was equal to the
quotient of $48.18, plus all accrued and unpaid dividends for each share
of the Series A convertible preferred stock, divided by the lesser of (x)
$1.75 or (y) 95% of the average of the two lowest closing bid prices of
the Company's common stock on the American Stock Exchange ("AMEX") out of
the fifteen trading days immediately prior to conversion.
In total, the Series A Preferred Holders converted 42,330 shares of the
Series A convertible preferred stock plus accrued dividends, into
1,806,210 shares of common stock prior to the redemption of the Series A
convertible preferred stock on October 6, 2004. The conversion prices
ranged from $1.07 to $1.75 based on the above formula.
In connection with a Stock Repurchase Agreement dated October 6, 2004, the
Company redeemed the remaining 30,316 Series A convertible preferred
shares held by the Series A Preferred Holders for a total price of
$2,279,688. All previously outstanding shares of the Series A convertible
preferred stock of the Company have now been cancelled.
The Company originally concluded under EITF 00-19, "Accounting for
Derivative Financial Instruments Indexed To, and Potentially Settled in
the Company's Own Stock," that the conversion feature was conventional and
that there was no need to separate the conversion right during the period
the Series A convertible preferred shares were outstanding. Subsequent to
the redemption of the remaining preferred shares, it has been determined
that certain features of the conversion option resulted in treatment
different from that historically reflected.
The preferred stock was a fixed-income security with no participating
rights and the dividend was 10% per annum in the first year and 8% per
annum in the second, third and fourth years. Therefore, consistent with
paragraph 61(l) of SFAS No. 133, "Accounting for Derivative Instruments
and Hedging Activities," the Company has concluded that the conversion
option was not clearly and closely related to the host instrument.
Ordinarily, an issuer does not need to separate a conversion right from a
convertible instrument. However, in accordance with paragraph 4 of EITF
00-19, the Company has determined that due to the fact that the embedded
conversion option contained a provision that could have resulted in a
conversion into an indeterminable number of common shares, that the
conversion feature was in fact "unconventional". Further, since the
conversion right embedded in the preferred stock has been considered a
derivative, the related dividends are also considered derivative
instruments. As a result, the embedded derivative was a liability that was
required to be separated from the preferred stock and this liability
should have been marked to market during reporting periods. The fair value
of the derivative instruments was determined using the Black-Scholes
pricing model. Based on this determination, the Company adjusted its
results for the three and six months ended September 30, 2004 to reflect a
derivative income of $442,606 and $321,487, respectively, related to the
change in the fair value of the embedded derivative instruments. As of
September 30, 2004, there was a derivative liability of $430,785.
12
Additionally, since the conversion of the Series A convertible preferred
stock could have resulted in a conversion into an indeterminable number of
common shares, the Company has determined that under the guidance in
paragraph 24 of EITF 00-19, it was prohibited from concluding that it had
sufficient authorized and unissued shares to net-share settle any warrants
or options issued to non-employees. Therefore, the Company has
reclassified to a liability the fair value of all warrants and options
issued to non-employees that were outstanding during the period that the
Series A convertible preferred stock was outstanding from April 2001 to
October 2004. The fair value of the warrants were determined using the
Black-Scholes pricing model. Any changes in the fair value of the
securities after the initial valuation in April 2001 should have been
marked to market during reporting periods. Based on this determination,
the Company recorded a warrant liability of $203,547 as of September 30,
2004. For the three and six months ended September 30, 2004, the Company
has restated to record a gain on the fair value of warrants of $620,247
and 461,351, respectively.
The following table summarizes the changes in the Statement of Operations
for the three months ended September 30, 2004:
As Previously Adjustment As Restated
Reported
----------------- ---------------- -----------------
Income (Loss) From Operations $ (575,754) $ -- $ (575,754)
Interest Expense (264,008) -- (264,008)
Derivative Income (Expense) -- 442,606 442,606
Gain (loss) on Fair Value of Warrants -- 620,247 620,247
----------------- ---------------- -----------------
Net Income (Loss) (839,762) 1,062,853 223,091
Less:
Preferred Stock Dividends 40,180 (2,174) 38,006
Preferred Stock Accretion to
Redemption Value (308,570) 83,266 (225,304)
----------------- ---------------- -----------------
Net Income (Loss) to Common
Stockholders $ (571,372) $ 981,761 $ 410,389
================= ================ =================
Basic and Diluted Net Loss per
Common Share $ (0.04) $ 0.07 $ 0.03
================= ================ =================
The following table summarizes the changes in the Statement of Operations
for the six months ended September 30, 2004:
As Previously Adjustment As Restated
Reported
----------------- ---------------- -----------------
Income (Loss) From Operations $ (557,534) $ -- $ (557,534)
Interest Expense (523,824) -- (523,824)
Derivative Income (Expense) -- 321,487 321,487
Gain (loss) on Fair Value of Warrants -- 461,351 461,351
----------------- ---------------- -----------------
Net Income (Loss) (1,081,358) 782,838 (298,520)
Less:
Preferred Stock Dividends 82,572 (2,174) 80,398
Preferred Stock Accretion to
Redemption Value 203,605 71,735 275,340
----------------- ---------------- -----------------
Net Income (Loss) to Common Stockholders $ (1,367,535) $ 713,277 $ (654,258)
================= ================ =================
Basic and Diluted Net Loss per
Common Share $ (0.09) $ 0.05 $ (0.04)
================= ================ =================
The Series A Preferred Holders had the right to receive on any outstanding
share of Series A convertible preferred stock a ten percent dividend,
payable one year after the issuance of such preferred stock, and an eight
percent dividend for the subsequent three years thereafter, payable in
either cash or shares of preferred stock. For the three and six months
ended September 30, 2004, the Company recorded preferred dividends of
$38,006 and $80,398, respectively, on the outstanding shares of the Series
A convertible preferred stock.
On April 6, 2001, the Company recorded the initial carrying value of the
preferred stock as $521,848. Each quarter the Company calculated an
estimated redemption value of the remaining preferred stock and then
calculated the difference between the initial carrying value and this
estimated redemption value. The difference was then accreted over the
redemption period (48 months beginning April 2001) using the straight-line
method, which approximates the effective interest method. For the three
and six months ended September 30, 2004, the Company recorded ($225,304)
and $275,340, respectively, related to the accretion of the redemption
value of preferred stock.
13
(6) Non-Cash Compensation Related to Stock-Based Transactions
Effective April 1, 2003, the Company elected to record compensation
expense measured at fair value for all stock-based award transactions
(including, but not limited to, restricted stock awards, stock option
grants, and warrant issuances) on or after April 1, 2003 under the
provisions of SFAS No. 123. Prior to April 1, 2003, the Company only
recorded the fair value of stock-based awards granted to non-employees or
non-directors under the provisions of SFAS No. 123. The fair value of the
stock-based award is determined on the date of grant using the
Black-Scholes pricing model and is expensed over the vesting period of the
related award. Prior to April 1, 2003, the Company accounted for its
stock-based employee and director compensation plans under the accounting
provisions of APB No. 25 as interpreted by FASB Interpretation No. 44
("FIN 44"). Any modifications of fixed stock options or awards granted to
employees or directors originally accounted for under APB No. 25 may
result in additional compensation expense under the provisions of FIN 44.
In accordance with the above accounting standards, the Company calculates
and records non-cash compensation related to its securities in the general
and administrative expense line item in the Statements of Operations based
on two primary items:
a. Stock-Based Award Issuances
During the three months ended September 30, 2005 and 2004, the Company
recorded $26,434 and $36,994, respectively, in non-cash compensation
expense related to stock-based transactions that were issued to and vested
by employees, officers, directors and consultants. During the six months
ended September 30, 2005 and 2004, the Company recorded $1,063,393 and
$41,202, respectively, in non-cash compensation expense related to
stock-based transactions that were issued to and vested by employees,
officers, directors and consultants.
b. Option Modifications for Awards granted to Employees or Directors
under APB No. 25
On October 11, 2002, the Company repriced all outstanding options granted
to employees prior to October 11, 2002 (4,284,108 shares at former prices
ranging from $2.84 to $10.28) to the market price of $2.05 per share.
Prior to the repricing modification, the options were accounted for as a
fixed award under APB No. 25. In accordance with FIN 44, the repricing of
the employee stock options requires additional compensation expense to be
recognized and adjusted in subsequent periods for changes in the price of
the Company's common stock that are in excess of the $2.05 stock price on
the date of modification (additional intrinsic value). If there is a
decrease in the market price of the Company's common stock compared to the
prior reporting period, the reduction is recorded as compensation income
to reverse all or a portion of the expense recognized in prior periods.
Compensation income is limited to the original base exercise price (the
intrinsic value) of the options. This variable accounting treatment for
these modified stock options began with the quarter ended December 31,
2002 and such variable accounting treatment will continue until the
related options have been cancelled, expired or exercised. There are
3,499,841 outstanding modified stock options remaining as of September 30,
2005. The Company recorded non-cash compensation expense/(income) of
($23,115) and ($158,166) for the three months ended September 30, 2005 and
2004, respectively, related to the modified options described above. The
Company recorded non-cash compensation expense/(income) of ($192,556) and
zero for the six months ended September 30, 2005 and 2004, respectively,
related to the modified options described above.
(7) Impairment of Property and Equipment
In light of the Asset Sale and Supply Arrangements discussed in Note 8,
the Company determined that it is more likely than not that a majority of
its fixed assets related to production activities will be sold or disposed
prior to the end of their useful life. These assets represent
approximately 98% of the value of Property and Equipment. In accordance
with SFAS No. 144, "Accounting for the Impairment of Disposal of Long-Term
Assets," the Company wrote down the value of its assets to their estimated
fair values in June 2005. The Company will continue to hold and use the
assets until they are sold. Therefore, all assets will continue to be
reported and depreciated under Property and Equipment in the Balance Sheet
until they are sold. The Company estimated the fair value based on the
sales price discussed below and the anticipated sales price related to any
other assets plus future cash flows related to the assets from July 1,
2005 until the sale. Based on this estimate, the Company recorded an
impairment of property and equipment of $7,896,554 in order to reflect a
net fair value of its equipment in June 2005.
(8) Disposal Activities
On June 30, 2005, the Company entered into a Supply Agreement (the "Supply
Agreement") with Schreiber Foods, Inc. ("Schreiber") whereby Schreiber
will manufacture and distribute all of the Company's products. The Company
simultaneously entered into an Asset Purchase Agreement with Schreiber
whereby Schreiber will purchase substantially all of the Company's
production machinery and equipment for a total of $8,700,000 (the
"Proposed Asset Sale").
14
The Proposed Asset Sale is expected to close on or about December 8, 2005.
The closing is subject to the satisfaction of various conditions,
including approval of the sale by the Company's stockholders and certain
lenders. The Company is requesting the approval of its stockholders at a
Special Meeting of Stockholders to be held on December 5, 2005. As stated
in Note 2, the Company has already received the necessary approvals from
its lenders.
The initial term of the Supply Agreement is for a period of five years
from the effective date of September 1, 2005 and is renewable at the
Company's option for up to two additional five-year periods (for a total
term of up to fifteen years). Since October 2005, Schreiber has begun to
purchase the Company's remaining raw materials, ingredients and packaging
at the Company's cost. In mid-November 2005, Schreiber will begin shipping
the finished products to the Company or its customers, and will bill the
Company for the production and shipments based on a pre-determined price
matrix.
The Supply Agreement provides for a contingent short-fall payment
obligation by the Company if a specified production level is not met
during the one-year period from September 1, 2006 to August 31, 2007. If a
contingent short-fall payment is accrued after such one-year period, it
may be reduced by the amount by which production levels in the one-year
period from September 1, 2007 to August 31, 2008 exceeds the specified
target level of production, if any. If the Proposed Asset Sale for
$8,700,000, as contemplated by the Asset Purchase Agreement is not
consummated, then the Company will not be required to pay any such
short-fall payment.
If the Company does not exercise its option to renew the Supply Agreement
at the end of the initial five-year period, there is a cancellation charge
of $1,500,000. If the Company does not exercise its option to renew the
Supply Agreement at the end of the second five-year period, there is a
cancellation charge of $750,000. If the Proposed Asset Sale for
$8,700,000, as contemplated by the Asset Purchase Agreement is not
consummated, then the Company will not be required to pay any such
cancellation charge.
The above transactions were communicated to the Company's employees on
July 6, 2005. It is anticipated that by January 2006, 113 employee
positions will be eliminated after the Proposed Asset Sale and the
completion of moving all manufacturing operations to Schreiber. The
Company is accounting for the costs associated with these transactions in
accordance with SFAS No. 146, "Accounting for Costs Associated with an
Exit or Disposal Activity," because the above arrangements are planned and
controlled by management and materially change the manner in which the
Company's business will be conducted. In accordance with SFAS No. 146,
costs associated with disposal activities should be reported as a
reduction of income from operations. For the three and six months ended
September 30, 2005, the Company incurred and reported $499,556 and
$754,567 as Costs of Disposal Activities in the Statement of Operations.
These costs of disposal activities are comprised of employee termination
costs and legal and consulting fees. The Company anticipates that in
future periods, there will be additional disposal costs related to legal
and consulting fees in addition to possible lease abandonment charges,
which have not yet been incurred and therefore have not been accrued. The
Company may be required to adjust its accrual and estimated expense
related to employee termination costs if the actual timing of the
terminations changes from original estimates.
As of September 30, 2005, the Company has accrued the following costs
associated with the above transactions:
Employee
Termination
Costs
-----------------
Balance March 31, 2005 $ --
Expensed 359,774
Paid --
-----------------
Balance, September 30, 2005 $ 359,774
=================
15
(9) Earnings Per Share
The following is a reconciliation of basic net earnings (loss) per share
to diluted net earnings (loss) per share:
THREE MONTHS ENDED SIX MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
----------------------------------- ------------------------------------
2005 2004 2005 2004
----------------- ---------------- ----------------- ------------------
RESTATED RESTATED
Net income (loss) to common
stockholders $ (1,416,138) $ 410,389 $ (10,560,252) $ (654,258)
================= ================ ================= ==================
Weighted average shares outstanding -
basic 20,045,953 15,767,924 19,358,496 15,717,439
Potential shares "in-the-money" under
stock option agreements -- 43,643 -- --
Less: Shares assumed repurchased
under the treasury stock method -- (34,355) -- --
----------------- ---------------- ----------------- ------------------
Weighted average shares outstanding - $ 20,045,953 $ 15,777,212 $ 19,358,496 $ 15,717,439
basic and diluted
================= ================ ================= ==================
Basic and diluted net income (loss)
per common share $ (0.07) $ 0.03 $ (0.55) $ (0.04)
================= ================ ================= ==================
Options for 5,059,809 shares and warrants for 648,213 shares have not been
included in the computation of diluted net loss per common share for the
three and six months ended September 30, 2005, as their effect would be
antidilutive. Potential conversion of Series A convertible preferred stock
for 2,148,829 shares, options for 4,783,701 shares and warrants for
1,235,356 shares have not been included in the computation of diluted net
loss per common share for the six months ended September 30, 2004, as
their effect would be antidilutive. Potential conversion of Series A
convertible preferred stock for 2,148,829 shares, options for 4,740,058
shares and warrants for 1,235,356 shares have not been included in the
computation of diluted net income per common share for the three months
ended September 30, 2004, as their effect would be antidilutive.
(10) Supplemental Cash Flow Information
For purposes of the statement of cash flows, all highly liquid investments
with a maturity date of three months or less are considered to be cash
equivalents.
Six months ended September 30, 2005 2004
--------------------------------------------------------------------- -------------------
Non-cash financing and investing activities:
Accrued preferred stock dividends $ -- $ 80,398
Accretion of discount on preferred stock -- 275,340
Purchase of equipment through a capital lease -- 34,476
Cash paid for:
Interest 571,876 433,391
(11) Related Party Transactions
Angelo S. Morini
In a Second Amended and Restated Employment Agreement effective October
13, 2003, Angelo S. Morini the Company's Founder, Vice-Chairman and
President resigned from his positions with the Company as Vice Chairman
and President and he is no longer involved in the daily operations of the
Company. He retains the title of Founder and has been named Chairman
Emeritus. Mr. Morini continues to be a member of the Company's Board of
Directors. Additionally, he may carry out special assignments designated
to him by the Chairman of the Board. The agreement is for a five-year
period beginning October 13, 2003 and provides for an annual base salary
of $300,000, plus standard health insurance benefits, club dues and an
auto allowance.
Because Mr. Morini is no longer performing ongoing services for the
Company, the Company accrued and expensed the five-year cost of this
agreement in October 2003. The total estimated costs expensed under this
agreement were $1,830,329 of which $1,110,192 remained unpaid but accrued
($366,305 as short-term liabilities and $743,887 as long-term liabilities)
as of September 30, 2005. The long-term portion will be paid out in nearly
equal monthly installments ending in October 2008.
16
In June 1999, in connection with an amended and restated employment
agreement for Mr. Morini, the Company consolidated two full recourse notes
receivable ($1,200,000 from November 1994 and $11,572,200 from October
1995) related to the exercise of 2,914,286 shares of the Company's common
stock into a single note receivable in the amount of $12,772,200 that is
due on June 15, 2006. This single consolidated note is non-interest
bearing and non-recourse and is secured by the 2,914,286 underlying shares
of the Company's common stock. Per the terms of the June 1999 Employment
Agreement that was amended and restated by the October 2003 Second Amended
and Restated Employment Agreement between the Company and Mr. Morini, this
loan may be forgiven upon the occurrence of any of the following events:
1) Mr. Morini is terminated without cause; 2) there is a material breach
in the terms of Mr. Morini's employment agreement; or 3) there is a change
in control of the Company for which Mr. Morini did not vote "FOR" in his
capacity as a director or a stockholder.
In the event that the $12,772,200 loan is forgiven, the Company would
reflect this amount as a forgiveness of debt in the Statement of
Operations. In the event that Mr. Morini is unable to pay the loan when
due and the Company forecloses on the shares, the Company will reflect a
loss on collection for the amount, if any, that the value of the 2,914,286
underlying collateral shares are below the value of the note. Assuming the
market price on September 30, 2005 of $1.61, the Company would reflect a
loss of approximately $8,080,200 in the Statement of Operations. Although
both of these scenarios will result in material losses to the Company's
operations, it will not have any affect on the balance sheet since the
$12,772,200 loan amount is already shown as a reduction to Stockholders'
Equity.
Christopher J. New
On July 8, 2004, Christopher J. New resigned from his position as Chief
Executive Officer in order to pursue other opportunities. In accordance
with the Separation and Settlement Agreement between the Company and Mr.
New, the Company recorded $444,883 related to the employment contract
expense in July 2004. This settlement will be paid out in nearly equal
installments over two years payable on the Company's regular payroll
dates. As of September 30, 2005, the remaining unpaid but accrued balance
reflected in short-term liabilities was $177,283.
(12) Economic Dependence
The Company had one customer that accounted for approximately 7% and 10%
of sales in the three and six months ended September 30, 2005. As of
September 30, 2005, the amount due from this customer is approximately 5%
of the balance of accounts receivable. The Company had one customer that
accounted for approximately 11% and 13% of sales in the three and six
months ended September 30, 2004.
(13) Subsequent Events
In October 2005, pursuant to several Note and Warrant Purchase Agreements
dated September 28, 2005, the Company received a $600,000 loan from
Conversion Capital Master, Ltd., a $485,200 loan from SRB Greenway Capital
(Q.P.), L.P., a $69,600 loan from SRB Greenway Capital, L.P., and a
$45,200 loan from SRB Greenway Offshore Operating Fund, L.P. These loans
were evidenced by unsecured promissory notes (the "Notes"). The Notes
require monthly interest only payments at 3% above the bank prime rate of
interest per the Federal Reserve Bank and mature on June 15, 2006. In
consideration for the Notes and in accordance with an exemption from
registration provided by Section 4(2) of the Securities Act of 1933, as
amended, the Company issued to Conversion Capital Master, Ltd., SRB
Greenway Capital (Q.P.), L.P., SRB Greenway Capital, L.P., and SRB
Greenway Offshore Operating Fund, L.P., warrants to purchase up to 150,000
shares, 121,300 shares, 17,400 shares, and 11,300 shares, respectively, of
the Company's common stock at an exercise price equal to $1.53 (95% of the
lowest closing price of the Company's common stock in the sixty calendar
days immediately preceding October 17, 2005). The warrants fully vested on
October 17, 2005 and can be exercised on or before the expiration date of
October 17, 2008. Also in consideration for the Notes, the Company granted
Conversion Capital Master, Ltd., SRB Greenway Capital (Q.P.), L.P., SRB
Greenway Capital, L.P., and SRB Greenway Offshore Operating Fund, L.P.
"piggy back" registration rights with respect to the shares underlying the
warrants. In accordance with the accounting provisions of SFAS No. 123,
the Company recorded the $210,731 initial fair value of the warrant as a
discount to debt in October 2005. This discount will be amortized from
October 2005 through June 2006.
17
GALAXY NUTRITIONAL FOODS, INC.
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
INFORMATION IN THIS MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS ("MD&A") IS INTENDED TO ENHANCE A READER'S
UNDERSTANDING OF THE FINANCIAL CONDITION, CHANGES IN FINANCIAL CONDITION AND
RESULTS OF OPERATIONS OF OUR COMPANY. THIS MD&A IS A SUPPLEMENT TO AND SHOULD BE
READ IN CONJUNCTION WITH OUR FINANCIAL STATEMENTS AND NOTES THERETO APPEARING
ELSEWHERE IN THIS REPORT. THE FOLLOWING DISCUSSION CONTAINS CERTAIN
FORWARD-LOOKING STATEMENTS, WITHIN THE MEANING OF THE "SAFE-HARBOR" PROVISIONS
OF THE PRIVATE SECURITIES REFORM ACT OF 1995, THE ATTAINMENT OF WHICH INVOLVES
VARIOUS RISKS AND UNCERTAINTIES. THESE STATEMENTS RELATE TO FUTURE EVENTS OR OUR
FUTURE FINANCIAL PERFORMANCE. THESE FORWARD-LOOKING STATEMENTS ARE BASED ON OUR
CURRENT EXPECTATIONS, ESTIMATES AND PROJECTIONS ABOUT OUR INDUSTRY, MANAGEMENT'S
BELIEFS AND CERTAIN ASSUMPTIONS MADE BY OUR COMPANY. WORDS SUCH AS "ANTICIPATE,"
"EXPECT," "INTEND," "PLAN," "BELIEVE," "SEEK," "PROJECT," "ESTIMATE," "MAY,"
"WILL," AND VARIATIONS OF THESE WORDS OR SIMILAR EXPRESSIONS ARE INTENDED TO
IDENTIFY FORWARD-LOOKING STATEMENTS. THESE STATEMENTS ARE NOT GUARANTEES OF
FUTURE PERFORMANCE AND ARE SUBJECT TO CERTAIN RISKS, UNCERTAINTIES AND
ASSUMPTIONS THAT ARE DIFFICULT TO PREDICT. THEREFORE, ACTUAL RESULTS MAY DIFFER
MATERIALLY FROM OUR HISTORICAL RESULTS AND THOSE EXPRESSED OR FORECASTED IN ANY
FORWARD-LOOKING STATEMENTS AS A RESULT OF A VARIETY OF FACTORS, INCLUDING BUT
NOT LIMITED TO, COMPETITION IN THE MARKET FOR OUR PRODUCTS, DEPENDENCE ON
SUPPLIERS, OUR MANUFACTURING EXPERIENCE, PRODUCTION DELAYS OR INEFFICIENCIES,
AND CHANGES IN ACCOUNTING STANDARDS. WE UNDERTAKE NO OBLIGATION TO PUBLICLY
UPDATE OR REVISE ANY FORWARD-LOOKING STATEMENTS FOR ANY REASON, EVEN IF NEW
INFORMATION BECOMES AVAILABLE OR OTHER EVENTS OCCUR IN THE FUTURE.
Terms such as "fiscal 2006" or "fiscal 2005" refer to our fiscal years ending
March 31, 2006 and 2005, respectively. Terms such as "first quarter," "second
quarter," "third quarter," or "fourth quarter" refer to the fiscal quarters
ending June 30, September 30, December 31 or March 31, respectively.
This MD&A contains the following sections:
o Restatement
o Business Environment
o Critical Accounting Policies
o Recent Accounting Pronouncements
o Results of Operations
o Liquidity and Capital Resources
Restatement
This Form 10-Q and the restated fiscal 2005 financial statements included herein
reflect a correction of our accounting and disclosure primarily related to the
warrants that were outstanding during the term of our Series A convertible
preferred stock, from April 2001 through October 2004. The issue relates to
accounting for securities that are reflected as income or expense through
earnings as non-cash charges. These non-cash charges do not affect our revenues,
cash flows from past or future operations, or our liquidity. As discussed in
Note 5 of the financial statements, for the three and six months ended September
30, 2004, we have restated our financial statements to reflect a net income
(loss) of $223,091 and ($298,520), which reflects an additional income of
$1,062,853 and $782,838, respectively, from what was previously reported for
this period in the Form 10-Q for the quarterly period ended September 30, 2004.
Business Environment
General
Galaxy Nutritional Foods, Inc. (our "Company") is principally engaged in
developing, manufacturing and marketing a variety of healthy cheese and dairy
related products, as well as other cheese alternatives, and is a leading
producer of dairy alternative products made with soy. These healthy cheese and
dairy related products include low or no fat, no saturated fat, no trans-fat,
low or no cholesterol and lactose-free varieties. These products are sold
throughout the United States and internationally to customers in the retail and
food service markets. Our company headquarters and manufacturing facilities are
located in Orlando, Florida.
18
Our Company is currently in a transition period with respect to its
manufacturing operations. We determined that our manufacturing capacity was
significantly in excess of our requirements, and that it would be advantageous
for us to outsource our manufacturing, packaging and delivery operations. On
June 30, 2005, our Company and Schreiber Foods, Inc., a Wisconsin corporation
("Schreiber"), entered into a Supply Agreement, whereby we agreed that, among
other things, as of November 1, 2005, Schreiber would become our sole source of
supply of substantially all of our products and we would purchase our
requirements of substantially all of our products exclusively from Schreiber.
Schreiber has also agreed to deliver such products directly to our customers.
The prices for such products are based on cost conversions determined by the
parties from time to time.
In connection with the Supply Agreement, we also entered into an Asset Purchase
Agreement, dated as of June 30, 2005, by and between Schreiber and our Company,
whereby we agreed to sell our manufacturing equipment to Schreiber in exchange
for $8,700,000, in cash, payable at closing. The closing of the sale is subject
to approval by our stockholders and satisfaction of certain other conditions. If
the stockholders do not approve the sale, we have agreed to consummate one or
two alternative transactions designed to facilitate Schreiber's manufacturing
responsibilities under the Supply Agreement. Regardless of whether the proposed
asset sale is consummated, our Company will convert into a branded marketing
company that will continue to market and sell our products, but will no longer
manufacture all of our products.
Healthy Cheese and Alternative Cheese Industry
We are the market leader within our alternative cheese category niche, but in
being so, the category increases or decreases partly as a result of our
marketing efforts. We believe that the greatest source of future growth in the
cheese alternative category will come through customers shifting to cheese
alternatives from natural cheese. Rather than focusing primarily on consumers
with a preference or medical condition predisposing them to non-dairy cheese and
comparing our products to other cheese alternative brands, we intend to focus on
educating cheese consumers on the healthy attributes of cheese alternatives
versus traditional cheese.
We use several internal and external reports to monitor sales by brand, segment,
form and channel of sale to determine which items are increasing or decreasing
both in units sold and price per unit. By reviewing these reports along with
industry data from publications, syndicated retail consumption reports, and
conversations with major retailers, other manufacturers in the food and beverage
industry, and ingredient and service suppliers, we analyze trends in the
consumer marketplace and make decisions on which brands to promote.
In the second quarter of fiscal 2006, we launched a consumer marketing sales
campaign focused on the following three primary strategies:
o Consumer focused advertising. We plan to increase consumer
advertising (in TV, magazine, and event sponsorship) and consumer
promotions (for example, on-pack "cents off" coupons, "cents off"
coupons delivered via newspapers, in-store product sampling, and
product benefit communication at the point of purchase/shelf) that
highlight and communicate the benefits of our products to meet the
consumer demand for low fat, no cholesterol and high calcium
products.
o Increase retailer penetration and geographical distribution. By
increasing our presence on the store shelves, we seek to increase
household penetration and build market share in specific markets.
o Increase brand awareness. We seek to increase sales by increasing
our customer base and generating consumer awareness of new products
or flavors through product trials and generating more repeat
purchases on our Veggie(TM) brand through improved taste, color,
aroma, texture and packaging.
We began the consumer television advertising campaign the first week in
September 2005 for the West Coast, InterMountain and Minneapolis markets. In
support of that advertising, we distributed coupons through the newspapers in
all those markets as well. Initial sales data from these markets in the four
weeks following the promotions, indicate that sales increased more than 10% from
sales in the four weeks prior to the promotions. At this time, we are unable to
determine if we will experience continued positive effects from the advertising
campaigns. Thus, sales improvements in these four weeks are not necessarily
indications of future results. We have also secured distribution of our new
product snack dips and chipotle- flavored chunks with over 70% of our current
customers. These new products have not had enough market time to impact sales,
but we are hopeful that by the end fiscal 2006, they will contribute to
increased sales and improved margins.
19
We believe that the combination of "healthy" product attributes, improved taste
and product functionality will lead to better than expected consumer experiences
with our products. Our focus is to transfer those improved consumer experiences
into enhanced market share and increased sales of our higher margin products.
Recent Material Developments
The Schreiber Transactions
Asset Purchase Agreement
On June 30, 2005, we entered into an Asset Purchase Agreement for the sale of
certain of our manufacturing and production equipment to Schreiber for
$8,700,000 in cash (the "Proposed Asset Sale"). The Proposed Asset Sale is
expected to close on or about December 8, 2005. The closing is subject to the
satisfaction of various conditions, including approval of the sale by our
stockholders and certain lenders. We are requesting the approval of our
stockholders at a Special Meeting of Stockholders to be held on December 5,
2005. Additionally, we have already received the necessary approvals from our
lenders.
If our stockholders do not approve the transaction, the Asset Purchase Agreement
provides for an alternative transaction whereby we would sell to Schreiber a
smaller portion of the assets, which would not constitute substantially all of
our assets and therefore would not require stockholder approval. The purchase
price for this alternative sale would be $2,115,000. This alternative sale is
subject to obtaining approval from our lenders.
If we are unable to obtain approval from our lenders with respect to this
alternative sale, then we will negotiate in good faith with Schreiber to make
the smaller portion of the assets available for Schreiber's use on reasonably
acceptable terms, not to exceed a term of 180 days. This alternative arrangement
is also subject to obtaining approval from our lenders.
The Supply Agreement
On June 30, 2005, our Company and Schreiber entered into a Supply Agreement,
whereby we agreed that, among other things, as of November 1, 2005, Schreiber
will manufacture and distribute all of our products directly to our customers.
The prices for such products are based on cost conversions determined by the
parties from time to time. Other key provisions of the Supply Agreement are as
follows:
o The initial term of the Supply Agreement is for a period of five
years from the effective date of September 1, 2005 and is renewable
at our option for up to two additional five-year periods (for a
total term of up to fifteen years). Since October 2005, Schreiber
has begun to purchase our remaining raw materials, ingredients and
packaging at our cost. In mid-November 2005, Schreiber will begin
shipping the finished products to our Company or its customers, and
will bill our Company for the production and shipments based on a
pre-determined price matrix.
o The Supply Agreement provides for a contingent short-fall payment
obligation by our Company if a specified production level is not met
during the one-year period from September 1, 2006 to August 31,
2007. If a contingent short-fall payment is accrued after such
one-year period, it may be reduced by the amount by which production
levels in the one-year period from September 1, 2007 to August 31,
2008 exceeds the specified target level of production, if any. If
the Proposed Asset Sale for $8,700,000, as contemplated by the Asset
Purchase Agreement is not consummated, then we will not be required
to pay any such short-fall payment.
o If we do not exercise our option to renew the Supply Agreement at
the end of the initial five-year period, there is a cancellation
charge of $1,500,000. If we do not exercise our option to renew the
Supply Agreement at the end of the second five-year period, there is
a cancellation charge of $750,000. If the Proposed Asset Sale for
$8,700,000, as contemplated by the Asset Purchase Agreement is not
consummated, then we will not be required to pay any such
cancellation charge.
o Schreiber is required to deliver products to our Company or our
customers that are in compliance with our standards and
specifications and all applicable laws. Schreiber will deliver all
products within 10 business days of the effective date of such
order, which is one business day after receipt of the order.
o After the transfer of all production responsibilities to Schreiber,
we may not manufacture any products governed by the Supply Agreement
during the term of the Supply Agreement.
20
o Schreiber may not manufacture our products or use any of our
intellectual property other than pursuant to the terms of the Supply
Agreement.
o We may terminate the Supply Agreement if our stockholders do not
approve the Proposed Asset Sale, by providing notice to Schreiber
within 30 days of the date that our stockholders vote on, but do not
approve, the Proposed Asset Sale. The effectiveness of such
termination may not be more than 180 days after the date of such
notice.
o If we do not terminate the Supply Agreement and we are unable to
consummate an alternative asset sale or use transaction with
Schreiber (as described above) prior to January 1, 2006, then
Schreiber may terminate the Supply Agreement by providing written
notice to our Company prior to February 1, 2006. The effectiveness
of such termination may not be less than 180 days after the date of
such notice.
o As indicated above, there are a number of conditions that must be
met prior to the consummation of these transactions. There can be no
guarantee that we will satisfy these conditions and, therefore,
there can be no guarantee that the transactions will be consummated.
Transition Challenges
We will face many challenges during this transition to solely a branded
marketing company, including, but are not limited to, the following:
o Coordinating customer shipments while the inventory and production
equipment is in transit from our facilities to the Schreiber
facilities;
o Reserving enough inventory on-hand to fill customer orders while
production equipment is in transit;
o Maintaining consistent formulas and quality in our products after
the transition;
o Maintaining enough cash to build inventory and pay any severance
arrangements during the transition;
o Reducing production personnel and agreeing upon severance
arrangements related to these personnel;
o Negotiating with our lenders to the extent debt is not paid in full
from the sale proceeds so that they will release their liens on the
assets to permit the sale. If they will not agree to do so, we may
be required to raise additional funds to pay our lenders in full
prior to their maturity dates; and
o Negotiating with the landlords of our leased premises to terminate
or assign our lease or to sublease our facilities.
Each one of these events must be carefully timed and coordinated in order to
avoid problems with cash flow, litigation, loss of customer sales, and other
tangible and intangible effects. In the event the asset sale to Schreiber as
contemplated by the Asset Purchase Agreement is not consummated, these
challenges will be much more difficult to overcome and we will be faced with the
additional challenge of seeking alternative options involving the sale of any
manufacturing equipment not sold to Schreiber. There can be no assurance that
any third party will offer to purchase our manufacturing equipment for a price
equal to or greater than the price proposed to be paid by Schreiber, or that
such equipment can otherwise be sold at all. Our failure to adequately address
any of these challenges would negatively affect our business, results of
operations and cash flows.
Transaction Effect
We believe that the long-term benefits in the transition from a manufacturing
company to a branded marketing company will far outweigh the short-term
challenges of the transition. Without the cash-flow burden of carrying inventory
and managing manufacturing overhead and production issues, we believe that we
can focus a substantially greater amount of time and resources on the sale of
our products. Additionally, we plan to enhance our marketing efforts in order to
increase our consumer base and sales volume.
Assuming that the sale of assets to Schreiber is completed in accordance with
the Proposed Asset Sale and we continue to operate under the Supply Agreement
with Schreiber, some of the effects of the transaction will be as follows:
o We will no longer be a manufacturing company, but will be solely a
branded marketing company.
o We have two facilities that we lease in Orlando, Florida. After all
production is moved completely to Schreiber, we may be required to
have discussions with our landlords regarding the use of our
facilities. We are still exploring our options regarding the
facilities, which include, but are not limited to: 1) negotiating an
early termination with the landlords; 2) continuing to make lease
payments until the end of the lease terms; or 3) subleasing the
facilities.
21
o We will be eliminating 115 employee positions and creating 5 new
employee positions. Our anticipated total number of full-time
employees after December 31, 2005 will be 31.
o We will use all the proceeds to pay down accrued liabilities and
short-term debt. Upon closing of the Proposed Asset Sale, we expect
to pay $1,319,583 to the Orange County Tax Collector for accrued
tangible property taxes and $7,361,985 to Beltway Capital Partners
LLC to pay the term loan in full. Any remaining balance will be used
to pay down our line of credit with Textron. Repayment of these
liabilities will result in annual interest savings in excess of
$800,000.
o We will no longer have the carrying value of inventory nor need to
use asset based financing to support the production of inventory. In
the recent past, we averaged 50 to 60 days of sales in inventory.
o We will be able to take advantage of Schreiber's lower production
costs rather than the high production costs of our underutilized
production facility.
o We anticipate substantial savings on delivery charges related to the
distribution of our products to our customers.
Debt Maturity and Going Concern Issues
We have incurred substantial debt in connection with the financing of our
business. The aggregate principal amount outstanding under our credit facilities
is approximately $12,200,608 as of November 11, 2005. This amount includes a
revolving line of credit from Textron Financial Corporation ("Textron") in the
amount of $2,328,623, a note payable to Beltway Capital Partners LLC, successor
by assignment from Wachovia Bank, ("Beltway") in the amount of $7,471,985, and
several notes payable to certain shareholders (as described under Debt
Financing) totaling $2,400,000. We anticipate that the proceeds from the sale of
our assets to Schreiber will pay the Beltway term loan in full. However, in the
event that the sale is not completed as anticipated, we will need to refinance
the Beltway term loan on or before its maturity date of July 31, 2006.
Additionally, we will need to refinance or raise proceeds to pay the Textron
line of credit on or before its maturity date of May 26, 2006 and the notes
payable to shareholders on or before their maturity date of June 15, 2006.
If we are unable to refinance or renew our existing credit facilities, or if
additional financing is not available on terms acceptable to us, we will be
unable to satisfy such facilities by their maturity dates. In such an event,
Textron, Beltway and the shareholders could exercise their respective rights
under their loan documents, which could include, among other things, declaring
defaults under the loans and pursuing foreclosure on our assets that are pledged
as collateral for such loans. If such an event occurred, it would be
substantially more difficult for us to effectively continue the operation of our
business, and it is unlikely that we would be able to continue as a going
concern.
Del Sunshine LLC
Pursuant to an oral contract manufacturing and distribution arrangement among
our Company, Del Sunshine LLC ("Del"), a Delaware limited liability company, and
Non-Dairy Specialty Foods, LLC ("Non-Dairy"), a Nevada limited liability company
and affiliate of Del, we began manufacturing certain private label products for
Del and delivering them directly to Del's customers, including Del's major
customer, Wal-Mart, Inc. in April 2004. These private label products were
produced using label and packaging trademarks owned by Del. Sales to Del
accounted for 12% of our sales during fiscal 2005, which attributed to 65% of
the increase in sales over fiscal 2004.
On April 11, 2005, we executed with Del a Trademark License Agreement and an
Assignment of Accounts Receivable Agreement. Pursuant to the Trademark License
Agreement, Del licensed to us the rights in certain Del trademarks, which
allowed us to sell products directly to Del's customers, including Wal-Mart,
Inc. and other food retailers, using such trademarks. In consideration for the
license, we agreed to pay to Del a 5% royalty on the net sales of such products.
In accordance with the Trademark License Agreement, we can offset any royalties
that we may owe to Del under the agreement against our account receivable and
other amounts owed to us by Del.
Pursuant to the Assignment of Accounts Receivable Agreement, Del assigned to us
any and all accounts receivable owed to Del by Wal-Mart, Inc. and other food
retailers, plus monies owed to Del under current purchase orders. It was
intended that the assignment of the accounts receivable and purchase order
amounts would offset, in part, our account receivable from Del. We also agreed
not to commence any legal proceedings against Del or Non-Dairy to collect
amounts owed to us by them, excluding defenses and counterclaims against Del or
Non-Dairy made in any legal proceeding brought by them.
The effectiveness of the Trademark License Agreement and the Assignment of
Accounts Receivable Agreement was conditioned upon Del providing us with proof,
satisfactory to us, that (a) Del would be transferring to us under the
Assignment of Accounts Receivable Agreement accounts receivable and purchase
orders in excess of $400,000 and (b) that Wal-Mart, Inc. would consent to the
transactions contemplated under both agreements. Del has not satisfied either of
the foregoing conditions and we do not believe that it is likely that Del will
be able to satisfy the conditions in the future. Although we waived the
conditions as they relate to the Trademark License Agreement, we did not waive
them with respect to the Assignment of Accounts Receivable Agreement. Currently,
we are exploring our options in addressing the issues with Del related to the
effectiveness and continuation of the Assignment of Accounts Receivable
Agreement and Del's payment of our account receivable. On or about June 15,
2006, we ceased selling products under Del's trademarks and we allowed the
Trademark License Agreement to expire according to its terms on September 30,
2005.
22
In the fourth quarter of fiscal 2005, we reserved nearly $1,550,000 in accounts
receivable and wrote off $210,000 in inventory related to Del based upon our
determination in April 2005 that collection from Del was questionable as of
March 31, 2005. During the first quarter of fiscal 2006, we accrued
approximately $40,000 in royalties under the Trademark License Agreement and
offset them against the receivable owed to us by Del. During the six months
ended September 30, 2005, we recorded approximately $261,000 in additional bad
debt related to Del. As of September 30, 2005, all amounts owed by Del have been
written off as uncollectible.
Measurements of Financial Performance
We focus on several items in order to measure our performance. In the short term
(1 to 3 years), we are working towards obtaining positive trends in the
following areas:
o Operating cash flow
o Gross margin in dollars and % of gross sales
o Operating income excluding certain employment contract expenses and
non-cash compensation related to stock based transactions
o EBITDA excluding certain employment contract expenses and non-cash
compensation related to stock based transactions
o Liquidity
o Net sales trends (as it relates to consumer demand)
o Key financial ratios (such as accounts receivable, accounts payable
and inventory turnover ratios)
o Other operating ratios and statistics
In the long term (over 3 years), we are striving to generate consistent and
predictable net sales growth with increased gross margins, while incrementally
enhancing net cash flow from operations.
Critical Accounting Policies
The preparation of financial statements in conformity with accounting principles
generally accepted in the United States of America requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and reported amounts of income and expense during the
reporting periods presented. Our significant estimates include the allowance for
doubtful accounts receivable, provision for obsolete inventory, valuation of
deferred taxes, valuation of compensation expense on options and warrants, and
accruals for disposal costs. Although we believe that these estimates are
reasonable, actual results could differ from those estimates given a change in
conditions or assumptions that have been consistently applied.
The critical accounting policies used by management and the methodology for
estimates and assumptions are as follows:
Valuation of Accounts Receivable and Chargebacks
We record revenue upon shipment of products to our customers and reasonable
assurance of collection on the sale. We generally provide credit terms to
customers based on net 30-day terms. We perform ongoing credit evaluations of
our accounts receivable balances and based on historical experience, make
reserves for anticipated future customer credits for promotions, discounts,
spoils, and other reasons. In addition, we evaluate the accounts for potential
uncollectible amounts based on a specific identification methodology and record
a general reserve for all remaining balances.
Based on the age of the receivable, cash collection history and past dilution in
the receivables, we make an estimate of our anticipated bad debt, anticipated
future authorized deductions due to current period activity and anticipated
collections on non-authorized amounts that customers have currently deducted on
past invoices. Based on this analysis, we reserved $1,186,000 and $797,000 for
known and anticipated future credits and doubtful accounts at September 30, 2005
and 2004, respectively. The reserve is higher at September 30, 2005 primarily
due to additional promotions that we initiated in August and September 2005. We
believe that this estimate is reasonable, but there can be no assurance that our
estimate will not change given a change in economic conditions or business
conditions within the food industry, our individual customer base or our
Company.
23
Inventory
Inventories are valued at the lower of cost or market. Cost is determined using
a weighted average, first-in, first out method. We review our inventory
valuation each month and write off the inventory related to obsolete and damaged
inventory. In addition, we reduce the value of any finished good item to market
value when that value is believed to be less than the cost of the inventory.
Deferred Taxes
Valuation allowances are established when necessary to reduce deferred tax
assets to the amount expected to be realized. We have reserved our net deferred
tax assets in full.
Valuation of Non-Cash Compensation
We have three stock-based employee compensation plans. Prior to April 1, 2003,
we accounted for those plans under the recognition and measurement provisions of
Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to
Employees," (APB No. 25), and related Interpretations.
Effective April 1, 2003, we adopted the fair value recognition provisions of
Statement of Financial Accounting Standards ("SFAS") No. 123, "Accounting for
Stock-Based Compensation," and apply SFAS No. 148, "Accounting for Stock-Based
Compensation - Transition and Disclosure," prospectively to all employee awards
granted on or after April 1, 2003. Awards from our plans vest over periods
ranging from immediate to five years. Therefore, the cost related to stock-based
compensation included in the determination of net income for the periods is less
than that which would have been recognized if the fair value based method had
been applied to all awards since the original effective date of SFAS No. 123.
The fair value of the stock-based award (including, but not limited to,
restricted stock awards, stock option grants, and warrant issuances) is
determined on the date of grant using the Black-Scholes pricing model and is
expensed over the vesting period of the related award. The difference between
the proforma and reported net loss per common share related to the issuance of
employee stock options during the three and six months ended September 30, 2005
and 2004 ranged from nearly zero to $0.01.
Several management estimates are needed to compute the fair value of the
stock-based transactions including anticipated life, risk free interest rates,
and volatility of our stock price. Currently, we estimate the life of all awards
granted assuming that the award will remain outstanding and not be exercised
until the end of its term. This results in the highest possible value of the
award. If we were to change our estimate of the anticipated life to something
less than the maximum term, then the fair value expense per share would decrease
by approximately $.01 to $.02 per month. If we were to change our estimate of
the volatility percentage, the fair value expense per share would change by
approximately $.02 per percentage change in the volatility. If we were to change
our estimate of the interest rate, the fair value expense per share would change
by approximately $.03 per percentage change in the interest rate.
SFAS No. 123 requires that we provide pro-forma information regarding net income
(loss) and earnings (loss) per share amounts as if compensation cost for all our
employee and director stock-based awards had been determined in accordance with
the fair value method prescribed in SFAS No. 123. We estimated the fair value of
each stock-based award (i.e. restricted stock awards, stock option grants, and
warrant issuances) during the periods presented by using the Black-Scholes
pricing model with the following assumptions:
September 30, September 30,
Six Months Ended: 2005 2004
-------------------- --------------------
Dividend Yield None None
Volatility 24.9%-46.0% 44.0%-59.0%
Risk Free Interest Rate 3.35%-3.45% 1.46%-3.96%
Expected Lives in Months 1-36 6-120
In addition to non-cash compensation expense related to new stock-based
transactions, we also record non-cash compensation expense in accordance with
the Financial Accounting Standards Board ("FASB") Interpretation No. 44 ("FIN
44") related to modifications in stock-based transactions. FIN 44 only relates
to original stock-based transactions with our employees and directors that were
granted prior to April 1, 2003 and accounted for under the accounting provisions
of APB No. 25.
FIN 44 states that when an option is repriced or there are items that
effectively reduce the price of an option, it is treated as a variable option
that is marked to market each quarter. Accordingly, any increase in the market
price of our common stock over the exercise price of the option that was not
previously recorded is recorded as compensation expense at each reporting
period. If there is a decrease in the market price of our common stock compared
to the prior reporting period, the reduction is recorded as compensation income
to reverse all or a portion of the expense recognized in prior periods.
Compensation income is limited to the original base exercise price (the
intrinsic value) of the options. Each period we record non-cash compensation
expense or income related to our analysis on approximately 3.5 million option
shares. Assuming that the stock price exceeds the intrinsic value on all the
variable option shares, a $0.01 increase or decrease in our common stock price
results in an expense or income, respectively, of $35,000. Due to the volatility
of the market price of our common stock, we are incapable of predicting whether
this expense will increase or decrease in the future.
24
Disposal Costs
We have recorded significant accruals in connection with the Proposed Asset Sale
and outsourcing arrangement with Schreiber. These accruals include estimates
pertaining to employee termination costs and, in the future, may also include
related abandonment of excess equipment and facilities and other potential
costs. Actual costs may differ from these estimates or our estimates
may change. In accordance with SFAS 146, "Accounting for Costs Associated with
Exit or Disposal Activities", costs associated with restructuring activities are
recognized when they are incurred rather than at the date of a commitment to an
exit or disposal plan. Given the significance and complexity of these
activities, and the timing of the execution of such activities, the accrual
process involves periodic reassessments of estimates made at the time the
original decisions were made, including evaluating estimated employment terms
and real estate market conditions for sub-lease rents. We will continually
evaluate the adequacy of the remaining liabilities under our restructuring
initiatives. Although we believe that these estimates accurately reflect the
costs of our activities, actual results may differ, thereby requiring us to
record additional provisions or reverse a portion of such provisions. Should the
timing of employee terminations change, our estimate of restructuring expenses
may have to be increased.
Recent Accounting Pronouncements
In November 2004, the FASB issued SFAS No. 151, "Inventory Costs, an amendment
of Accounting Research Bulletin No. 43, Chapter 4." SFAS No. 151 requires that
abnormal amounts of idle facility expense, freight, handling costs and wasted
materials (spoilage) be recorded as current period charges and that the
allocation of fixed production overheads to inventory be based on the normal
capacity of the production facilities. SFAS No. 151 is effective during fiscal
years beginning after June 15, 2005, although earlier application is permitted.
We believe that the adoption of this Statement will not have a significant
impact on our financial position, results of operations or cash flows.
In December 2004, the FASB issued SFAS No. 123 (revised 2004), "Share-Based
Payment" ("SFAS No. 123R"), which addresses the accounting for share-based
payment transactions in which a company receives employee services in exchange
for (a) equity instruments of the company or (b) liabilities that are based on
the fair value of the company's equity instruments or that may be settled by the
issuance of equity instruments. SFAS No. 123R supercedes APB Opinion No. 25 and
amends SFAS No. 95, "Statement of Cash Flows." Under SFAS No. 123R, companies
are required to record compensation expense for all share-based payment award
transactions measured at fair value as determined by an option valuation model.
Currently, we use the Black-Scholes pricing model to calculate the fair value of
its share-based transactions. This statement is effective for fiscal years
beginning after June 15, 2005. Since we currently recognize compensation expense
at fair value for share-based transactions in accordance with SFAS No. 123, we
do not anticipate adoption of this standard will have a significant impact on
our financial position, results of operations, or cash flows. However, we are
still evaluating all aspects of the revised standard.
In December 2004, the FASB issued SFAS No. 153, "Exchanges of Nonmonetary Assets
an Amendment of APB Opinion No. 29." SFAS No. 153 amends APB Opinion No. 29 to
eliminate the exception for nonmonetary exchanges of similar productive assets
from being measured based on the fair value of the assets exchanged. SFAS No.
153 now provides a general exception for exchanges of nonmonetary assets that do
not have commercial substance. SFAS No. 153 is effective for fiscal periods
beginning after June 15, 2005. We believe that the adoption of this Statement
will not have a significant impact on our financial position, results of
operations or cash flows.
In May 2005, the FASB issued SFAS No. 154, "Accounting Changes and Error
Corrections - a replacement of APB Opinion No. 20 and SFAS No. 3." SFAS No. 154
changes the requirements for the accounting for and reporting of a change in
accounting principle and a change required by an accounting pronouncement when
the pronouncement does not include specific transition provisions. SFAS No. 154
requires retrospective application of changes as if the new accounting principle
had always been used. SFAS No. 154 is effective for fiscal years beginning after
December 15, 2005. We are still evaluating all aspects of the revised standard
in order to evaluate the impact on our financial position and results of
operations.
25
Results of Operations
3-Months Ended September 30, 6-Months Ended September 30,
---------------------------------------------- ----------------------------------------------
2005 2004 $ % 2005 2004 $ %
Change Change Change Change
- --------------------------------------------------------------------------- ----------------------------------------------
Net Sales 10,438,225 11,900,553 (1,462,328) -12.3% 20,289,378 23,092,231 (2,802,853) -12.1%
Cost of Goods Sold 7,817,351 9,319,969 (1,502,618) -16.1% 15,400,206 17,571,299 (2,171,093) -12.4%
---------------------------------------------- ----------------------------------------------
Gross Margin 2,620,874 2,580,584 40,290 1.6% 4,889,172 5,520,932 (631,760) -11.4%
============================================== ==============================================
Gross Profit % 25.1% 21.7% 24.1% 23.9%
======================== =========================
Net Sales
Net sales in the three and six months ended September 30, 2005 decreased 12%
from net sales in such periods in the prior year primarily due to a decline in
private label sales volume to Wal-Mart. During fiscal 2005, we sold indirectly
to Wal-Mart through Del Sunshine, a private label customer, but beginning in
April 2005, we began selling direct to Wal-Mart. During the first six months of
fiscal 2005, Del accounted for approximately 13% of net sales. During the first
six months of fiscal 2006, sales to Wal-Mart accounted for approximately 10% of
net sales. Private label and imitation sales consist primarily of products that
generate high sales volumes but lower gross margins. Sales also decreased in the
first quarter of fiscal 2006 due to a package size change in our Veggie(TM) and
Vegan products. Our customers did not reorder our products in the new package
size until they had sold out every product in the old package size. The size
change was completed by early September. Finally, sales declines can also be
attributed to overall consumer resistance to the multiple price increases we
have taken during the past fourteen months to offset our rising production
costs.
Certain key initiatives and tactical actions were initiated by our Company
during fiscal 2005 and will be continued throughout fiscal 2006. Such key
initiatives and tactical actions for fiscal 2006 include, but are not limited
to, the following:
o Creating and communicating a new more meaningful brand position for
our flagship Veggie(TM) brand and adding new products. The recent
focus is to highlight the superior nutritional factors such as
cholesterol and trans-fat free, as well as targeting a broader
universe of consumers. We are attempting to attract incremental
users by convincing users of conventional cheese that the Veggie(TM)
brand items can satisfy their needs with great tasting nutrition.
This is a departure from our past product positioning where
physiological and medical requirements were a key driver in why
consumers should buy the "healthy alternatives."
o Improving product quality in terms of taste, color, aroma, and
texture of our Veggie(TM) and Rice and Vegan products.
o Reducing or eliminating most of our contract manufacturing customers
due to the continued high cost of certain raw materials which result
in gross margins that are below our acceptance level.
o Continued emphasis and resource allocation of our marketing strategy
to increase sales through consumer advertising (in TV, magazine, and
event sponsorship) and consumer promotions (for example, on-pack
"cents off" coupons, "cents off" coupons delivered via newspapers,
in-store product sampling, product benefit communication at the
point of purchase/shelf). These marketing campaigns were launched in
the second quarter of fiscal 2006. In fiscal 2006, we saw an
increase in sales through our consumer advertising and promotions,
which highlighted and communicated the benefits of our products to
meet the consumer demand for low fat, no cholesterol and and high
calcium products. We experienced over a 10% increase in sales in
those markets where there were consumer- advertising promotions in
the second quarter of fiscal 2006.
While initial response from the advertising campaign in the limited markets are
positive, we are unable to determine if we will experience continued positive
effects from the advertising campaigns. Thus, sales improvements in the test
markets in September 2006 are not necessarily indications of future results.
We use several internal and external reports to monitor sales by brand, segment,
form and channel of sale to determine the outside factors affecting the sales
levels. These reports provide management information on which brand, segments,
forms and/or channel sales are increasing or decreasing both in units sold and
price per unit. By reviewing these reports along with industry data from
publications, syndicated retail consumption reports, and conversations with
major retailers, other manufacturers in the food and beverage industry, and
ingredient and service suppliers, we make decisions on which brands to promote
and analyzes trends in the consumer marketplace.
26
We anticipate that our direct sales to Wal-Mart will range between 5% and 10% of
sales in fiscal 2006. Due to the reduction in our estimate of lower margin sales
to Wal-Mart, we anticipate a decline of 5% and 10% in sales volume in fiscal
2006 compared to fiscal 2005, but we expect to continue to show improved margins
so that the gross margin dollars in fiscal 2006 will exceed the gross margin
dollars in fiscal 2005.
Cost of Goods Sold
Cost of goods sold was approximately 76% of net sales for each of the first six
months of fiscal 2006 and 2005. However, we noted a 3% percentage point decrease
in cost of goods sold to 75% of net sales in the second quarter of fiscal 2006
compared to 78% of net sales in the second quarter of fiscal 2005. This three
percentage point decrease in cost of goods sold was primarily due to a $270,000
decrease in direct labor expenses and a $491,000 decrease in overhead costs. We
experienced lower costs in direct labor and overhead costs as a result of
improved production efficiencies and changes in the allocation of certain
overhead costs to various departments. Certain allocation costs are allocated
based on a square footage method. As a result of lower square footage in our
production areas in fiscal 2006 compared to prior fiscal years, there is a
higher percentage of overhead allocated to non-production departments beginning
in April 2005. We anticipate that the cost of goods sold will also decrease as a
result of the outsourcing arrangement with Schreiber. However, actual results
could differ from our expectations.
We monitor our costs and production efficiencies through various ratios
including pounds produced per hour and cost per pound sold and use these ratios
to make decisions in purchasing, production and setting sales prices.
In the second quarter of fiscal 2006, gross margin has improved because casein
prices have stabilized and our current sales mix of the branded and remaining
private label products are able to give us a higher level of income. In fiscal
2006, we expect our annual gross profit percentage to improve over the annual
fiscal 2005 levels because we have implemented price increases on some of our
products, additional sales growth is expected in our higher margin products and
we have eliminated certain low margin private label manufacturing accounts.
EBITDA
We utilize certain GAAP measures such as Operating Income and Net Income and
certain non-GAAP measures such as EBITDA and exclude non-cash compensation
related to stock based transactions included in general and administrative
expenses and certain employment contract expenses in order to compute our key
financial measures that are reviewed by management, lenders and investors in
order to effectively review our current on-going operations and analyze trends
related in our financial condition and results of operations. Additionally,
these measures are key factors upon which we prepare our budgets and forecasts,
calculate bonuses, and evaluate loan covenants. These adjusted measures are not
in accordance with, or an alternative for, generally accepted accounting
principles and may be different from non-GAAP measures reported by other
companies.
3-Months Ended September 30, 6-Months Ended September 30,
---------------------------------------------- ------------------------------------------------
2005 2004 $ % 2005 2004 $ %
Change Change Change Change
- --------------------------------------------------------------------------- ------------------------------------------------
Restated Restated
Gross Margin 2,620,874 2,580,584 40,290 1.6% 4,889,172 5,520,932 (631,760) -11.4%
---------------------------------------------- ------------------------------------------------
Selling 1,557,547 1,572,470 (14,923) -0.9% 2,493,792 3,032,870 (539,078) -17.8%
Delivery 726,078 615,257 110,821 18.0% 1,341,549 1,208,583 132,966 11.0%
Employment contract
expense(2) - 444,883 (444,883) -100.0% - 444,883 (444,883) -100.0%
General and administrative,
including $3,319,
($121,172), $870,837 and
$41,202 in non-cash stock
compensation (1) 921,934 444,796 477,138 107.3% 2,523,464 1,240,512 1,282,952 103.4%
Research and development 89,052 78,932 10,120 12.8% 180,094 151,618 28,476 18.8%
Cost of disposal activities 499,556 - 499,556 100.0% 754,567 - 754,567 100.0%
Impairment of fixed assets - - - 0.0% 7,896,554 - 7,896,554 100.0%
(Gain)Loss on disposal of
assets 6,242 - 6,242 100.0% 5,606 - 5,606 100.0%
---------------------------------------------- ------------------------------------------------
Total operating expenses 3,800,409 3,156,338 644,071 20.4% 15,195,626 6,078,466 9,117,160 150.0%
---------------------------------------------- ------------------------------------------------
Income (Loss) from
Operations(3) (1,179,535) (575,754) (603,781) 104.9% (10,306,454) (557,534) (9,748,920) 1748.6%
27
3-Months Ended September 30, 6-Months Ended September 30,
---------------------------------------------- ------------------------------------------------
2005 2004 $ % 2005 2004 $ %
Change Change Change Change
- --------------------------------------------------------------------------- ------------------------------------------------
Restated Restated
Other Income (Expense), Net
Interest expense (293,603) (264,008) (29,595) 11.2% (650,798) (523,824) (126,974) 24.2%
Derivative income - 442,606 (442,606) -100.0% - 321,487 (321,487) -100.0%
Gain/(loss) on FV of
warrants 57,000 620,247 (563,247) -90.8% 397,000 461,351 (64,351) -13.9%
---------------------------------------------- ------------------------------------------------
Total (236,603) 798,845 (1,035,448) -129.6% (253,798) 259,014 (512,812) -198.0%
---------------------------------------------- ------------------------------------------------
NET INCOME (LOSS) (1,416,138) 223,091 (1,639,229) -734.8% (10,560,252) (298,520) (10,261,732) 3437.5%
Interest expense 293,603 264,008 29,595 11.2% 650,798 523,824 126,974 24.2%
Depreciation 536,749 546,045 (9,296) -1.7% 1,075,852 1,092,086 (16,234) -1.5%
---------------------------------------------- ------------------------------------------------
EBITDA, (a non-GAAP measure) (585,786) 1,033,144 (1,618,930) -156.7% (8,833,602) 1,317,390 (10,150,992) -770.5%
============================================== ================================================
(1) In our calculation of key financial measures, we exclude the
non-cash compensation related to stock-based transactions because we
believe that this item does not accurately reflect our current
on-going operations. Many times non-cash compensation is calculated
based on fluctuations in our stock price, which can skew the
financial results dramatically up and down. The price of our common
shares as traded on AMEX is outside our control and typically does
not reflect our current operations. Additionally, this item is
excluded by our lenders when calculating compliance with loan
covenants.
(2) In our calculation of key financial measures, we exclude the
employment contract expenses related to Angelo S. Morini and
Christopher J. New because we believe that these items do not
reflect expenses related to our current on-going operations.
Additionally, these items are excluded by our lenders when
calculating compliance with loan covenants.
(3) Operating Income (Loss) has declined due the increase in non-cash
stock compensation expense as discussed below under general and
administrative and the fixed asset impairment charges and disposal
costs related to the Asset Purchase Agreement and the Supply
Agreement with Schreiber as discussed under Recent Material
Developments.
Selling
Selling expenses in the second quarter of fiscal 2006 compared to the second
quarter of fiscal 2005 were nearly the same in dollars, but they were 2% higher
as a percentage of net sales. This is due to increased promotion, demonstration
and sampling costs in the second quarter of fiscal 2006. We anticipate that the
selling expenses will continue to increase as a percentage of net sales due to
large promotion and advertising campaigns that will be continue throughout
fiscal 2006. We sell our products through our internal sales force and an
independent broker network.
Selling expenses in the first six months of fiscal 2006 compared to the first
six months of fiscal 2005 were lower in dollars, but 1% lower as a percentage of
net sales due to lower promotion, demonstration and print advertising costs in
the first quarter of fiscal 2006.
Delivery
Delivery expense is primarily a function of sales. In the past, delivery expense
remained consistent at approximately 5% of net sales. However, this increased to
7% of net sales in the second quarter of fiscal 2006 due to higher fuel prices
and surcharges charged by the transportation companies and due to higher
overhead allocation charges as discussed under Cost Of Goods Sold.
After the anticipated transfer of all production and distribution
responsibilities to Schreiber by the end of the third quarter of fiscal 2006, we
expect our delivery expenses to decrease significantly as a result of an agreed
upon delivery price per pound of product with Schreiber that is lower than our
current delivery cost per pound of product.
General and administrative
General and administrative expenses increased in the first six months of fiscal
2006 due to approximately $830,000 in additional non-cash compensation related
to stock-based transactions, as detailed below, approximately $261,000 of
additional bad debt costs related to the Del Sunshine account as discussed under
Recent Material Developments, $71,875 in liquidated damages accrued in related
to a registration rights agreement as discussed below under Equity Financing,
$65,000 additional insurance costs due to higher coverages and increased
premiums effective in April 2005, and $135,000 in additional professional fees
for legal and audit services due to additional contracts and SEC filings during
the first six months of fiscal 2006.
28
In May 2003, we entered into a Master Distribution and Licensing Agreement (the
Prior Agreement) with Fromageries Bel S.A. ("Bel"), a French corporation that is
a leading branded cheese company in Europe. Under the agreement, we granted Bel
exclusive distribution rights for our products in a territory comprised of the
European Union States and to more than 21 other European countries and
territories (the "Territory"). We also granted Bel the exclusive option during
the term of the agreement to elect to manufacture the products designated by Bel
for distribution in the Territory. Pursuant to a Termination, Settlement and
Release Agreement signed on July 22, 2005 and effective February 15, 2005 (the
"Termination Agreement"), the parties mutually agreed to cancel the Prior
Agreement and to terminate the distribution relationship. In consideration for
our time, effort and expenses incurred during the distribution relationship, Bel
paid $150,000 to our Company. This payment was recorded as a reduction of
general and administrative expenses in the second quarter of fiscal 2006.
Excluding the effects of non-cash compensation related to stock-based
transactions, which cannot be predicted, we anticipate that general and
administrative expenses will be higher than prior year levels for the first
three quarters of fiscal 2006 due to the higher insurance costs and increased
audit services required. However, we expect that general and administrative
expenses in the fourth quarter of fiscal 2006 will be significantly reduced due
to the non-recurrence of the $1.6 million in bad debt expense that occurred in
the fourth quarter of fiscal 2005.
The change in non-cash compensation related to stock-based transactions that are
included in general and administrative expenses are detailed as follows:
3-Months Ended September 30, 2005 6-Months Ended September 30, 2005
----------------------------------------------- -----------------------------------------------
2005 2004 $ % Change 2005 2004 $ % Change
Change Change
- ----------------------------------------------------------------------------- -----------------------------------------------
Stock-based award
compensation - initial
issuance 26,434 36,994 (10,560) -28.5% 1,063,393 41,202 1,022,191 2480.9%
Option modifications under
APB 25 awards (23,115) (158,166) 135,051 -85.4% (192,556) - (192,556) -100.0%
----------------------------------------------- -----------------------------------------------
Non-cash compensation related
to stock based transactions 3,319 (121,172) 124,491 -102.7% 870,837 41,202 829,635 2013.6%
=============================================== ===============================================
Effective April 1, 2003, we elected to record compensation expense measured at
fair value for all stock-based award transactions (including, but not limited
to, restricted stock awards, stock option grants, and warrant issuances) on or
after April 1, 2003 under the provisions of SFAS No. 123. Prior to April 1,
2003, we only recorded the fair value of stock-based awards granted to
non-employees or non-directors under the provisions of SFAS No. 123. The fair
value of the stock-based award is determined on the date of grant using the
Black-Scholes pricing model and is expensed over the vesting period of the
related award. Prior to April 1, 2003, we accounted for our stock-based employee
and director compensation plans under the accounting provisions of APB No. 25 as
interpreted by FASB Interpretation No. 44 ("FIN 44"). Any modifications of fixed
stock options or awards granted to employees or directors originally accounted
for under APB No. 25 may result in additional compensation expense under the
provisions of FIN 44. FIN 44 covers specific events that occurred after December
15, 1998 and was effective as of July 1, 2000.
In accordance with the above accounting standards, we calculate and record
non-cash compensation related to our securities in the general and
administrative line item in our Statements of Operations based on two primary
items:
a. Stock-Based Award Issuances
During the three months ended September 30, 2005 and 2004, we recorded
$26,434 and $36,994, respectively, in non-cash compensation expense
related to stock-based transactions that were issued to and vested by
employees, officers, directors and consultants. During the six months
ended September 30, 2005 and 2004, we recorded $1,063,393 and $41,202,
respectively, in non-cash compensation expense related to stock-based
transactions that were issued to and vested by employees, officers,
directors and consultants.
b. Option Modifications for Awards granted to Employees or Directors
under APB No. 25
On October 11, 2002, we repriced all outstanding options granted to
employees prior to October 11, 2002 (4,284,108 shares at former prices
ranging from $2.84 to $10.28) to the market price of $2.05 per share.
Prior to the repricing modification, the options were accounted for as a
fixed award under APB No. 25. In accordance with FIN 44, the repricing of
the employee stock options requires additional compensation expense to be
recognized and adjusted in subsequent periods for changes in the price of
our common stock that are in excess of the $2.05 stock price on the date
of modification (additional intrinsic value). If there is a decrease in
the market price of our common stock compared to the prior reporting
period, the reduction is recorded as compensation income to reverse all or
a portion of the expense recognized in prior periods. Compensation income
is limited to the original base exercise price (the intrinsic value) of
the options. This variable accounting treatment for these modified stock
options began with the quarter ended December 31, 2002 and such variable
accounting treatment will continue until the related options have been
cancelled, expired or exercised. There are 3,499,841 outstanding modified
stock options remaining as of September 30, 2005. We recorded non-cash
compensation expense/(income) of ($23,115) and ($158,166) for the three
months ended September 30, 2005 and 2004, respectively, related to the
modified options described above. We recorded non-cash compensation
expense/(income) of ($192,556) and zero for the six months ended September
30, 2005 and 2004, respectively, related to the modified options described
above.
29
Research and development
Research and development expense increased in the first six months of fiscal
2006 primarily due to the addition of one employee to the department during the
first quarter of fiscal 2006. The remaining increase was due to higher overhead
allocation charges during fiscal 2006 as discussed under Cost Of Goods Sold.
We anticipate that there may be a significant increase in research and
development expenses in fiscal 2006 due to an increase in the number of
personnel in the department and renewed focus on developing new products for the
market.
Cost of disposal activities
We are accounting for the costs associated with the Schreiber transactions in
accordance with SFAS No. 146, "Accounting for Costs Associated with an Exit or
Disposal Activity," because the arrangements are planned and controlled by
management and materially change the manner in which our business will be
conducted. In accordance with SFAS No. 146, costs associated with disposal
activities should be reported as a reduction of income from operations. For the
three and six months ended September 30, 2005, we incurred and reported $499,556
and $754,567 as Costs of Disposal Activities in the Statement of Operations.
These costs of disposal activities are comprised of employee termination costs
and legal and consulting fees. During the second quarter of fiscal 2006, we
accrued $359,774 in anticipated employee termination costs related to the
termination of nearly 115 employee positions during the transition. We
anticipate that in future periods, there will be additional disposal costs
related to legal and consulting fees in addition to possible lease abandonment
charges, which have not yet been incurred and therefore have not been accrued.
We may be required to adjust our accrual and estimated expense related to
employee termination costs if the actual timing of the terminations changes from
original estimates.
Impairment of property and equipment
In light of the Schreiber transactions discussed above under Recent Material
Developments, we determined that it is more likely than not that a majority of
our fixed assets related to production activities will be sold or disposed prior
to the end of their useful life. These assets represent approximately 98% of the
value of property and equipment. In accordance with SFAS No. 144, "Accounting
for the Impairment of Disposal of Long-Term Assets," we wrote down the value of
our assets to their estimated fair values in June 2005. We will continue to hold
and use the assets until they are sold. Therefore, all assets will continue to
be reported and depreciated under Property and Equipment in the Balance Sheet
until they are sold. We estimated the fair value based on the sales price in the
Asset Purchase Agreement and the anticipated sales price related to any other
assets plus future cash flows related to the assets from July 1, 2005 until the
sale. Based on this estimate, we recorded an impairment of property and
equipment of $7,896,554 in June 2005.
Other income and expense
Interest expense increased approximately $30,000 and $127,000 in the three and
six months ended September 30, 2005, respectively, due to higher prime rates (on
average 2.5% higher) and 3% higher rates charged by Textron Financial
Corporation during May and June as further described below. We are incurring
increased interest expense, and anticipate further increases during the first
three quarters of fiscal 2006 compared to the first three quarters of fiscal
2005 due to increases in the floating interest rates used by our lenders which
are based on prevailing market interest rates. However, assuming the
consummation of the Asset Purchase Agreement as discussed under Recent Material
Developments, we expect that our debt to Beltway will be paid in full and there
will be a significant reduction in interest expense due to lower debt balances
in the fourth quarter of fiscal 2006 as compared to the fourth quarter of fiscal
2005.
Derivative income/expense represents the adjustment for the change in the fair
value of the embedded derivative in our Series A convertible preferred stock,
which met the criteria for bifurcation and separate accounting under SFAS No.
133. The fair value of the embedded derivative was computed based on several
factors including the underlying value of our common stock at the end of each
quarter. This income was $442,606 and $321,487 in the three and six months ended
September 30, 2005, respectively, but there was no income or expense in these
comparative periods in fiscal 2006 because the Series A convertible preferred
stock was partially converted and the remaining shares redeemed in the third
quarter of fiscal 2005.
30
Since the conversion of our Series A convertible preferred stock could have
resulted in a conversion into an indeterminable number of common shares, we
determined that under the guidance in paragraph 24 of EITF 00-19, "Accounting
for Derivative Financial Instruments Indexed To, and Potentially Settled in the
Company's Own Stock," we were prohibited from concluding that we had sufficient
authorized and unissued shares to net-share settle any warrants or options
issued to non-employees. Therefore, we reclassified to a liability the fair
value of all warrants and options issued to non-employees that were outstanding
during the period that the Series A convertible preferred stock was outstanding
from April 2001 to October 2004. Additionally, in accordance with EITF 00-19, if
a contract requires settlement in registered shares, then it may be required to
record the value of the securities as a liability and/or temporary equity. Any
changes in the fair value of the securities based on the Black-Scholes pricing
model after the initial valuation are marked to market during reporting periods.
Additionally, pursuant to a Note and Warrant Purchase Agreement dated September
12, 2005, as further described under Debt Financing, we issued a warrant to
purchase up to 300,000 shares of our common stock at an exercise price equal to
$1.53 (95% of the lowest closing price of our common stock in the sixty calendar
days immediately preceding October 17, 2005). In accordance with the accounting
provisions of SFAS No. 123, we recorded the $234,000 initial fair value of the
warrant as a discount to debt on September 12, 2005. This discount is being
amortized from September 2005 through June 2006. We amortized $13,000 in the
second quarter of fiscal 2006. Since the exercise price for the warrant was not
fixed until October 17, 2005, we revalued the warrant obligation on September
30, 2005 and calculated a fair value of $177,000. The $57,000 difference between
the initial value of the warrant and the value of the warrant on September 30,
2005 was recorded as a gain on fair value of warrants in the Statement of
Operations.
During the second quarter of fiscal 2006 and 2005, we recorded a gain of $57,000
and $620,247 related to the change in the fair values of the warrants. During
the first six months if fiscal 2006 and 2005, we recorded a gain of $340,000 and
a 461,351, respectively, related to the change in the fair values of the
warrants.
Liquidity And Capital Resources
6-Months Ended
-------------------------------------------------
September 30, 2005 2004 $ % Change
Change
- ---------------------------------------------------------------------------------------
Cash from (used in) operating
activities (1,565,532) (624,208) (941,324) 150.8%
Cash from (used in) investing
activities (61,825) (54,725) (7,100) 13.0%
Cash from (used in) financing
activities 1,065,575 652,734 412,841 63.2%
-------------------------------------------------
Net increase (decrease) in cash (561,782) (26,199) (535,583) 2044.3%
=================================================
Operating and Investing Activities
Cash from operating activities declined in the first half of fiscal 2006 due to
higher operating expenses and reductions in inventory levels related selling
activities and the outsourcing transition costs described under Recent Material
Developments. Additionally, accounts receivable is increasing back to its levels
similar to those as of September 2004. The accounts receivable balance as of
March 31, 2005 was lower than average for the sales volume due to a large
reserve of nearly $1.6 million that was recorded as of March 31, 2005 (See Del
Sunshine LLC under Recent Material Developments for further details). We are
continually reviewing our collection practices, payment terms to vendors and
inventory levels in order to maximize cash flow from operations.
Cash used in investing activities primarily relates to our purchase of office
and manufacturing equipment in each fiscal period. We do not anticipate any
large capital expenditures during fiscal 2006, but rather expect to receive
substantial cash provided by investing activities from the consummation of the
Proposed Asset Sale to Schreiber in the third quarter of fiscal 2006.
As part of the outsourcing transition, we expect to see a decrease in cash from
operations due to the additional disposal costs. However, upon complete
implementation in the fourth quarter of fiscal 2006, we expect to improve cash
flows from operations due to the elimination of excess overhead costs and
inventory costs. We will need additional cash to build up finished good
inventory levels to maintain standard orders to customers and to pay one-time
costs associated with the transition such as severance arrangements, and
contract and lease cancellation fees. Based on current projections, we expect
that much of the additional cash requirements will be returned in the sale of
our usable raw materials and packaging inventory and production equipment to
Schreiber in the third quarter of fiscal 2006.
31
Financing Activities
6-Months Ended
-------------------------------------------------
September 30, 2005 2004 $ % Change
Change
- ---------------------------------------------------------------------------------------
Net borrowings (payments) on line of
credit and bank overdrafts (1,052,424) 1,276,485 (2,328,909) -182.4%
Net borrowings (payments) of debt and
capital leases & associated costs 374,578 (613,731) 988,309 -161.0%
Issuances of stock & associated
costs 1,743,421 (10,020) 1,753,441 -17499.4%
-------------------------------------------------
Cash from (used in) financing
activities 1,065,575 652,734 412,841 63.2%
=================================================
Debt Financing
On May 27, 2003, we obtained from Textron Financial Corporation ("Textron") a
revolving credit facility (the "Textron Loan") with a maximum principal amount
of $7,500,000 pursuant to the terms and conditions of a Loan and Security
Agreement dated May 27, 2003 (the "Textron Loan Agreement"). The Textron Loan is
secured by our inventory, accounts receivable and all other assets. Generally,
subject to the maximum principal amount, which can be borrowed under the Textron
Loan and certain reserves that must be maintained during the term of the Textron
Loan, the amount available under the Textron Loan for borrowing by our Company
from time to time is equal to the sum of (i) 85% of the net amount of its
eligible accounts receivable plus (ii) 60% of our eligible inventory not to
exceed $3,500,000. Advances under the Textron Loan bear interest at a variable
rate, adjusted on the first (1st) day of each month, equal to the prime rate
plus 1.75% per annum (8.5% at September 30, 2005) calculated on the average cash
borrowings for the preceding month. The initial term of the Textron Loan ends on
May 26, 2006. As of September 30, 2005, the outstanding principal balance on the
Textron Loan was $4,275,221.
The Textron Loan Agreement contains certain financial and operating covenants.
On June 3, 2005, we executed a fourth amendment to the Textron Loan that
provided a waiver on all the existing defaults for the fiscal quarters ended
December 31, 2004 and March 31, 2005, and amended the fixed charge coverage
ratio and the adjusted tangible net worth requirements for periods after March
31, 2005. Additionally, the fourth amendment allowed the Textron Loan to be in
an over-advance position not to exceed $750,000 until July 31, 2005. In exchange
for the waiver and amendments, our interest rate on the Textron Loan was set at
Prime plus 4.75% and we paid a fee of $50,000 in four weekly installments of
$12,500.
On June 16, 2005, we used a portion of the proceeds from the warrant exercises
described below under Equity Financing to satisfy the $750,000 over-advance with
Textron. In connection with the satisfaction of the over-advance, we agreed to
immediately terminate Textron's obligation to permit any over-advances under the
Textron Loan, which obligation was to expire on July 31, 2005. With the
termination of the over-advance facility, the interest rate on the Textron Loan
returned to its prior level of Prime plus 1.75%.
Due to the Cost of Disposal Activities and Impairment of Property and Equipment,
we fell below the requirements for the fixed charge coverage ratio and the
adjusted tangible net worth requirements in the fixed charge coverage ratio and
the adjusted tangible net worth calculation from June 30, 2005 through September
30, 2005. Effective October 1, 2005, we executed a fifth amendment to the
Textron Loan Agreement that provided a waiver for the defaults in the fixed
charge coverage ratio and the adjusted tangible net worth requirements, in
addition to certain over-advances on the Textron Loan, during the periods from
June 2005 through September 2005. The fifth amendment amends and replaces
several financial covenants, allows eligibility for borrowing on inventory until
December 31, 2005 and provides that the Textron Loan will expire at the end of
the initial term on May 26, 2006. Additionally, Textron consented to the sale of
our manufacturing equipment to Schreiber and the termination of their liens on
the assets being sold. In exchange for the waiver and amendments, we paid a fee
of $50,000, and has agreed to pay an administration fee in the following
installments if the Textron Loan has not then been paid in full: 5,000 on
February 1, 2006, $10,000 on March 1, 2006, $15,000 on April 1, 2006 and $20,000
May 1, 2006. We anticipate that we will be in compliance with the amended
covenants and reporting requirements through the end of the term of the Textron
Loan on May 26, 2006.
Simultaneous with the closing of the Textron Loan in May 2003, Wachovia Bank,
N.A. successor by merger to SouthTrust Bank ("Wachovia") extended our Company a
new term loan in the principal amount of $2,000,000. This term loan was
consolidated with our March 2000 term loan with Wachovia, which had a then
outstanding principal balance of $8,131,985 for a total term loan amount of
$10,131,985. This term loan is secured by all of our equipment and certain
related assets. Additionally, the term loan bears interest at Wachovia's Base
Rate plus 1% (7.75% at September 30, 2005).
32
On June 30, 2005, we entered into a Loan Modification Agreement with Wachovia
regarding its term loan. The agreement modified the following terms of the loan:
1) the loan will mature and be payable in full on July 31, 2006 instead of June
1, 2009; 2) the principal payments will remain at $110,000 per month with
accrued interest at Wachovia's Base Rate plus 1% instead of increasing to
$166,250 on July 1, 2005 as provided by the terms of the promissory note
evidencing the loan; and 3) all covenants related to our tangible net worth,
total liabilities to tangible net worth, and maximum funded debt to EBITDA
ratios are waived and compliance is not required by us through the maturity of
the loan on July 31, 2006. In connection with the agreement, we agreed to pay
$60,000, of which $30,000 was paid upon execution of the agreement and $30,000
was paid on August 1, 2005. As required by the terms of the agreement, if we
sell our equipment securing the loan as discussed under the Schreiber
Transactions in Recent Material Developments above, the loan will be due and
payable in full at the time of sale. Therefore, the proceeds from the sale of
our manufacturing equipment to Schreiber will be used to pay the loan in full.
In September 2005, Wachovia assigned this term loan to Beltway Capital Partners
LLC. The balance outstanding on the term loan as of September 30, 2005 was
$7,691,985.
Pursuant to a Note and Warrant Purchase Agreement dated September 12, 2005, we
received $1,200,000 as a loan from Mr. Frederick A. DeLuca, a greater than 10%
shareholder, which loan was evidenced by an unsecured promissory note (the
"Note"). The Note requires monthly interest only payments at 3% above the bank
prime rate of interest per the Federal Reserve Bank and matures on June 15,
2006. In consideration for the Note and in accordance with an exemption from
registration provided by Section 4(2) of the Securities Act of 1933, as amended,
we issued to Mr. DeLuca a warrant to purchase up to 300,000 shares of our common
stock at an exercise price equal to $1.53 (95% of the lowest closing price of
our common stock in the sixty calendar days immediately preceding October 17,
2005). The warrant fully vested on October 17, 2005 and can be exercised on or
before the expiration date of October 17, 2008. Also in consideration for the
Note, we granted Mr. DeLuca "piggy back" registration rights with respect to the
shares underlying the warrant. In accordance with the accounting provisions of
SFAS No. 123, we recorded the $234,000 initial fair value of the warrant as a
discount to debt on September 12, 2005. This discount is being amortized from
September 2005 through June 2006.
Pursuant to several Note and Warrant Purchase Agreements dated September 28,
2005, in October 2005, we received a $600,000 loan from Conversion Capital
Master, Ltd., a $485,200 loan from SRB Greenway Capital (Q.P.), L.P., a $69,600
loan from SRB Greenway Capital, L.P., and a $45,200 loan from SRB Greenway
Offshore Operating Fund, L.P. These loans were evidenced by unsecured promissory
notes (the "Notes"). The Notes require monthly interest only payments at 3%
above the bank prime rate of interest per the Federal Reserve Bank and mature on
June 15, 2006. In consideration for the Notes and in accordance with an
exemption from registration provided by Section 4(2) of the Securities Act of
1933, as amended, we issued to Conversion Capital Master, Ltd., SRB Greenway
Capital (Q.P.), L.P., SRB Greenway Capital, L.P., and SRB Greenway Offshore
Operating Fund, L.P., warrants to purchase up to 150,000 shares, 121,300 shares,
17,400 shares, and 11,300 shares, respectively, of our common stock at an
exercise price equal to $1.53 (95% of the lowest closing price of our common
stock in the sixty calendar days immediately preceding October 17, 2005). The
warrants fully vested on October 17, 2005 and can be exercised on or before the
expiration date of October 17, 2008. Also in consideration for the Notes, we
granted Conversion Capital Master, Ltd., SRB Greenway Capital (Q.P.), L.P., SRB
Greenway Capital, L.P., and SRB Greenway Offshore Operating Fund, L.P. "piggy
back" registration rights with respect to the shares underlying the warrants. In
accordance with the accounting provisions of SFAS No. 123, we recorded the
$210,731 initial fair value of the warrant as a discount to debt in October
2005. This discount will be amortized from October 2005 to June 2006.
Equity Financing
In accordance with a warrant agreement dated April 10, 2003, we issued to Mr.
Frederick DeLuca, a greater than 10% shareholder, a warrant to purchase up to
100,000 shares of our common stock at an exercise price of $1.70 per share.
Additionally, in accordance with a warrant agreement dated October 6, 2004, we
issued to Mr. DeLuca a warrant to purchase up to 500,000 shares of our common
stock at an exercise price of $1.15 per share. Subsequently in June 2005, we
agreed to reduce the per-share exercise price on these warrants to $1.36 and
$0.92, respectively, in order to induce Mr. DeLuca to exercise his warrants. All
of the warrants were exercised on June 16, 2005 for total proceeds of $596,000.
33
On each of April 24, 2003 and October 6, 2004, BH Capital Investments, LP and
Excalibur Limited Partnership each received warrants to purchase up to 250,000
shares of our common stock at an exercise price of $2.00 per share. Also,
Excalibur Limited Partnership received a warrant to purchase up to 30,000 shares
of our common stock at an exercise price of $2.05 per share on June 26, 2002.
Subsequently in June 2005, we agreed to reduce the per-share exercise price on
all such warrants to $1.10 in order to induce BH Capital Investments, LP and
Excalibur Limited Partnership to exercise their warrants. All of the warrants
were exercised on June 16, 2005 for total proceeds of $1,133,000.
In accordance with the accounting provisions of SFAS No. 123, we recorded
$1,024,500 in non-cash compensation expense related to the reduction in the
exercise price of the above-mentioned warrants in June 2005.
We used a portion of the proceeds from the warrant exercises to satisfy the
$750,000 over-advance provided by Textron under the Fourth Amendment and Waiver
to the Textron Loan Agreement, as described under Debt Financing and the
remaining proceeds from the warrant exercises were used for working capital
purposes.
In accordance with a registration rights agreement dated October 6, 2004 with
Mr. Frederick DeLuca, we agreed that within 180 days we would file with the
Securities and Exchange Commission ("SEC") and obtain effectiveness of a
registration statement that included 2,000,000 shares issued in a private
placement and 500,000 shares related to a stock purchase warrant. Per the terms
of the agreement, if a registration statement was not filed, or did not become
effective within 180 days, then in addition to any other rights Mr. DeLuca may
have, we would be required to pay certain liquidated damages. We filed a
registration statement on Form S-3 on March 14, 2005. However, this registration
statement has not yet been declared effective. Mr. DeLuca granted an extension
of time to have the registration statement declared effective by the SEC and
waived all damages and remedies for failure to have an effective registration
statement until September 1, 2005. As of September 1, 2005, we are accruing
liquidated damages of $71,875 (2.5% times the product of 2,500,000 registerable
shares and the share price of $1.15 per share) every thirty days until the
registration statement becomes effective. We are in the process of completing a
pre-effective amendment to the registration statement and will request
acceleration of the effectiveness of the registration statement as soon after
its filing as reasonably practicable.
Summary
As we continue with the Proposed Asset Sale and outsourcing transition, we
anticipate that we will see additional non-recurring expenses, gains/losses from
the sale of assets, and a general decrease in our line of credit with Textron
due to no inventory for lending purposes. However, we expect that we will reduce
interest bearing debt and property tax accruals by nearly $8,700,000 resulting
in annual interest savings in excess of $800,000.
We believe that with the above debt service savings and anticipated reductions
in our costs of goods sold beginning in January 2006, we will have enough cash
to meet our needs for general operations through September 30, 2006. However, it
is uncertain at this time if we will have enough cash from operations to repay
the Textron Loan that matures in May 2006 and the aggregate of $2,400,000 in
shareholder loans that mature in June 2006 as discussed under Debt Financing. If
we cannot generate enough cash from operations and the sale of our assets by
these maturity dates, and we are unable to refinance or renew these loans, or if
additional financing is not available on terms acceptable to us, we will be
unable to satisfy such facilities by their maturity dates. In such an event,
Textron and the shareholders could exercise their respective rights under their
loan documents, which could include, among other things, declaring defaults
under the loans and pursuing foreclosure on our assets that are pledged as
collateral for such loans. If such an event occurred, it would be substantially
more difficult for us to effectively continue the operation of our business, and
it is unlikely that we would be able to continue as a going concern.
34
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Our exposure to market risk results primarily from fluctuations in interest
rates. The interest rates on our outstanding debts to Wachovia and Textron are
floating and based on the prevailing market interest rates. For market-based
debt, interest rate changes generally do not affect the market value of the debt
but do impact future interest expense and hence earnings and cash flows,
assuming other factors remain unchanged. A theoretical 1% increase or decrease
in market rates in effect on September 30, 2005 with respect to our debt as of
such date would increase or decrease interest expense and hence reduce or
increase the net income of our Company by approximately $132,000 per year or
$33,000 per quarter.
Our sales during the quarters ended September 30, 2005 and 2004, which were
denominated in a currency other than U.S. Dollars, were less than 5% of gross
sales and no net assets were maintained in a functional currency other than U.
S. Dollars during such periods. However, further declines in the U.S. Dollar on
the international market, may cause our foreign suppliers of raw materials,
particularly casein, to increase their U.S. Dollar prices on future orders from
our Company. Therefore, while we believe that the effects of changes in foreign
currency exchange rates have not historically been significant to our operations
or net assets, we are unable to forecast the effects that foreign currency
exchange rates may have on our future operations.
Item 4. Controls and Procedures
As of September 30, 2005, an evaluation was performed under the supervision and
with the participation of our management, including the Chief Executive Officer
("CEO"), and the Chief Financial Officer ("CFO"), of the effectiveness of the
design and operation of our disclosure controls and procedures to insure that
the Company records, processes, summarizes and reports in a timely and effective
manner the information required to be disclosed in reports filed with or
submitted to the Securities and Exchange Commission. Based on that evaluation,
our management, including the CEO and CFO, concluded that our disclosure
controls and procedures were effective in timely bringing to their attention
material information related to our Company required to be included in our
periodic Securities and Exchange Commission filings, except for the control
noted below. Since the date of this evaluation, there have been no changes in
our internal controls or in other factors that are reasonably likely to
materially affect those controls, except as noted below.
The CEO and CFO considered the restatement of our financial statements in
October 2005 for the periods from March 31, 2001 through June 30, 2005 and
concluded that such restatements were the result of a material weakness relating
to the accounting and disclosure for complex and non-standard stockholders'
equity transactions. To address our Company's material weakness related to the
accounting and disclosure for complex and non-standard stockholders' equity
transactions, we have enhanced our internal control processes in order to be
able to comprehensively review the accounting and disclosure implications of
such transactions on a timely basis. As part of the enhancement, we have
subscribed to additional outside research materials and will consult with
additional outside consultants to confirm our understanding of complex
transactions, as necessary.
35
PART II. OTHER INFORMATION
Item 3. Defaults Upon Senior Securities
On May 27, 2003, we obtained from Textron Financial Corporation ("Textron") a
revolving credit facility (the "Textron Loan") with a maximum principal amount
of $7,500,000 pursuant to the terms and conditions of a Loan and Security
Agreement dated May 27, 2003 (the "Textron Loan Agreement"). The Textron Loan is
secured by our inventory, accounts receivable and all other assets. Generally,
subject to the maximum principal amount, which can be borrowed under the Textron
Loan and certain reserves that must be maintained during the term of the Textron
Loan, the amount available under the Textron Loan for borrowing by our Company
from time to time is equal to the sum of (i) 85% of the net amount of its
eligible accounts receivable plus (ii) 60% of our eligible inventory not to
exceed $3,500,000. Advances under the Textron Loan bear interest at a variable
rate, adjusted on the first (1st) day of each month, equal to the prime rate
plus 1.75% per annum (8.5% at September 30, 2005) calculated on the average cash
borrowings for the preceding month. The initial term of the Textron Loan ends on
May 26, 2006. As of September 30, 2005, the outstanding principal balance on the
Textron Loan was $4,275,221.
The Textron Loan Agreement contains certain financial and operating covenants.
On June 3, 2005, we executed a fourth amendment to the Textron Loan Agreement
that provided a waiver on all the existing defaults for the fiscal quarters
ended December 31, 2004 and March 31, 2005, and amended the fixed charge
coverage ratio and the adjusted tangible net worth requirements for periods
after March 31, 2005. Additionally, the fourth amendment allowed the Textron
Loan to be in an over-advance position not to exceed $750,000 until July 31,
2005. In exchange for the waiver and amendments, our interest rate on the
Textron Loan was set at Prime plus 4.75% and we paid a fee of $50,000 in four
weekly installments of $12,500.
On June 16, 2005, we used a portion of the proceeds from the warrant exercises
described in Note 5 to satisfy the $750,000 over-advance with Textron. In
connection with the satisfaction of the over-advance, we agreed to immediately
terminate Textron's obligation to permit any over-advances under the Textron
Loan, which obligation was to expire on July 31, 2005. With the termination of
the over-advance facility, the interest rate on the Textron Loan returned to its
prior level of Prime plus 1.75%.
Due to the cost of disposal activities and impairment of property and equipment,
we fell below the requirements in the fixed charge coverage ratio and the
adjusted tangible net worth calculation from June 30, 2005 through September 30,
2005. Effective October 1, 2005, we executed a fifth amendment to the Textron
Loan Agreement that provided a waiver for the defaults in the fixed charge
coverage ratio and the adjusted tangible net worth requirements, in addition to
certain over-advances on the Textron Loan, during the periods from June 2005
through September 2005. The fifth amendment amends and replaces several
financial covenants, allows eligibility for borrowing on inventory until
December 31, 2005 and provides that the Textron Loan will expire at the end of
the initial term on May 26, 2006. Additionally, Textron has consented to the
sale of our manufacturing equipment to Schreiber and the termination
of their liens on the assets being sold. In exchange for the waiver and
amendments, we paid a fee of $50,000, and has agreed to pay an administration
fee in the following installments if the Textron Loan has not then been paid in
full: 5,000 on February 1, 2006, $10,000 on March 1, 2006, $15,000 on April 1,
2006 and $20,000 May 1, 2006.
We anticipate that we will be in compliance with the amended covenants and
reporting requirements through the end of the term of the Textron Loan on May
26, 2006.
36
PART II. OTHER INFORMATION
Item 6. Exhibits
The following exhibits are filed as part of this Form 10-Q.
Exhibit No Exhibit Description
* 3.1 Restated Certificate of Incorporation of the Company as filed with the Secretary of
State of the State of Delaware on December 23, 2002 (Filed as Exhibit 3.2 on Form 10-Q for the fiscal
quarter ended December 31, 2002.)
* 3.2 By-laws of the Company, as amended (Filed as Exhibit 3.2 to Registration Statement on
Form S-18, No. 33-15893-NY.)
* 4.1 Stock Purchase Option Agreement and Stock Purchase Warrant by and between Excalibur
Limited Partnership and BH Capital Investments, L.P. and Galaxy Nutritional Foods dated as of April
24, 2003 (Filed as Exhibit 10.52 on Form 10-Q for the fiscal quarter ended June 30, 2003.)
* 4.2 Warrant to Purchase Securities of Galaxy Nutritional Foods, Inc. dated as of May 29,
2003 in favor of Wachovia Bank (Filed as Exhibit 10.7 on Form 8-K filed June 2, 2003.)
* 4.3 Securities Purchase Agreement dated as of May 21, 2003 between Galaxy Nutritional
Foods, Inc. and Fromageries Bel S.A. (Filed as Exhibit 10.8 on Form 8-K filed June 2, 2003.)
* 4.4 Registration Rights Agreement dated as of May 21, 2003 between Galaxy Nutritional
Foods, Inc. and Fromageries Bel S.A. (Filed as Exhibit 10.9 on Form 8-K filed June 2, 2003.)
* 4.5 Securities Purchase Agreement dated as of May 21, 2003 between Galaxy Nutritional
Foods, Inc. and Frederick A. DeLuca (Filed as Exhibit 10.10 on Form 8-K filed June 2, 2003.)
* 4.6 Registration Rights Agreement dated as of May 21, 2003 between Galaxy Nutritional
Foods, Inc. and Frederick A. DeLuca (Filed as Exhibit 10.11 on Form 8-K filed June 2, 2003.)
* 4.7 Securities Purchase Agreement dated as of May 21, 2003 between Galaxy Nutritional
Foods, Inc. and Apollo Capital Management Group, L.P. (Filed as Exhibit 10.12 on Form 8-K filed June
2, 2003.)
* 4.8 Registration Rights Agreement dated as of May 21, 2003 between Galaxy Nutritional
Foods, Inc. and Apollo Capital Management Group, L.P. (Filed as Exhibit 10.13 on Form 8-K filed June
2, 2003.)
* 4.9 Securities Purchase Agreement dated as of May 21, 2003 between Galaxy Nutritional
Foods, Inc. and Apollo MicroCap Partners, L.P. (Filed as Exhibit 10.14 on Form 8-K filed June 2, 2003.)
* 4.10 Registration Rights Agreement dated as of May 21, 2003 between Galaxy Nutritional Foods, Inc.
and Apollo MicroCap Partners, L.P. (Filed as Exhibit 10.15 on Form 8-K filed June 2, 2003.)
* 4.11 Securities Purchase Agreement dated as of May 21, 2003 between Galaxy Nutritional Foods, Inc.
and Ruggieri of Windermere Family Limited Partnership (Filed as Exhibit 10.16 on Form 8-K filed June
2, 2003.)
* 4.12 Registration Rights Agreement dated as of May 21, 2003 between Galaxy Nutritional Foods, Inc.
and Ruggieri of Windermere Family Limited Partnership (Filed as Exhibit 10.17 on Form 8-K filed June
2, 2003.)
* 4.13 Securities Purchase Agreement dated as of May 21, 2003 between Galaxy Nutritional Foods, Inc.
and Ruggieri Financial Pension Plan (Filed as Exhibit 10.18 on Form 8-K filed June 2, 2003.)
37
Exhibit No Exhibit Description
* 4.14 Registration Rights Agreement dated as of May 21, 2003 between Galaxy Nutritional Foods, Inc.
and Ruggieri Financial Pension Plan (Filed as Exhibit 10.19 on Form 8-K filed June 2, 2003.)
* 4.15 Securities Purchase Agreement dated as of May 21, 2003 between Galaxy Nutritional Foods, Inc.
and David Lipka (Filed as Exhibit 10.20 on Form 8-K filed June 2, 2003.)
* 4.16 Registration Rights Agreement dated as of May 21, 2003 between Galaxy Nutritional Foods, Inc.
and David Lipka (Filed as Exhibit 10.21 on Form 8-K filed June 2, 2003.)
* 4.17 Stockholder Agreement dated as of October 13, 2003 between Galaxy Nutritional Foods, Inc. and
Angelo S. Morini (Filed as Exhibit 10.55 on Form 10-Q for the fiscal quarter ended September 30,
2003.)
* 4.18 Securities Purchase Agreement dated as of October 6, 2004 between Galaxy Nutritional Foods,
Inc. and Frederick A. DeLuca (Filed as Exhibit 4.18 on Form 8-K filed October 8, 2004.)
* 4.19 Registration Rights Agreement dated as of October 6, 2004 between Galaxy Nutritional Foods,
Inc. and Frederick A. DeLuca (Filed as Exhibit 4.19 on Form 8-K filed October 8, 2004.)
* 4.20 Warrant to Purchase Securities of Galaxy Nutritional Foods, Inc. dated as of October 6, 2004
in favor of Frederick A. DeLuca (Filed as Exhibit 4.20 on Form 8-K filed October 8, 2004.)
* 4.21 Stock Repurchase Agreement dated as of October 6, 2004 by and among Galaxy Nutritional Foods,
Inc., BH Capital Investments L.P. and Excalibur Limited Partnership (Filed as Exhibit 4.21 on Form 8-K
filed October 8, 2004.)
* 4.22 Registration Rights Agreement dated as of October 6, 2004 by and among Galaxy Nutritional
Foods, Inc., BH Capital Investments L.P. and Excalibur Limited Partnership (Filed as Exhibit 4.22 on
Form 8-K filed October 8, 2004.)
* 4.23 Warrant to Purchase Securities of Galaxy Nutritional Foods, Inc. dated as of October 6, 2004
in favor of BH Capital Investments L.P. (Filed as Exhibit 4.23 on Form 8-K filed October 8, 2004.)
* 4.24 Warrant to Purchase Securities of Galaxy Nutritional Foods, Inc. dated as of October 6, 2004
in favor of Excalibur Limited Partnership (Filed as Exhibit 4.24 on Form 8-K filed October 8, 2004.)
* 4.25 Investor relations contract between Galaxy Nutritional Foods, Inc. and R.J. Falkner dated as of
September 29, 2004 (Filed as Exhibit 4.25 on Form S-3 filed March 14, 2005.)
* 4.26 Asset Purchase Agreement dated June 30, 2005 between Galaxy Nutritional Foods, Inc. and Schreiber
Foods, Inc. (Filed as Exhibit 4.25 on Form 8-K filed July 6, 2005.)
* 10.1 Master Distribution and License Agreement dated as of May 22, 2003 between Galaxy
Nutritional Foods, Inc. and Fromageries Bel S.A. (Filed as Exhibit 10.22 on Form 8-K filed June 2,
2003.)
* 10.2 Loan and Security Agreement dated as of May 27, 2003 between Galaxy Nutritional
Foods, Inc. and Textron Financial Corporation (Filed as Exhibit 10.1 on Form 8-K filed June 2, 2003.)
* 10.3 Patent, Copyright and Trademark Collateral Security Agreement dated as of May 27,
2003 between Galaxy Nutritional Foods, Inc. and Textron Financial Corporation (Filed as Exhibit 10.2
on Form 8-K filed June 2, 2003.)
* 10.4 Renewal Promissory Note in the principal amount of $10.131,984.85 dated as of May 28,
2003 by Galaxy Nutritional Foods, Inc. in favor of Wachovia Bank (Filed as Exhibit 10.3 on Form 8-K
filed June 2, 2003.)
* 10.5 Renewal Promissory Note in the principal amount of $501,000.00 dated as of May 28,
2003 by Galaxy Nutritional Foods, Inc. in favor of Wachovia Bank (Filed as Exhibit 10.4 on Form 8-K
filed June 2, 2003.)
38
Exhibit No Exhibit Description
* 10.6 Amendment of Loan Agreement dated as of May 28, 2003 between Galaxy Nutritional
Foods, Inc. and Wachovia Bank (Filed as Exhibit 10.5 on Form 8-K filed June 2, 2003.)
* 10.7 Amendment of Security Agreement dated as of May 28, 2003 between Galaxy Nutritional
Foods, Inc. and Wachovia Bank (Filed as Exhibit 10.6 on Form 8-K filed June 2, 2003.)
* 10.8 Waiver Letter from Textron Financial Corporation to the Company dated August 13, 2003
(Filed as Exhibit 10.53 on Form 10-Q for the fiscal quarter ended June 30, 2003.)
* 10.9 Second Amended and Restated Employment Agreement dated as of October 13, 2003 between
Galaxy Nutritional Foods, Inc. and Angelo S. Morini (Filed as Exhibit 10.1 on Form 8-K filed October
20, 2003.)
* 10.10 Settlement Agreement dated May 6, 2004 between Galaxy Nutritional Foods, Inc. and Schreiber
Foods, Inc. (Filed as Exhibit 10.1 on Form 8-K filed May 11, 2004.)
* 10.11 Modification Letter on the Security Agreement dated as of May 21, 2004 between Galaxy
Nutritional Foods, Inc. and Wachovia Bank (Filed as Exhibit 10.11 on Form 10-K for the fiscal year
ended March 31, 2004.)
* 10.12 Second Amendment to Loan and Security Agreement dated June 25, 2004 between Galaxy
Nutritional Foods, Inc. and Textron Financial Corporation (Filed as Exhibit 10.12 on Form 10-K for
the fiscal year ended March 31, 2004.)
* 10.13 Third Amendment to Lease Agreement dated June 10, 2004 between Galaxy Nutritional Foods, Inc.
and Cabot Industrial Properties, L.P. (Filed as Exhibit 10.13 on Form 10-K for the fiscal year ended
March 31, 2004.)
* 10.14 Separation and Settlement Agreement dated July 8, 2004 between Galaxy Nutritional Foods, Inc.
and Christopher J. New (Filed as Exhibit 10.14 on Form 8-K filed July 13, 2004.)
* 10.15 Employment Agreement dated July 8, 2004 between Galaxy Nutritional Foods, Inc. and Michael E.
Broll (Filed as Exhibit 10.15 on Form 8-K filed July 13, 2004.)
* 10.16 Third Amendment to Loan and Security Agreement dated November 10, 2004 between Galaxy
Nutritional Foods, Inc. and Textron Financial Corporation (Filed as Exhibit 10.16 on Form 10-Q for
the fiscal quarter ended December 31, 2004.)
* 10.17 Fourth Amendment to Loan and Security Agreement dated June 3, 2005 between Galaxy Nutritional
Foods, Inc. and Textron Financial Corporation (Filed as Exhibit 10.17 on Form 8-K filed June 22,
2005.)
* 10.18 Letter Agreement dated June 17, 2005 between Galaxy Nutritional Foods, Inc. and Textron
Financial Corporation (Filed as Exhibit 10.18 on Form 8-K filed June 22, 2005.)
* 10.19 Supply Agreement dated June 30, 2005 between Galaxy Nutritional Foods, Inc. and Schreiber Foods, Inc.
(Filed as Exhibit 10.19 on Form 8-K filed July 6, 2005.)
* 10.20 Loan Modification Agreement June 30, 2005 between Galaxy Nutritional Foods, Inc. and Wachovia
Bank N.A (formerly SouthTrust Bank). (Filed as Exhibit 10.20 on Form 8-K filed July 6, 2005.)
* 10.21 Termination, Settlement and Release Agreement dated July 20, 2005 between Galaxy Nutritional Foods,
Inc. and Fromageries Bel S.A. (Filed as Exhibit 10.21 on Form 8-K filed July 26, 2005.)
* 10.22 Note and Warrant Purchase Agreement dated September 12, 2005 between Galaxy Nutritional
Foods, Inc. and Frederick A. DeLuca (Filed as Exhibit 10.22 on Form 8-K filed September 16, 2005.)
39
Exhibit No Exhibit Description
* 10.23 Note and Warrant Purchase Agreement dated September 28, 2005 between Galaxy Nutritional
Foods, Inc. and Conversion Capital Master, Ltd. (Filed as Exhibit 10.23 on Form 8-K filed October 4,
2005.)
* 10.24 Note and Warrant Purchase Agreement dated September 28, 2005 between Galaxy Nutritional
Foods, Inc. and SRB Greenway Capital, L.P. (Filed as Exhibit 10.24 on Form 8-K filed October 4, 2005.)
* 10.25 Note and Warrant Purchase Agreement dated September 28, 2005 between Galaxy Nutritional
Foods, Inc. and SRB Greenway Capital (Q.P.), L.P. (Filed as Exhibit 10.25 on Form 8-K filed October 4,
2005.)
* 10.26 Note and Warrant Purchase Agreement dated September 28, 2005 between Galaxy Nutritional
Foods, Inc. and SRB Greenway Offshore Operating Fund, L.P. (Filed as Exhibit 10.26 on Form 8-K filed
October 4, 2005.)
10.27 First Amendment to Note and Warrant Purchase Agreement dated October 7, 2005 between Galaxy
Nutritional Foods, Inc. and Frederick A. DeLuca (Filed herewith.)
10.28 Fifth Amendment to Loan and Security Agreement dated November 14, 2005 between Galaxy
Nutritional Foods, Inc. and Textron Financial Corporation (Filed herewith.)
* 14.1 Code of Ethics (Filed as Exhibit 14.1 on Form 10-K for the fiscal year ended March
31, 2005.)
* 20.1 Audit Committee Charter (Filed as Exhibit 20.1 on Form 10-Q for the fiscal quarter
ended September 30, 2003.)
* 20.2 Compensation Committee Charter (Filed as Exhibit 20.2 on Form 10-Q for the fiscal
quarter ended September 30, 2003.)
31.1 Section 302 Certification of our Chief Executive Officer (Filed herewith.)
31.2 Section 302 Certification of our Chief Financial Officer (Filed herewith.)
32.1 Section 906 Certification of our Chief Executive Officer (Filed herewith.)
32.2 Section 906 Certification of our Chief Financial Officer (Filed herewith.)
* Previously filed and incorporated herein by reference.
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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.
GALAXY NUTRITIONAL FOODS, INC.
Date: November 14, 2005 /s/ Michael E. Broll
-------------------------------------------
Michael E. Broll
Chief Executive Officer
(Principal Executive Officer)
Date: November 14, 2005 /s/ Salvatore J. Furnari
-------------------------------------------
Salvatore J. Furnari
Chief Financial Officer
(Principal Accounting and Financial Officer)
41