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, 2006
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.)
5955 T. G. Lee Blvd Suite201
Orlando, Florida 32822
(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 a large accelerated filer,
an accelerated filer, or a non-accelerated filer. See definition of "accelerated
filer and large accelerated filer" in Rule 12b-2 of the Exchange Act (Check
one):
Large accelerated filer |_| Accelerated filer |_| Non-accelerated filer |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 10, 2006, there were 17,109,910 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, 2006
PAGE NO.
--------
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Balance Sheets 3
Statements of Operations 4
Statement of Stockholders' Deficit 5
Statements of Cash Flows 6
Notes to Financial Statements 7
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations 18
Item 3. Quantitative and Qualitative Disclosures About Market
Risk 29
Item 4. Controls and Procedures 29
PART II. OTHER INFORMATION
Item 1A. Risk Factors 30
Item 4. Submission of Matters to a Vote of Security Holders 32
Item 6. Exhibits 33
SIGNATURES 37
2
PART I. FINANCIAL INFORMATION
GALAXY NUTRITIONAL FOODS, INC.
Balance Sheets
SEPTEMBER 30, MARCH 31,
Notes 2006 2006
----- ------------- ------------
(unaudited)
ASSETS
CURRENT ASSETS:
Cash $ 441,284 $ 435,880
Trade receivables, net 2,700,789 4,018,806
Inventories 283,170 273,528
Prepaid expenses and other 257,713 70,717
------------ ------------
Total current assets 3,682,956 4,798,931
PROPERTY AND EQUIPMENT, NET 129,738 226,349
ASSETS HELD FOR SALE 1,500 61,950
OTHER ASSETS 160,183 162,840
------------ ------------
TOTAL $ 3,974,377 $ 5,250,070
============ ============
LIABILITIES AND STOCKHOLDERS' DEFICIT
CURRENT LIABILITIES:
Secured borrowings 3 $ 1,399,182 $ 1,919,002
Accounts payable 1,717,112 2,665,963
Accrued disposal costs 4 114,219 480,404
Accrued and other current liabilities 248,358 542,811
Related party notes payable 3 -- 2,273,021
Current portion of accrued employment contracts 5 366,305 434,114
Current portion of obligations under capital leases -- 20,231
------------ ------------
Total current liabilities 3,845,176 8,335,546
ACCRUED EMPLOYMENT CONTRACTS, less current portion 5 378,622 559,677
RELATED PARTY NOTE PAYABLE, less debt discount 3 2,669,944 --
OBLIGATIONS UNDER CAPITAL LEASES, less current portion -- 37,507
------------ ------------
Total liabilities 6,893,742 8,932,730
------------ ------------
COMMITMENTS AND CONTINGENCIES 6 -- --
STOCKHOLDERS' DEFICIT:
Common stock 171,099 200,546
Additional paid-in capital 70,146,702 71,345,556
Accumulated deficit (73,237,166) (72,456,301)
------------ ------------
(2,919,365) (910,199)
Less: Notes receivable arising from the exercise of
stock options 5 -- (2,652,000)
Treasury stock 5 -- (120,461)
------------ ------------
Total stockholders' deficit (2,919,365) (3,682,660)
------------ ------------
TOTAL $ 3,974,377 $ 5,250,070
============ ============
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 2006 2005 2006 2005
----- ---------- ----------- ----------- ------------
NET SALES $6,727,777 $10,438,225 $14,560,339 $ 20,289,378
COST OF GOODS SOLD 3,957,750 7,817,351 9,032,962 15,400,206
---------- ----------- ----------- ------------
Gross margin 2,770,027 2,620,874 5,527,377 4,889,172
---------- ----------- ----------- ------------
OPERATING EXPENSES:
Selling 880,823 1,557,547 1,846,802 2,493,792
Delivery 179,741 726,078 426,283 1,341,549
General and administrative, including
$92,330, $3,319, $98,160 and
$870,837 non-cash compensation
related to stock based transactions 7 872,766 937,290 1,857,628 2,604,762
Research and development 44,449 89,052 86,783 180,094
Reserve on stockholder note receivable 5 -- -- 1,428,000 --
Cost of disposal activities 4 47,059 484,200 148,803 673,269
Impairment of equipment -- -- -- 7,896,554
Loss on sale of assets 37,329 6,242 24,505 5,606
---------- ----------- ----------- ------------
Total operating expenses 2,062,167 3,800,409 5,818,804 15,195,626
---------- ----------- ----------- ------------
INCOME (LOSS) FROM OPERATIONS 707,860 (1,179,535) (291,427) (10,306,454)
---------- ----------- ----------- ------------
OTHER INCOME (EXPENSE):
Interest expense (146,296) (293,603) (489,438) (650,798)
Gain on fair value of warrants -- 57,000 -- 397,000
---------- ----------- ----------- ------------
Total other income (expense) (146,296) (236,603) (489,438) (253,798)
---------- ----------- ----------- ------------
NET INCOME (LOSS) $ 561,564 $(1,416,138) $ (780,865) $(10,560,252)
========== =========== =========== ============
BASIC AND DILUTED NET INCOME (LOSS)
PER COMMON SHARE 8 $ 0.03 (0.07) $ (0.04) $ (0.55)
========== =========== =========== ============
See accompanying notes to financial statements.
4
GALAXY NUTRITIONAL FOODS, INC.
Statement of Stockholders' Deficit
Six Months Ended September 30, 2006
(UNAUDITED)
Common Stock
--------------------- Additional Notes
Par Paid-In Accumulated Receivable for Treasury
Shares Value Capital Deficit Common Stock Stock Total
---------- -------- ----------- ------------- -------------- ------------ -----------
Balance at March 31, 2006 20,054,623 $200,546 $71,345,556 $(72,456,301) $(2,652,000) $ (120,461) $(3,682,660)
Fair value of stock-based
transactions -- -- 116,160 -- -- -- 116,160
Reserve on stockholder
note receivable -- -- -- -- 1,428,000 -- 1,428,000
Value of returned shares
transferred to treasury stock -- -- -- -- 1,224,000 (1,224,000) --
Rounding shares 16 -- -- -- -- -- --
Cancellation of treasury stock (2,944,729) (29,447) (1,315,014) -- -- 1,344,461 --
Net loss -- -- -- (780,865) -- -- (780,865)
---------- -------- ----------- ------------ ----------- ----------- -----------
Balance at September 30, 2006 17,109,910 $171,099 $70,146,702 $(73,237,166) $ -- $ -- $(2,919,365)
========== ======== =========== ============ =========== =========== ===========
See accompanying notes to financial statements.
5
GALAXY NUTRITIONAL FOODS, INC.
Statements of Cash Flows
(UNAUDITED)
Six Months Ended September 30, Notes 2006 2005
----- ----------- ------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net Loss $ (780,865) $(10,560,252)
Adjustments to reconcile net loss to net cash from (used in)
operating activities:
Depreciation and amortization 106,097 1,075,853
Amortization of debt discount and financing costs 242,047 105,718
Provision for promotional deductions and losses on trade
receivables (619,150) 754,451
Provision for loss on stockholder note receivable 5 1,428,000 --
Loss on disposal and impairment of assets 24,505 7,902,160
Gain on fair value of warrants -- (397,000)
Non-cash compensation related to stock-based transactions 7 98,160 870,837
(Increase) decrease in:
Trade receivables 1,937,167 (2,136,345)
Inventories (9,642) 528,376
Prepaid expenses and other (186,996) (151,955)
Increase (decrease) in:
Accounts payable (948,851) 141,169
Accrued and other liabilities (624,398) 301,456
----------- ------------
NET CASH FROM (USED IN) OPERATING ACTIVITIES 666,074 (1,565,532)
----------- ------------
CASH FLOWS FROM INVESTING ACTIVITIES: 9
Purchase of property and equipment (9,638) (82,525)
Proceeds from sale of equipment 42,955 20,700
Decrease in other assets 34,440 --
----------- ------------
NET CASH FROM (USED IN) INVESTING ACTIVITIES 67,757 (61,825)
----------- ------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Increase in book overdrafts -- 130,834
Net borrowings (payments) on secured borrowings (519,820) (1,183,258)
Borrowings on term notes payable 1,200,000 1,200,000
Repayments on term notes payable (1,200,000) (550,000)
Principal payments on capital lease obligations (64,596) (96,329)
Financing costs for long term debt (144,011) (179,093)
Proceeds from issuance of common stock under employee stock
purchase plan -- 11,861
Proceeds from exercise of common stock options -- 2,560
Proceeds from exercise of common stock warrants, net of costs -- 1,729,000
----------- ------------
NET CASH FROM (USED IN) FINANCING ACTIVITIES (728,427) 1,065,575
----------- ------------
NET INCREASE (DECREASE) IN CASH 5,404 (561,782)
CASH, BEGINNING OF PERIOD 435,880 561,782
----------- ------------
CASH, END OF PERIOD $ 441,284 $ --
=========== ============
See accompanying notes to financial statements.
6
GALAXY NUTRITIONAL FOODS, INC.
Notes To Financial Statements
(UNAUDITED)
(1) Basis of Presentation
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, 2006 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 for the
fiscal year ended March 31, 2006. Interim results of operations for the
six-month period ended September 30, 2006 may not necessarily be
indicative of the results to be expected for the full year.
During fiscal 2006, the Company transitioned its manufacturing and
distribution operations to an outside supplier. In November 2005,
Schreiber Foods, Inc., a Wisconsin corporation ("Schreiber"), began
manufacturing and distributing substantially all of the Company's products
in accordance with a Supply Agreement that was signed on June 30, 2005.
The prices for such products are based on cost plus a processing fee as
determined by the parties from time to time. Additionally, in December
2005, the Company sold substantially all of its manufacturing and
production equipment to Schreiber for $8,700,000 in cash pursuant to an
Asset Purchase Agreement dated June 30, 2005.
The Company has incurred substantial losses in recent years and, as a
result, has a stockholders deficit of $2,919,365 as of September 30, 2006.
Losses for the years ended March 31, 2006, 2005 and 2004 were $24,148,553,
$3,859,783 and $3,299,277, respectively. Additionally, the Company
received a report from its independent accountants relating to its audited
financial statements as of March 31, 2006 containing a paragraph stating
that because it was then in default of its notes payable, had suffered
recurring losses from operations and at March 31, 2006 had deficiencies in
working capital and equity, there was substantive doubt as to its ability
to continue as a going concern. The Company's ability to continue as a
going concern depended upon successfully obtaining sufficient cash
resources to refinance its $2.4 million of unsecured related party notes
payable that matured on June 15, 2006 and obtaining positive cash flow
from operations to sustain normal business operations.
The Company's current business plan eliminated certain low margin private
label and Galaxy imitation business from its sales mix. The elimination of
these low margin items and the elimination of excess overhead that was
part of the Company's former manufacturing operations has resulted in
higher gross margins and produced positive cash flows from operations in
the six months ended September 30, 2006.
As a result of the successful refinancing of the $2.4 million short-term
notes and line of credit for the Company's receivables financing (See Note
3) and the positive cash flow that the Company is currently experiencing
from operations, management believes that the Company has sufficient cash
resources to meet its current liquidity needs. Therefore, the Company's
financial statements have been prepared in accordance with accounting
principles generally accepted in the United States of America assuming
that it will continue on a going concern basis. This assumes the
realization of assets and the satisfaction of liabilities in the normal
course of business.
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, valuation of deferred taxes, valuation of compensation expense on
options and warrants, and accruals for disposal costs. Actual results
could differ from those estimates.
7
Reclassifications
Certain items in the financial statements of the prior period have been
reclassified to conform to current period presentation.
(2) Summary of Significant Accounting Policies
Revenue Recognition
Sales are recognized upon shipment of products to customers. The Company
offers a right of return policy on certain products sold to certain retail
customers in the conventional grocery stores and mass merchandising
industry. If the product is not sold during its shelf life, the Company
will allow a credit for the unsold merchandise. Since the shelf life of
the Company's products range from 6 months to one year, the Company
historically averages less than 2% in credits for unsold product. The
Company's reserve on accounts receivable takes these potential future
credits into consideration. Certain expenses such as returns, slotting
fees, rebates, coupons and other discounts are accounted for as a
reduction to Revenues.
Disposal Costs
The Company has recorded accruals in connection with the asset sale and
outsourcing arrangements with Schreiber. These accruals include estimates
pertaining to employee termination costs and 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 No. 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, contract cancellation charges 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.
Stock Based Compensation
On September 29, 2006, the shareholders approved the 2006 Stock Incentive
Plan. This 2006 Plan has up to 1,000,000 shares available for stock awards
to employees and directors and expires on January 20, 2016.
Effective April 1, 2006, the Company adopted SFAS No. 123 (revised 2004),
"Share-Based Payment" ("SFAS No. 123R"). SFAS No. 123R requires companies
to measure the cost of employee services received in exchange for an award
of equity instruments, including stock options, based on the grant-date
fair value of the award and to recognize it as compensation expense over
the period the employee is required to provide service in exchange for the
award, usually the vesting period.
SFAS No. 123R applies to new awards and to awards modified, repurchased,
or cancelled after the effective date, as well as to the unvested portion
of awards outstanding as of the effective date. The Company uses the
Black-Scholes model to value its new stock option grants under SFAS No.
123R, applying the "modified prospective method" for existing grants which
requires the Company to value stock options prior to its adoption of SFAS
No. 123R under the fair value method and expense the unvested portion over
the remaining vesting period. SFAS No. 123R also requires the Company to
estimate forfeitures in calculating the expense related to stock-based
compensation. In addition, SFAS No. 123R requires the Company to reflect
cash flows resulting from the tax benefits related to tax deductions in
excess of the compensation cost recognized for those options to be
classified as a cash inflow from financing activities and a cash outflow
from operating activities.
Prior to April 1, 2006 and beginning April 1, 2003, the Company accounted
for stock awards granted to employees under the fair value recognition
provisions of SFAS No. 123, "Accounting for Stock-Based Compensation," and
applied SFAS No. 148, "Accounting for Stock-Based Compensation -
Transition and Disclosure," prospectively to all employee awards granted
on or after April 1, 2003. Prior to April 1, 2003, the Company accounted
for stock awards granted to employees under the recognition and
measurement principles of Accounting Principles Board Opinion No. 25,
"Accounting for Stock Issued to Employees, and related Interpretations."
As a result, no compensation expense was previously recognized for stock
options granted to employees prior to April 1, 2003 other than as related
to option grants to employees and directors below the fair market value of
the underlying stock at the date of grant or as related to subsequent
modifications to options granted to employees and directors.
8
The Black-Scholes model requires subjective assumptions, including future
stock price volatility and expected time to exercise, which greatly affect
the calculated values. The risk-free rate is based on the U.S Treasury
rates in effect during the corresponding period of grant. Expected
volatilities are based on the historical volatility of the Company's
stock. In the past, the Company input the expected life of options granted
as the contractual life of the options granted. For any new awards, the
Company will input the expected term of options granted based on
information derived from historical data on employee exercises and
post-vesting employment termination behavior. There is no expected
dividend yield. These factors could change in the future, which would
affect the stock-based compensation expense in future periods. SFAS No.
123R requires forfeitures to be estimated at the time of grant and
revised, if necessary, in subsequent periods if actual forfeitures differ
from those estimates.
The Company's financial statements for the six months ended September 30,
2006 reflect the impact of SFAS No. 123R. In accordance with the modified
prospective transition method, the Company's financial statements for
prior periods have not been restated to reflect, and do not include, the
impact of SFAS No. 123R.
Stock-based compensation expense recognized during the period is based on
the value of the portion of share-based payment awards that is ultimately
expected to vest during the period. Stock-based compensation expense
recognized in the Company's Statements of Operations for the three and six
months ended September 30, 2006 included compensation expense for
share-based payment awards granted prior to, but not yet vested as of
March 31, 2006 based on the grant date fair value estimated in accordance
with the pro forma provisions of SFAS 123 and compensation expense for the
share-based payment awards granted subsequent to March 31, 2006 based on
the grant date fair value estimated in accordance with the provisions of
SFAS No. 123R. As stock-based compensation expense recognized in the
Statement of Operations is based on awards ultimately expected to vest and
to be exercised, it will be reduced for estimated forfeitures. There was
no forfeiture rate applied to the stock-based compensation expense for the
three and six months ended September 30, 2006 as all options were fully
vested and are expected to be exercised. In the Company's pro forma
information required under SFAS 123 for the periods prior to April 1,
2006, the Company accounted for forfeitures as they occurred. The Company
estimated the fair value of each stock-based award using the Black-Scholes
pricing model with the following assumptions:
Three Months Ended Six Months Ended
September 30, 2006 September 30, 2006
------------------ ------------------
Risk-free interest rate 4.07-4.94% 4.07-4.94%
Volatility 50.3-51.9% 50.3-51.9%
Expected life (months) 36-60 36-60
Dividends None None
The following table summarizes nonvested plan and non-plan stock options
as of September 30, 2006, as well as activity for the three months then
ended.
Three Months Ended Six Months Ended
September 30, 2006 September 30, 2006
--------------------- ---------------------
Weighted Weighted
Average Average
Grant Date Grant Date
Shares Fair Value Shares Fair Value
-------- ---------- -------- ----------
Beginning of period 3,000 $1.76 53,000 $0.51
Granted 500,000 0.18 500,000 0.18
Vested (503,000) 0.19 (553,000) 0.22
Forfeited -- -- -- --
-------- ----- -------- -----
End of period -0- $ -0- -0- $ -0-
======== ===== ======== =====
Compensation cost arising from nonvested stock granted to employees and
from non-employee stock awards is recognized as expense using the graded
vesting attribution method over the vesting period. As of September 30,
2006, there was no remaining unrecognized compensation cost related to
nonvested stock. For the three and six months ended September 30, 2006,
the Company's total stock-based compensation expense was $92,330 and
$98,160, respectively.
9
The following table summarizes plan and non-plan stock options outstanding
as of September 30, 2006 as well as activity during the six months then
ended:
Three Months Ended
September 30, 2006
---------------------
Weighted-
Weighted- Average
Average Remaining Aggregate
Exercise Contractual Intrinsic
Shares Price Term Value
--------- --------- ----------- ---------
Outstanding at beginning of period 4,846,406 $3.12
Granted 500,000 0.44
Exercised -- --
Forfeited (32,429) 2.04
--------- -----
Outstanding at end of period 5,313,977 $2.88 3.0 Years $-0-
========= ===== === ====
Exercisable at end of period 5,313,977 $2.88 3.0 Years $-0-
========= ===== === ====
At September 30, 2006, the aggregate intrinsic value of options
outstanding and options exercisable was zero, because the market value of
the underlying stock was below the exercise price of all options. The
average fair value computed during the three and six months ended
September 30, 2005 was $0.18. There were no options granted and thus no
average fair value computed during the three and six months ended
September 30, 2005.
Pro Forma Information for Periods Prior to April 1, 2006
The Company estimated the fair value of each stock-based award during the
three months ended September 30, 2005 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. The fair
value of each option grant is estimated on the date of grant using the
Black-Scholes option-pricing model. The risk-free rate is based on the U.S
Treasury rates in effect during the corresponding period of grant.
Expected volatilities are based on the historical volatility of the
Company's stock. Expected life of options granted is computed using the
contractual life of the options granted. There is no expected dividend
yield. The Company estimated the fair value of each stock-based award
using the Black-Scholes pricing model with the following assumptions:
Six Months Ended
September 30, 2005
------------------
Risk-free interest rate 3.35-3.45%
Volatility 24.9-46.0%
Expected life (months) 1-36
Dividends None
The following table illustrates the effect on net loss and net loss per
share for the three and six months ended September 30, 2005 as if the
Company's stock-based compensation had been determined based on the fair
value at the grant dates for awards made prior to April 1, 2006, under
those plans and consistent with SFAS 123:
Three Months Six Months
Ended Ended
September 30, September 30,
2005 2005
------------- -------------
Net loss as reported $(1,416,138) $(10,560,252)
Add: Stock-based compensation included in reported net loss 3,319 870,837
Deduct: Stock-based compensation under fair-value based
method for all awards (13,652) (891,245)
----------- ------------
Pro forma net loss $(1,426,471) $(10,580,660)
=========== ============
Pro forma basic and diluted net loss per common share:
Pro forma net loss per common share - basic and diluted $ (0.07) $ (0.55)
=========== ============
Reported net loss per common share - basic and diluted $ (0.07) $ (0.55)
=========== ============
10
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
sells to customers throughout the United States and 14 other countries.
Recent Accounting Pronouncements
In July 2006, the FASB issued Interpretation No. 48, "Accounting for
Uncertainty in Income Taxes - An Interpretation of FASB Statement No. 109"
("FIN 48"). FIN 48 provides guidance on the financial statement
recognition and measurement of a tax position taken or expected to be
taken in a tax return. FIN 48 also provides guidance on derecognition,
classification, interest and penalties, accounting in interim periods,
disclosures, and transition. FIN 48 is effective for fiscal years
beginning after December 15, 2006. The Company is currently evaluating the
impact of this standard on its financial statements.
In September 2006, the FASB issued SFAS 157, "Fair Value Measurements."
SFAS 157 simplifies and codifies guidance on fair value measurements under
generally accepted accounting principles. This standard defines fair
value, establishes a framework for measuring fair value and prescribes
expanded disclosures about fair value measurements. SFAS 157 is effective
for financial statements issued for fiscal years beginning after November
15, 2007, and interim periods within those fiscal years, with early
adoption permitted. The Company is currently evaluating the effect, if
any, the adoption of SFAS 157 will have on its financial condition,
results of operations and cash flows.
(3) Secured Borrowings and Related Party Notes Payable
Secured Borrowings
On June 23, 2006, the Company entered into a Receivables Purchase
Agreement with Systran Financial Services Corporation, a subsidiary of
Textron Financial Corporation ("Systran"), whereby Systran will provide
financing to the Company through advances against certain trade receivable
invoices due to the Company (the "Systran Agreement"). The Systran
Agreement is secured by the Company's accounts receivable and all other
assets. Generally, subject to a maximum principal amount of $3,500,000
which can be borrowed under the Systran Agreement, the amount available
for borrowing is equal to 85% of the Company's eligible accounts
receivable invoices less a dilution reserve and any required fixed dollar
reserves. The dilution and fixed dollar reserves have been initially set
at 7% and $100,000, respectively. Advances under the Systran Agreement
bear interest at a variable rate equal to the prime rate plus 1.5% per
annum (9.75% on September 30, 2006). The Company paid a one-time closing
fee of $35,000 and is also obligated to pay a $1,500 monthly service fee.
The initial term of the Systran Agreement ends on June 23, 2009 and may
renew automatically for consecutive twelve-month terms unless terminated
sooner.
In accordance with SFAS No. 140, "Accounting for Transfers and Servicing
of Financial Assets and Extinguishments of Debt," the Company accounts for
the Systran Agreement as a liability since it is a full-recourse agreement
and the Company maintains effective control over the accounts receivable.
On June 23, 2006, Systran advanced $2,379,262 under the Systran Agreement
of which $1,839,086 was used to pay in full and terminate the Company's
obligations under its line of credit with Textron Financial Corporation
which was to terminate on June 27, 2006 pursuant to a Sixth Amendment to
the Textron Loan Agreement that was executed on May 26, 2006. The Sixth
Amendment provided for an extension of the Textron Loan from May 26, 2006
until June 27, 2006 and reduced the maximum principal amount which could
be borrowed under the Textron Loan to $3,000,000. In exchange for the
amendment and extension, the Company paid a fee of $10,000. As of
September 30, 2006, advances under the Systran Agreement totaled
$1,399,182.
Related Party Notes Payable
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. 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. The combined total of these loans was $2,400,000. The
loans were evidenced by unsecured promissory notes (the "Notes") held by
the above referenced parties (the "Note Holders"). The Notes required
monthly interest-only payments at 3% above the bank prime rate of interest
per the Federal Reserve Bank and matured on June 15, 2006.
11
The Company did not have the short-term liquidity to pay its related party
Note Holders on the $2.4 million Notes that matured on June 15, 2006 in
accordance with their original terms. The Company received a letter on
June 20, 2006 from all of the Note Holders, other than Mr. DeLuca,
notifying the Company that its failure to pay the amounts due and owing on
the maturity date constitutes a default under $1.2 million of the Notes
held by those Note Holders. Pursuant to the terms of the Notes, since the
Company did not cure the default within 10 days after receipt of the
notice of default, it was obligated to pay interest at the default rate of
8% above the Prime Rate beginning July 1, 2006.
Pursuant to a Note Purchase Agreement dated July 19, 2006, the Company
issued a new unsecured convertible note for $2,685,104 (the "Convertible
Note") to Mr. DeLuca. The proceeds from the Convertible Note were used to
repay or refinance the above mentioned $2.4 million Notes that matured on
June 15, 2006 and a $285,104 registration rights penalty owed to Mr.
DeLuca. The Convertible Note accrues interest at 12.5% per annum. No
interest or principal payments are required under the Note until its
maturity on October 19, 2007. Principal, together with any accrued and
unpaid interest, on the Convertible Note is convertible at any time prior
to payment into shares of the Company's common stock at a conversion price
of $0.35 per share. The market price of the Company's common stock as
quoted on the OTC on July 19, 2006 was $0.28. As additional consideration
for making the loan, the Company issued Mr. DeLuca a warrant (the
"Warrant") to purchase up to 200,000 shares of the Company's common stock
at an exercise price equal to $0.35 per share. The Warrant is fully vested
and can be exercised on or before the expiration date of July 19, 2009. In
July 2006, the Company recorded the $18,000 fair value of the Warrant as a
discount to debt that is being amortized from July 2006 through October
2007.
The Company amortized $2,840 and $129,819 related to debt discounts in the
three and six months ended September 30, 2006, respectively. As of
September 30, 2006, the outstanding principal balance of $2,685,104 on the
Notes less the remaining debt discount of $15,160 is $2,669,944.
(4) Disposal Activities
On December 8, 2005, the Company completed the sale of substantially all
of its manufacturing and production equipment to Schreiber Foods, Inc., a
Wisconsin corporation ("Schreiber"), for $8,700,000 in cash pursuant to an
Asset Purchase Agreement dated June 30, 2005. In connection with the Asset
Purchase Agreement, the Company also entered into a Supply Agreement with
Schreiber (the "Supply Agreement") on June 30, 2005 pursuant to which,
Schreiber became the Company's sole source of supply and distributor for
substantially all of its products in November 2005.
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 were 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. The above transactions were
communicated to the Company's employees on July 6, 2005. During the year
ended March 31, 2006, all 104 employee positions related to the
manufacturing and distribution of the Company's products were eliminated.
The remaining employee termination costs are expected to be paid in fiscal
2007. In December 2005, the Company abandoned its distribution facility
and the production portion of its administrative facility and accrued
$396,197 related to abandonment of these facilities. This amount was
calculated as the present value of the remaining lease rentals, reduced by
the estimated market value of sublease rentals. The actual expense will
exceed this estimate for the time that the Company does not sublease these
facilities. Other exit costs consist primarily of legal and professional
fees related to the disposal activities and maintenance costs on the
abandoned facilities.
12
As of September 30, 2006, the Company has accrued the following costs
associated with the above transactions:
Employee
Termination Excess Other Exit
Costs Facilities Costs Total
----------- ---------- ---------- ---------
Accrued Balance March 31, 2005 $ -- $ -- $ -- $ --
Charges -- -- 189,069 189,069
Payments -- -- (189,069) (189,069)
--------- --------- --------- ---------
Accrued Balance, June 30, 2005 -- -- -- --
Charges 359,774 -- 124,425 484,199
Payments -- -- (124,425) (124,425)
--------- --------- --------- ---------
Accrued Balance, September 30, 2005 359,774 -- -- 359,774
Charges 51,638 396,197 221,101 668,936
Payments (204,847) -- (221,101) (425,948)
--------- --------- --------- ---------
Accrued Balance, December 31, 2005 206,565 396,197 -- 602,762
Charges 39,590 122,282 142,414 304,286
Payments (220,277) (168,530) (37,837) (426,644)
--------- --------- --------- ---------
Accrued Balance, March 31, 2006 25,878 349,949 104,577 480,404
Charges -- 88,955 12,789 101,744
Payments (7,257) (136,260) (18,427) (161,944)
--------- --------- --------- ---------
Accrued Balance, June 30, 2006 $ 18,621 $ 302,644 $ 98,939 $ 420,204
Charges -- 23,905 23,154 47,059
Payments -- (280,420) (72,624) (353,044)
--------- --------- --------- ---------
Accrued Balance, September 30, 2006 $ 18,621 $ 46,129 $ 49,469 $ 114,219
========= ========= ========= =========
The Company reports its disposal costs for the period as Costs of Disposal
Activities in the Statement of Operations. A summary of the six months and total
disposal costs incurred is as follows:
Employee
Termination Excess Other Exit
Costs Facilities Costs Total
----------- ---------- ---------- ----------
Six Months Ended September 30, 2005 $359,774 $ -- $313,494 $ 673,268
======== ======== ======== ==========
Six Months Ended September 30, 2006 -- 112,860 35,943 148,803
======== ======== ======== ==========
Total Costs Incurred from
inception through September 30,
2006 $451,002 $631,339 $712,952 $1,795,293
======== ======== ======== ==========
The Company anticipates that in future periods, there will be additional
disposal costs related to professional fees and leasehold repair charges
incurred upon its exit from its leasehold facility in October 2006.
From April 15, 2006 through November 12, 2006, the Company received
approximately $90,355 in rental income under a sublease agreement for a
portion of its unused manufacturing facility and parking spaces. This
rental income offset the Company's lease payment obligations recorded in
Cost of Disposal Activities during fiscal 2007.
Effective July 31, 2006, the Company entered into a lease termination
agreement with its landlord, CLP Industrial Properties, regarding its
unused leased distribution facilities whereby the landlord released the
Company from $1,068,869 in future payment obligations from August 1, 2006
through July 31, 2009 under the terms of its current operating lease, in
exchange for a termination fee of $228,859 payable as follows: $128,859
upon the effective date, followed by payments of $75,000 and $25,000
thirty and forty-five days thereafter, respectively.
13
(5) 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 stockholder and 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 $744,927 remained unpaid but accrued
($366,305 as short-term liabilities and $378,622 as long-term liabilities)
as of September 30, 2006. The long-term portion is being paid out in
nearly equal monthly installments ending in October 2008.
In June 1999, in connection with an amended and restated employment
agreement for Angelo S. Morini, the Company consolidated two full-recourse
notes receivable ($1,200,000 from November 1994 and $11,572,200 from
October 1995) related to his purchase of 2,914,286 shares of the Company's
common stock into a single stockholder note receivable in the amount of
$12,772,200 that was due on June 15, 2006. This stockholder note
receivable was non-interest bearing and non-recourse and was secured by
the 2,914,286 shares of the Company's common stock (the "Shares").
On June 16, 2006, Mr. Morini failed to repay the non-recourse note
obligation to the Company. The 2,914,286 shares being held as collateral
were deemed to be no longer outstanding and thus considered as treasury
stock. On June 20, 2006, the Company delivered notice to Mr. Morini that
it intended to exercise its rights to the Shares and retain all the Shares
in full satisfaction of his obligations under the stockholder note
receivable. On July 6, 2006, Mr. Morini consented to the Company's
acceptance of the Shares in full satisfaction of his obligations under the
stockholder note receivable. Based upon the $0.42 closing price of the
Company's common stock as quoted on the OTC Bulletin Board on June 16,
2006, the Shares had an approximate value of $1,224,000 on such date.
Accordingly, the Company recorded an additional expense of $1,428,000 in
the six months ended September 30, 2006 in order to record the additional
decline in the value of the Shares from its $2,652,000 value as of March
31, 2006. In July 2006, the Company cancelled the Shares along with its
other 30,443 treasury shares.
Although this expense resulted in a material loss to the Company's
operations, it did not have any affect on the balance sheet since the
stockholder note receivable was already shown as a reduction to
Stockholders' Deficit.
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 was paid out in nearly equal
installments over two years payable on the Company's regular payroll dates
until July 2006.
Board of Directors
On August 7, 2006, the Board of Directors the Company appointed two new
directors, Mr. Peter J. Jungsberger and Mr. Robert S. Mohel. As a result
of these appointments, all then vacancies on the Company's Board of
Directors were filled. The current Board consists of three independent
directors (including Messrs. Jungsberger and Mohel) and two inside
directors. Upon their appointment, the Board of Directors issued to each
Mr. Jungsberger and Mr. Mohel an option to purchase up to 100,000 shares
of the Company's common stock with an exercise price of $0.45 (110% of the
$.041 market price as quoted on the OTC Bulletin Board on August 7, 2006).
The options were granted outside of any stock option plan and are
immediately vested and expire on August 7, 2011. In accordance with the
accounting provisions of SFAS No. 123R, the Company recorded a fair value
expense of $38,000 upon the issuance of these options.
On August 17, 2006, the Board of Directors approved the grant of options
to acquire 100,000 shares of the Company's common stock to each of David
Lipka, Michael Broll and Angelo Morini, each a director of the Company.
Each of these options has an exercise price of $0.44 (110% of the $.40
market price as quoted on the OTC Bulletin Board on August 17, 2006). The
options were granted outside of any stock option plan and are immediately
vested and expire on
14
August 17, 2011. In accordance with the accounting provisions of SFAS No.
123R, the Company recorded a fair value expense of $54,000 upon the
issuance of these options.
On August 17, 2006, in recognition of David Lipka's substantial efforts on
behalf of the Company, the Board voted to increase his compensation in his
capacity as Chairman of the Board of Directors of the Company, from
$60,000 per year to $120,000 per year. As a result of this increase, Mr.
Lipka will no longer be considered an "independent" director within the
meaning of applicable securities regulations. In addition, the Board
resolved that the entire Board should act as the audit committee of the
Board and appointed Robert Mohel, an independent director, to serve as
Chairman of the meetings of the audit committee.
(6) Commitments and Contingencies
Supply Agreement
In November 2005, Schreiber began manufacturing and distributing
substantially all of the Company's products in accordance with a Supply
Agreement that was signed on June 30, 2005. The prices for such products
are based on cost plus a processing fee as determined by the parties from
time to time. Other material terms 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 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 cost. If the Company does
not exercise its first option to extend the term, then the Company
will be obligated to pay Schreiber $1,500,000. If the Company has
exercised the first option to extend the term, but does not exercise
its second option to extend the term, then the Company will be
obligated to pay Schreiber $750,000.
o The Supply Agreement provided for a contingent short-fall payment
obligation up to $8,700,000 by the Company if a specified production
level was not met during the one-year period from September 1, 2006
to August 31, 2007. If a contingent short-fall payment was 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 exceeded the specified target level of production,
if any. In November 2006, the Supply Agreement was amended so that
the short-fall payment obligation would not be measured until
September 1, 2009 to August 31, 2010 and the target level of
production was reduced by approximately 22%.
Operating Leases
On October 3, 2006, the Company entered into a sublease agreement with
Oracle Corporation whereby the Company moved its corporate headquarters
from the Viscount location to 5955 T.G. Lee Boulevard Suite 201 in
Orlando, Florida. The Sublease Agreement requires monthly base rental
payments of $12,333.33 through November 14, 2007, $12,706.67 from November
15, 2007 through November 14, 2008, and $13,086.67 from November 15, 2008
through January 31, 2009.
(7) Non-Cash Compensation Related to Stock-Based Transactions
Effective April 1, 2006, SFAS No. 123R applies to new awards and to awards
modified, repurchased, or cancelled after the effective date, as well as
to the unvested portion of awards outstanding as of the effective date.
The Company uses the Black-Scholes model to value its new stock option
grants under SFAS No. 123R, applying the "modified prospective method" for
existing grants which requires the Company to value stock options prior to
its adoption of SFAS No. 123R under the fair value method and expense the
unvested portion over the remaining vesting period. For the three and six
months ended September 30, 2006, the Company's total stock-based
compensation expense was $92,330 and $98,160, respectively.
Prior to April 1, 2006 and beginning April 1, 2003, the Company accounted
for stock awards granted to employees under the fair value recognition
provisions of SFAS No. 123, "Accounting for Stock-Based Compensation," and
applied SFAS No. 148, "Accounting for Stock-Based Compensation -
Transition and Disclosure," prospectively to all employee awards granted
on or after April 1, 2003. Prior to April 1, 2003, the Company accounted
for stock awards granted to employees under the recognition and
measurement principles of Accounting Principles Board Opinion No. 25,
"Accounting for Stock Issued to Employees, and related Interpretations"
("APB No. 25"). As a result, no compensation expense was previously
recognized for stock options granted to employees prior to April 1, 2003
other than as related to option grants to employees and directors below
the fair market value of the underlying stock at the date of grant or as
related to subsequent modifications to options granted to employees and
directors. For the three and
15
six months ended September 30, 2005, the Company's total stock-based
compensation expense was $3,319 and $870,837 including an expense of
$1,063,393 for awards valued pursuant to SFAS No. 123 and income of
$192,556 for modification of awards valued pursuant to APB No. 25.
(8) Earnings Per Share
The following is a reconciliation of basic net income (loss) per share to
diluted net income (loss) per share:
THREE MONTHS ENDED SIX MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
-------------------------- --------------------------
2006 2005 2006 2005
----------- ------------ ----------- ------------
Net income (loss) - basic $ 561,564 $(1,416,138) $ (780,865) $(10,560,252)
Plus interest on convertible related
party note payable 67,128 -- -- --
----------- ------------ ----------- ------------
Net income (loss) - diluted $ 628,692 $ (1,416,138) $ (780,865) $(10,560,252)
=========== ============ =========== ============
Weighted average shares outstanding -
basic 17,109,910 20,045,953 18,336,298 19,358,496
Potential shares issued upon
conversion of related party note
payable 7,671,726 -- -- --
Potential shares "in-the-money" under
stock option agreements -- -- -- --
Less: Shares assumed repurchased
under the treasury stock method -- -- -- --
----------- ------------ ----------- ------------
Weighted average shares outstanding
-diluted $24,781,636 $ 20,045,953 $18,336,298 $ 19,358,496
=========== ============ =========== ============
Basic and diluted net income (loss)
per common share $ 0.03 $ (0.07) $ (0.04) $ (0.55)
=========== ============ =========== ============
Options for 5,313,977 shares and warrants for 1,323,142 shares have not
been included in the computation of diluted net income (loss) per common
share for the three and six months ended September 30, 2006, as their
effect would be antidilutive. Potential conversion of the related party
note payable for 7,671,726 shares have not been included in the
computation of diluted net income (loss) per common share for the six
months ended September 30, 2006, as their effect would be antidilutive.
Options for 5,059,809 shares and warrants for 648,213 shares have not been
included in the computation of diluted net income (loss) per common share
for the three and six months ended September 30, 2005, as their effect
would be antidilutive.
(9) 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, 2006 2005
------------------------------ ---------- --------
Non-cash financing and investing activities:
Purchase of equipment through a capital lease $ 6,858 $ --
Payment of note payable through issuance of
revised note payable 1,200,000 --
Payment of accrued liability through issuance of
note payable 285,104 --
Cash paid for:
Interest 191,530 571,876
(10) Economic Dependence and Segment Information
The Company has one operating segment and sells to customers throughout
the United States and 14 other countries. For the three months ended
September 30, 2006 and 2005, the Company's gross sales were $7,423,299 and
$11,403,251, respectively. For the six months ended September 30, 2006 and
2005, the Company's gross sales were
16
$16,157,837 and $22,106,286, respectively. Gross sales derived from
foreign countries were approximately $1,091,000 and $1,624 representing
15% and 14% of total sales for the three months ended September 30, 2006
and 2005, respectively. Gross sales derived from foreign countries were
approximately $2,211,000 and $2,715,000 representing 14% and 12% of total
sales for the six months ended September 30, 2006 and 2005, respectively.
Gross sales are attributed to individual countries based on the customer's
shipping address. The Company has no long-term assets located outside of
the United States.
The following table sets forth the percentage of foreign gross sales to
each country, which accounted for 10% or more of the Company's foreign
gross sales for the three and six months ended September 30, 2006 and
2005:
Three Months Ended Six Months Ended
September 30, September 30,
------------------ ----------------
2006 2005 2006 2005
---- ---- ---- ----
Canada 66.2% 66.8% 66.1% 58.2%
Puerto Rico 13.9% 19.2% 14.9% 23.5%
The Company had one customer that accounted for approximately 13% and 12%
of gross sales for the three and six months September 30, 2006,
respectively. There were no customers whose balance outstanding was
greater than 10% of accounts receivable as of September 30, 2006. The
Company had no customers that accounted for more than 10% of gross sales
for the three and six months ended September 30, 2005 nor more than 10% of
accounts receivable as of September 30, 2005.
For the three and six months ended September 30, 2006, the Company
purchased approximately 98% and 96%, respectively, of its inventory for
sale to customers from Schreiber. For the three and six months ended
September 30, 2005, the Company did not have any supplier that comprised
more than 10% of total raw material purchases.
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. This Form 10-Q & MD&A contain forward-looking
statements within the meaning of the federal securities laws that 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," "could," "should," "potential," or
"continue" or the negative or variations of these words or similar expressions
are intended to identify forward-looking statements. Additionally, these
forward-looking statements include, but are not limited to statements regarding:
o Improving cash flows from operations;
o Marketing our existing products and those under development;
o Our estimates of future revenue and profitability;
o Our expectations regarding future expenses, including cost of goods
sold, delivery, selling, general and administrative, research and
development expenses, and disposal costs;
o Our estimates regarding capital requirements and our needs for
additional financing; and
o Competition in our market.
Although we believe that these forward-looking statements are reasonable at the
time they are made, 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 those set forth under
"Risk Factors" and elsewhere in, or incorporated by reference into, this Form
10-Q. We are not required and 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 2007" or "fiscal 2006" refer to our fiscal years ending
March 31, 2007 and 2006, 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 Business Environment
o Basis of Presentation
o Critical Accounting Policies
o Results of Operations
o Liquidity and Capital Resources
o Recent Accounting Pronouncements
Business Environment
General
Galaxy Nutritional Foods, Inc. (our "Company") is principally engaged in
developing and globally marketing plant-based cheese and dairy alternatives, as
well as processed organic cheese and cheese food to grocery and natural foods
retailers, mass merchandisers and foodservice accounts. Veggie, the leading
brand in the grocery cheese alternative category and our Company's top selling
product group, is primarily merchandised in the produce section and provides
calcium and protein without cholesterol, saturated fat or trans-fat. Other
popular brands include: Rice, Veggy, Vegan, and Wholesome Valley. We are
dedicated to developing nutritious products to meet the taste and dietary needs
of today's increasingly health conscious consumers. Our company headquarters are
located in Orlando, Florida.
18
In fiscal 2006, we determined that our manufacturing capacity was significantly
in excess of our requirements and that it would be advantageous to outsource
manufacturing and distribution operations. On June 30, 2005, Galaxy Nutritional
Foods, Inc. and Schreiber Foods, Inc., a Wisconsin corporation ("Schreiber"),
entered into a Supply Agreement, whereby we agreed that Schreiber would become
our sole source of supply for substantially all of our products. In November
2005, Schreiber began to deliver such products directly to our customers.
On December 8, 2005, we completed the sale of substantially all of our
manufacturing and production equipment to Schreiber for $8,700,000 in cash
pursuant to an Asset Purchase Agreement dated June 30, 2005. Our Company has now
converted from a manufacturing company into a branded marketing company that
will continue to develop, market and sell our products.
Cheese Alternative Category
We are the market leader within our cheese alternative category niche, but in
being so, the category increases or decreases partly as a result of our
marketing and pricing efforts. We believe that the greatest source of future
growth in the cheese alternative category will come through consumers shifting
to cheese alternatives from natural cheese. Our strategy is to broaden the
consumer base to include younger, less price sensitive consumers seeking
products with overall health and nutrition attributes. Historically, our
products and marketing efforts appealed to older consumers purchasing cheese
alternatives for specific dietary concerns.
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 analyze trends in the consumer marketplace.
In fiscal 2006, we launched a regional consumer marketing campaign to educate
conventional cheese users on the benefits and location of Galaxy branded
products. The campaign drivers included traditional consumer advertising, price
based promotions, secondary placement and event marketing.
The consumer focused advertising included a 30 second TV commercial in key
markets on major networks including Food Network, Lifetime, Travel Channel,
Oxygen and USA during September 2005 and January 2006. Price based promotions
included a cents off coupon in free standing inserts distributed in major
regional newspapers in September 2005 and January 2006. We also tested secondary
placement with select retailers in Florida, Los Angeles and Chicago. Event
marketing included sponsorship of the Komen Race for the Cure in New York and
Houston. This provided an opportunity to educate women on the benefits of cheese
alternatives and introduce them to our brands with samples, coupons and product
information.
The fiscal 2006 marketing campaign provided valuable insight as to what types of
marketing efforts produced short-term and long-term benefits for brand
recognition and accomplished our goal of increasing consumer education in order
to broaden the consumer base within the cheese alternative category. We are
using the results from fiscal 2006, to focus the fiscal 2007 marketing campaign
as we enter the year as a branded marketing company.
Recent Material Developments
Debt Refinancing
On June 23, 2006, we entered into a Receivables Purchase Agreement with Systran
Financial Services Corporation, a subsidiary of Textron Financial Corporation
("Systran"), whereby Systran will provide financing to our Company through
advances against certain trade receivable invoices due to our Company (the
"Systran Agreement"). On June 23, 2006, Systran advanced $2,379,262 under the
Systran Agreement of which $1,839,086 was used to pay in full and terminate our
obligations under our line of credit with Textron Financial Corporation which
was to terminate on June 27, 2006.
Pursuant to a Note Purchase Agreement dated July 19, 2006, we issued a new
unsecured convertible note for $2,685,104 (the "Convertible Note") to Frederick
A. DeLuca, a greater than 10% shareholder. The proceeds from the Convertible
Note were used to repay or refinance $2,400,000 in unsecured promissory notes
that matured on June 15, 2006 (including one such note in the principal amount
of $1,200,000 owned by Mr. DeLuca) and a $285,104 registration rights penalty
owed to Mr. DeLuca.
See Debt Financing under Liquidity and Capital Resources for additional
information on the above refinancing.
19
Outsourcing Effect
We believe that the long-term benefits in the transition from a manufacturing
company to a branded marketing company will substantially outweigh the
short-term costs 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 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.
Some of the effects of the transaction are as follows:
o We are solely a branded marketing company without any manufacturing
and distribution functions.
o In December 2005, we ceased to use the manufacturing portion of our
main leased facility at 2441 Viscount Row in Orlando, Florida where
our administrative offices were located, but we continued to stay in
this location through the end of our lease in November 2006. From
April 15, 2006 through November 12, 2006, we received approximately
$90,355 in rental income under a sublease agreement for a portion of
our unused manufacturing facility and parking spaces. This rental
income offset our lease payment obligations recorded in Cost of
Disposal Activities during fiscal 2007.
o On October 3, 2006, we entered into a sublease agreement with Oracle
Corporation whereby we moved our corporate headquarters from the
Viscount location to 5955 T.G. Lee Boulevard Suite 201 in Orlando,
Florida. The Sublease Agreement requires monthly base rental
payments of $12,333.33 through November 14, 2007, $12,706.67 from
November 15, 2007 through November 14, 2008, and $13,086.67 from
November 15, 2008 through January 31, 2009. This sublease results in
savings of over $20,000 per month in rent compared to the monthly
rent we paid for our Viscount location.
o In December 2005, we abandoned our distribution facility that had a
lease termination date of July 31, 2009. Effective July 31, 2006, we
entered into a lease termination agreement with our landlord, CLP
Industrial Properties, regarding our unused leased distribution
facilities whereby the landlord released us from $1,068,869 in
future payment obligations from August 1, 2006 through July 31, 2009
under the terms of our current operating lease, in exchange for a
termination fee of $228,859.
o We eliminated 104 employee positions related to the manufacturing
and distribution of our products and created 2 new employee
positions. We now maintain 30 full time positions.
o We used the proceeds from the sale of our manufacturing equipment to
reduce a substantial portion of our outstanding debt and
liabilities. Repayment of these liabilities will result in annual
interest savings in excess of $800,000.
o We no longer have the carrying value of inventory nor need to use
asset based financing to support the production of inventory. Prior
to the outsourcing, we averaged 50 to 60 days of sales in inventory.
o We anticipate substantial savings on delivery charges related to the
distribution of our products to our customers. In the second quarter
of fiscal 2007, delivery expenses amounted to 3% of net sales
compared to 7% of net sales in the second quarter of fiscal 2006.
o We anticipate substantial savings on costs of goods sold and
improved gross margins as a result of reduced overhead and lower
material costs In the second quarter of fiscal 2007, gross margin
was approximately 41% of net sales compared to 25% of net sales in
the second quarter of fiscal 2006.
Measurements of Financial Performance
We focus on several items in order to measure our performance. 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 non-cash compensation and reserves
related to stock based transactions, disposal costs and fixed asset
impairment charges
o EBITDA excluding non-cash compensation and reserves related to stock
based transactions, disposal costs and fixed asset impairment
charges
o Liquidity
o Key financial ratios (such as accounts receivable and accounts
payable turnover ratios)
Basis Of Presentation; Going Concern Issues
We have incurred substantial losses in recent years and, as a result, have a
stockholders deficit of $2,919,365 as of September 30, 2006. Losses for the
years ended March 31, 2006, 2005 and 2004 were $24,148,553, $3,859,783 and
20
$3,299,277, respectively. Additionally, we received a report from our
independent accountants relating to our audited financial statements as of March
31, 2006 containing a paragraph stating that because we were then in default of
our notes payable, had suffered recurring losses from operations and at March
31, 2006 had deficiencies in working capital and equity, there was substantive
doubt as to our ability to continue as a going concern. Our ability to continue
as a going concern depended upon successfully obtaining sufficient cash
resources to refinance our $2.4 million of unsecured notes payable that matured
on June 15, 2006 and obtaining positive cash flow from operations to sustain
normal business operations.
Our current business plan eliminated certain low margin private label and Galaxy
imitation business from our sales mix. The elimination of these low margin items
and the elimination of excess overhead that was part of our former manufacturing
operations has resulted in higher gross margins with lower operating costs and
produced positive cash flows from operations in fiscal 2007.
As a result of the successful refinancing of the $2.4 million short-term notes
and line of credit for our receivables financing and the positive cash flow that
we are currently experiencing from operations, we believe that we have
sufficient cash resources to meet our current liquidity needs. Therefore, our
financial statements have been prepared in accordance with accounting principles
generally accepted in the United States of America assuming that we will
continue on a going concern basis. This assumes the realization of assets and
the satisfaction of liabilities in the normal course of business.
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 and chargebacks, 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.
Management has discussed the selection of critical accounting policies and
estimates with our Board of Directors and the Board of Directors has reviewed
our disclosure relating to critical accounting policies and estimates in this
quarterly report on Form 10-Q. Our significant accounting policies are described
in Note 1 to our financial statements for fiscal 2007. The critical accounting
policies used by management and the methodology for its estimates and
assumptions are as follows:
Valuation of Accounts Receivable and Chargebacks
We record revenue upon shipment of products to our customers and upon 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 $1,152,000 and $1,186,000 for
known and anticipated future credits and doubtful accounts at September 30, 2006
and 2005, respectively. 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.
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
Effective April 1, 2006, we adopted SFAS No. 123 (revised 2004), "Share-Based
Payment" ("SFAS No. 123R"). SFAS No. 123R requires companies to measure the cost
of employee services received in exchange for an award of equity
21
instruments, including stock options, based on the grant-date fair value of the
award and to recognize it as compensation expense over the period the employee
is required to provide service in exchange for the award, usually the vesting
period.
SFAS No. 123R applies to new awards and to awards modified, repurchased, or
cancelled after the effective date, as well as to the unvested portion of awards
outstanding as of the effective date. We use the Black-Scholes model to value
our new stock option grants under SFAS No. 123R, applying the "modified
prospective method" for existing grants which requires us to value stock options
prior to our adoption of SFAS No. 123R under the fair value method and expense
the unvested portion over the remaining vesting period. SFAS No. 123R also
requires us to estimate forfeitures in calculating the expense related to
stock-based compensation. In addition, SFAS No. 123R requires us to reflect cash
flows resulting from the tax benefits related to tax deductions in excess of the
compensation cost recognized for those options to be classified as a cash inflow
from financing activities and a cash outflow from operating activities.
Prior to April 1, 2006 and beginning April 1, 2003, we accounted for stock
awards granted to employees under the fair value recognition provisions of SFAS
No. 123, "Accounting for Stock-Based Compensation," and applied SFAS No. 148,
"Accounting for Stock-Based Compensation - Transition and Disclosure,"
prospectively to all employee awards granted on or after April 1, 2003. Prior to
April 1, 2003, we accounted for stock awards granted to employees under the
recognition and measurement principles of Accounting Principles Board Opinion
No. 25, "Accounting for Stock Issued to Employees, and related Interpretations."
As a result, no compensation expense was previously recognized for stock options
granted to employees prior to April 1, 2003 other than as related to option
grants to employees and directors below the fair market value of the underlying
stock at the date of grant or as related to subsequent modifications to options
granted to employees and directors.
The Black-Scholes model requires subjective assumptions, including future stock
price volatility and expected time to exercise, which greatly affect the
calculated values. The risk-free rate is based on the U.S Treasury rates in
effect during the corresponding period of grant. Expected volatilities are based
on the historical volatility of our stock. In the past, we input the expected
life of options granted as the contractual life of the options granted. For any
new awards, we will input the expected term of options granted based on
information derived from historical data on employee exercises and post-vesting
employment termination behavior. There is no expected dividend yield. These
factors could change in the future, which would affect the stock-based
compensation expense in future periods. SFAS No. 123R requires forfeitures to be
estimated at the time of grant and revised, if necessary, in subsequent periods
if actual forfeitures differ from those estimates.
Disposal Costs
We have recorded accruals in connection with the asset sale and outsourcing
arrangements with Schreiber. These accruals include estimates pertaining to
employee termination costs and 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 No. 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, contract cancellation charges 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.
Results of Operations
3-Months Ended September 30, 6-Months Ended September 30,
-------------------------------------------- ---------------------------------------------
$ % $ %
2006 2005 Change Change 2006 2005 Change Change
--------- ---------- ---------- ------ ---------- ---------- ---------- -------
Net Sales 6,727,777 10,438,225 (3,710,448) -35.5% 14,560,339 20,289,378 (5,729,039) -28.2%
Cost of Goods Sold 3,957,750 7,817,351 (3,859,601) -49.4% 9,032,962 15,400,206 (6,367,244) -41.3%
--------- ---------- ---------- ----- ---------- ---------- ---------- -----
Gross Margin 2,770,027 2,620,874 149,153 5.7% 5,527,377 4,889,172 638,205 13.1%
========= ========== ========== ===== ========== ========== ========== =====
Gross Profit % 41.2% 25.1% 38.0% 24.1%
========= ========== ========== ==========
22
Sales
For the three months ended September 30, 2006 and 2005, our gross sales were
$7,423,299 and $11,403,251, respectively. For the six months ended September 30,
2006 and 2005, our gross sales were $16,157,837 and $22,106,286, respectively.
The following chart sets forth the percentage of gross sales derived from our
product brands during the three and six months ended September 30, 2006 and
2005:
Three Months Ended Six Months Ended
September 30, September 30,
------------------ ----------------
Brand 2006 2005 2006 2005
- ---------------------------------- ---- ---- ---- ----
Veggie 58.7% 49.5% 56.9% 49.8%
Private Label, Imitation and Other 19.9% 34.7% 22.4% 34.0%
Rice 9.9% 7.3% 10.3% 7.3%
Veggy 4.6% 3.8% 4.3% 4.2%
Wholesome Valley Organic 3.5% 2.7% 3.1% 2.7%
Vegan 3.4% 2.0% 3.0% 2.0%
Net sales, after discounts, returns and allowances, in the three and six months
ended September 30, 2006 decreased 36% and 28% from net sales in the three and
six months ended September 30, 2005, respectively primarily due to the
elimination of certain private label and Galaxy imitation products as
demonstrated by the above shift in product mix.
During fiscal 2007, we plan to continue to reduce marginally profitable private
label and Galaxy imitation sales, which has led to the improvement in our gross
margins. Additionally, we plan to increase the effectiveness of our price based
promotions in fiscal 2007 to generate higher sales on our branded products. We
anticipate that our sales in fiscal 2007 will continue to be lower than sales in
fiscal 2006 due to our specific focus to eliminate marginally profitable private
label and other products.
Cost of Goods Sold
Cost of goods sold was approximately 59% and 62% of net sales in the three and
six months ended September 30, 2006 compared to 75% and 76% of net sales in the
three and six months ended September 30, 2005, respectively. This sharp decrease
in cost of goods sold is primarily due to the elimination of production overhead
through the outsourcing of our manufacturing operations in November 2005 as
discussed under Recent Material Developments. Our production overhead was
substantially higher than the current processing fee charged for the production
of our products due to an 85% underutilization of our manufacturing equipment
and facilities.
We anticipate that the cost of goods sold will remain improved over prior year
levels as a result of the outsourcing arrangement with Schreiber. However,
actual results could differ from our expectations.
Gross Margin
Despite a $5.7 million decline in sales, gross margin dollars in the six months
ended September 30, 2006 was approximately $638,000 higher than in the first six
months ended September 30, 2005 due to the elimination of certain low margin
private label and Galaxy imitation business, the change in our product mix and
the reduction in excess overhead. Our anticipated higher margin sales combined
with our lower overhead burden, should produce higher gross margins in dollars
and as a percentage of sales throughout fiscal 2007.
EBITDA
We utilize certain GAAP measures such as Operating Income and Net Income and
certain non-GAAP measures, in order to compute 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 to our financial
condition and results of operations. Additionally, these measures are key
factors upon which we prepare our budgets and forecasts, and calculate bonuses.
In our calculation of key financial non-GAAP measures for adjusted Operating
Income, adjusted Net Income and adjusted EBITDA, we exclude items such as
non-cash compensation and reserves related to stock based transactions, disposal
costs and fixed asset impairment and disposal charges. 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.
23
EBITDA, (a non-GAAP measure):
3-Months Ended September 30, 6-Months Ended September 30,
-------------------------------------------- ---------------------------------------------
$ % $ %
2006 2005 Change Change 2006 2005 Change Change
--------- ---------- ---------- ------ --------- ----------- ---------- ------
Gross Margin 2,770,027 2,620,874 149,153 5.7% 5,527,377 4,889,172 638,205 13.1%
--------- ---------- ---------- ------- --------- ----------- ---------- -------
Operating Expenses:
Selling 880,823 1,557,547 (676,724) -43.4% 1,846,802 2,493,792 (646,990) -25.9%
Delivery 179,741 726,078 (546,337) -75.2% 426,283 1,341,549 (915,266) -68.2%
General and administrative,
including $92,330 and $3,319,
$98,160 and $870,837 non-cash
stock compensation 872,766 937,290 (64,524) -6.9% 1,857,628 2,604,762 (747,134) -28.7%
Research and development 44,449 89,052 (44,603) -50.1% 86,783 180,094 (93,311) -51.8%
Reserve on stockholder note
receivable -- -- -- -- 1,428,000 -- 1,428,000 100.0%
Cost of disposal activities 47,059 484,200 (437,141) -90.3% 148,803 673,269 (524,466) -77.9%
Impairment of fixed assets -- -- -- 0.0% -- 7,896,554 (7,896,554) -100.0%
(Gain)/loss on disposal of
assets 37,329 6,242 31,087 498.0% 24,505 5,606 18,899 337.1%
--------- ---------- ---------- ------- --------- ----------- ---------- ------
Total operating expenses 2,062,167 3,800,409 (1,738,242) -45.7% 5,818,804 15,195,626 (9,376,822) -61.7%
--------- ---------- ---------- ------- --------- ----------- ---------- ------
Income (Loss) from Operations 707,860 (1,179,535) 1,887,395 -160.0% (291,427) (10,306,454) 10,015,027 -97.2%
Other Income (Expense), Net
Interest expense, net (146,296) (293,603) 147,307 -50.2% (489,438) (650,798) 161,360 -24.8%
Gain (loss) on FV of warrants -- 57,000 (57,000) -100.0% -- 397,000 (397,000) -100.0%
--------- ---------- ---------- ------- --------- ----------- ---------- ------
Total (146,296) (236,603) 90,307 -38.2% (489,438) (253,798) (235,640) 92.8%
--------- ---------- ---------- ------- --------- ----------- ---------- ------
NET INCOME (LOSS) 561,564 (1,416,138) 1,977,702 -139.7% (780,865) (10,560,252) 9,779,387 -92.6%
Interest expense, net 146,296 293,603 (147,307) -50.2% 489,438 650,798 (161,360) -24.8%
Depreciation 53,275 536,749 (483,474) -90.1% 106,097 1,075,852 (969,755) -90.1%
--------- ---------- ---------- ------- --------- ----------- ---------- ------
EBITDA, (a non-GAAP measure) 761,135 (585,786) 1,346,921 -229.9% (185,330) (8,833,602) 8,648,272 -97.9%
========= ========== ========== ======= ========= =========== ========== ======
(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 market price of our common shares is outside our control and
typically does not reflect our current operations.
(2) In our calculation of key financial measures, we exclude the reserve on
stockholder note receivable, disposal costs and fixed asset impairment
charges because we believe that these items do not reflect expenses
related to our current on-going operations. See below for a detailed
description of these items.
(3) Operating Loss has decreased due to the changes in non-cash compensation
related to stock-based transactions as discussed below under general and
administrative, and certain non-standard expenses such as the reserve on
stockholder note receivable, disposal costs and fixed asset impairment
charges related to the Asset Purchase Agreement and the Supply Agreement
with Schreiber as discussed under Recent Material Developments.
Selling
Selling expense is partly a function of sales through variable costs such as
brokerage commissions and promotional costs along with certain fixed costs for
employee salaries and benefits and marketing campaigns. Our selling expense
typically averages between 12% and 13% of net sales. Selling expenses for the
six months ended September 30, 2006 and 2005 were 13% and 12%, respectively.
Selling expenses for the three months ended September 30, 2006 and 2005 were 13%
and 15%, respectively. Selling expenses were higher than average in the second
quarter of fiscal 2006 due to a large television promotion during this period.
We expect fixed selling expenses for advertising and market research in fiscal
2007 to be nearly the same level as in fiscal 2006, but with a more focused use
of funds. We sell our products through our internal sales force and an
independent broker network.
24
Delivery
Delivery expense is primarily a function of sales, and historically ranged from
approximately 5% to 6% of net sales. In fiscal 2007, delivery expense decreased
to 3% of net sales due to our Supply Agreement with Schreiber. The Supply
Agreement fixed the delivery charges based on a per pound rate that was lower
than our historical delivery cost per pound. However, this rate can be adjusted
by the parties as agreed upon from time to time. In September 2006, the parties
adjusted the rate to reflect current market conditions. As a result, we
anticipate delivery expense will increase to up to 5% of net sales, but still
remain lower than our delivery expense prior to the outsourcing.
General and administrative
During the six months ended September 30, 2006, general and administrative
expenses decreased approximately $747,000 compared to the six months ended
September 30, 2005. During the six months ended September 30, 2006, non-cash
compensation related to stock-based transactions decreased by nearly $773,000,
as detailed below, and we did not incur a net $183,000 expense of unusual items
that were incurred during the six months ended September 30, 2005. These items
include: a) $261,000 of additional bad debt costs related to the Del Sunshine
account; b) $71,875 in liquidated damages accrued in related to a registration
rights agreement; and c) $150,000 income received pursuant to a Termination,
Settlement and Release Agreement signed on July 22, 2005 between our Company and
Fromageries Bel S.A. During the six months ended September 30, 2006, we expensed
an additional $200,000 in general overhead costs such as corporate insurance,
property taxes and depreciation as general and administrative expenses. Prior to
the outsourcing, these costs were allocated to cost of goods sold.
Excluding the effects of non-cash compensation related to stock-based
transactions, which cannot be predicted, we anticipate that general and
administrative expenses will decrease in fiscal 2007 due to the non-recurrence
of the highly intensive consulting, legal and audit services related to major
contracts, review of strategic alternatives and additional SEC filings that were
required in fiscal 2006. Additionally, we do not anticipate the occurrence of
liquidated damages related to stock registration that were incurred in fiscal
2006. However, we anticipate that we will begin incurring additional costs
related to the implementation of Sarbanes Oxley 404 in the fourth quarter of
fiscal 2007 and throughout fiscal 2008.
The reduction of $772,677 in non-cash compensation related to stock-based
transactions included in general and administrative expenses was a result of the
following:
Effective April 1, 2006, SFAS No. 123R applies to new awards and to awards
modified, repurchased, or cancelled after the effective date, as well as
to the unvested portion of awards outstanding as of the effective date. We
use the Black-Scholes model to value our new stock option grants under
SFAS No. 123R, applying the "modified prospective method" for existing
grants which requires us to value stock options prior to our adoption of
SFAS No. 123R under the fair value method and expense the unvested portion
over the remaining vesting period. For the three and six months ended
September 30, 2006, our total stock-based compensation expense was $92,330
and $98,160, respectively.
Prior to April 1, 2006 and beginning April 1, 2003, we accounted for stock
awards granted to employees under the fair value recognition provisions of
SFAS No. 123, "Accounting for Stock-Based Compensation," and applied SFAS
No. 148, "Accounting for Stock-Based Compensation - Transition and
Disclosure," prospectively to all employee awards granted on or after
April 1, 2003. Prior to April 1, 2003, we accounted for stock awards
granted to employees under the recognition and measurement principles of
Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued
to Employees, and related Interpretations" ("APB No. 25"). As a result, no
compensation expense was previously recognized for stock options granted
to employees prior to April 1, 2003 other than as related to option grants
to employees and directors below the fair market value of the underlying
stock at the date of grant or as related to subsequent modifications to
options granted to employees and directors. For the three and six months
ended September 30, 2005, our total stock-based compensation expense was
$3,319 and $870,837 including an expense of $1,063,393 for awards valued
pursuant to SFAS No. 123 and income of $192,556 for modification of awards
valued pursuant to APB No. 25.
Reserve on stockholder note receivable
In June 1999, in connection with an amended and restated employment agreement
for Angelo S. Morini, our Founder, stockholder and a member of our Board of
Directors, we consolidated two full-recourse notes receivable ($1,200,000 from
November 1994 and $11,572,200 from October 1995) related to his purchase of
2,914,286 shares of our common stock into a single stockholder note receivable
in the amount of $12,772,200 that was due on June 15, 2006. This stockholder
note receivable was non-interest bearing and non-recourse and was secured by the
2,914,286 shares of our common stock (the "Shares").
25
On June 16, 2006, Mr. Morini failed to repay the non-recourse note obligation to
our Company. The 2,914,286 shares being held as collateral were deemed to be no
longer outstanding and thus considered as treasury stock. On June 20, 2006, we
delivered notice to Mr. Morini that we intended to exercise our rights to the
Shares and retain all the Shares in full satisfaction of his obligations under
the stockholder note receivable. On July 6, 2006, Mr. Morini consented to our
acceptance of the Shares in full satisfaction of his obligations under the
stockholder note receivable. Based upon the $0.42 closing price of our common
stock as quoted on the OTC Bulletin Board on June 16, 2006, the Shares had an
approximate value of $1,224,000 on such date. Accordingly, we recorded an
additional expense of $1,428,000 in the three months ended September 30, 2006 in
order to record the additional decline in the value of the Shares from its
$2,652,000 value as of March 31, 2006. As of September 30, 2006, the value of
the Shares is reflected in treasury stock. In July 2006, we cancelled the Shares
along with our other 30,443 treasury shares.
Although this expense resulted in a material loss to our operations, it does not
have any affect on the balance sheet since the stockholder note receivable was
already shown as a reduction to Stockholders' Deficit.
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 were 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. During
the year ended March 31, 2006, all 104 employee positions related to the
manufacturing and distribution of our products were eliminated. The remaining
employee termination costs are expected to be paid in fiscal 2007. In December
2005, we abandoned our distribution facility and the production portion of our
administrative facility and accrued $396,197 related to abandonment of these
facilities. This amount was calculated as the present value of the remaining
lease rentals, reduced by the estimated market value of sublease rentals. The
actual expense will exceed this estimate for the time that we do not sublease
these facilities. Other exit costs consist primarily of legal and professional
fees related to the disposal activities and maintenance costs on the abandoned
facilities.
We report disposal costs for the period as Costs of Disposal Activities in the
Statement of Operations. A summary of the six months and total disposal costs
incurred is as follows:
Employee
Termination Excess Other Exit
Costs Facilities Costs Total
----------- ---------- ---------- ----------
Six Months Ended September 30, 2005 $359,774 $ -- $313,494 $ 673,268
======== ======== ======== ==========
Six Months Ended September 30, 2006 -- 112,860 35,943 148,803
======== ======== ======== ==========
Total Costs Incurred from
inception through September 30, 2006 $451,002 $631,339 $712,952 $1,795,293
======== ======== ======== ==========
We anticipate that in future periods, there will be additional disposal costs
related to professional fees and leasehold repair charges incurred upon our exit
from our leasehold facility in October 2006. These leasehold repair charges are
expected to exceed $100,000 during the second half of fiscal 2007.
Impairment of property and equipment and loss on sale of assets
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 would be sold or disposed
prior to the end of their useful life. In accordance with SFAS No. 144,
"Accounting for the Impairment or Disposal of Long-Term Assets," we wrote down
the value of our assets to their estimated fair values in June 2005. We
estimated the fair value based on the $8,700,000 sales price to Schreiber and
the anticipated sales price related to any other assets to be held for sale plus
future cash flows related to the assets from July 1, 2005 until the end of
production in November 2005. Based on this estimate, we recorded an impairment
of property and equipment of $7,896,554 in order to reflect a net fair value of
our equipment in June 2005.
26
All assets continued to be used and depreciated under Property and Equipment
until the sale of substantially all of our production machinery and equipment on
December 8, 2005. For the three and six months ended September 30, 2006, we
recorded a loss of $37,329 and $24,505 on the sale of assets sold or abandoned
after production ceased in December 2005. For the three and six months ended
September 30, 2005, we recorded a loss of $6,242 and $5,606 on the sale of
assets sold
We have reclassified our remaining assets available for sale as Assets Held for
Sale in the Balance Sheet and expect to sell these remaining assets by December
2006. We have estimated the fair value of these assets to be $1,500. Any
difference between the actual proceeds received and this estimated fair value
will be recognized as a gain or loss on the sale of assets in the period that
they are sold.
Other income and expense
Interest expense decreased approximately $161,360 or 25% in the six months ended
September 30, 2006 compared to the six months ended September 31, 2005. In the
six months ended September 30, 2006, we saw interest expense related to our debt
facilities decrease by approximately $294,000 due to the lower principal
balances and the payment in full of our property taxes with the proceeds from
the sale of our manufacturing equipment to Schreiber. This decrease was offset
by an increase in the amortization of loan costs and non-cash debt discounts.
The amortization of loan costs increased by approximately $20,000 due to
additional loan fees charged by our lenders. Additionally, pursuant to several
Note and Warrant Purchase Agreements entered into in fiscal 2006 and fiscal
2007, we issued warrants to purchase up to 800,000 shares of our common stock.
We recorded the initial fair value of the warrants of $18,000 and $444,731 in
fiscal 2007 and fiscal 2006, respectively, as a discount to debt. During the six
months ended September 30, 2006 and 2005, we amortized $129,819 and $13,000 of
this non-cash debt discount as interest expense.
Several of our loans facilities accrue interest based on a variable prime plus
rate. Due to the increases in the prime rate (currently at 8.25%), we will
experience higher interest rates in fiscal 2007 as compared to fiscal 2006 (in
which the prime rate averaged 6.7%). However, we anticipate that our interest
expense will decrease nearly 50% in fiscal 2007, despite the higher interest
rates, due to lower debt balances and lower non-cash debt discount amortization.
In accordance with EITF 00-19, if a contract requires settlement in registered
shares, then we 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. During the three and six months
ended September 30, 2005, we recorded a gain on the fair value of warrants of
$57,000 and $397,000 related to the change in the fair values of the warrants
during the period. There were no warrants that required a revaluation of fair
value during the three and six months ended September 30, 2006.
Liquidity And Capital Resources
$ %
6-Months Ended September 30, 2006 2005 Change Change
- ---------------------------------------- -------- ---------- ---------- -------
Cash from (used in) operating activities 666,074 (1,565,532) 2,231,606 -142.5%
Cash from (used in) investing activities 67,757 (61,825) 129,582 -209.6%
Cash used in financing activities (728,427) 1,065,575 (1,794,002) -168.4%
-------- --------- ---------- -----
Net increase (decrease) in cash 5,404 (561,782) 567,186 -101.0%
======== ========= ========== =====
Future Capital Needs
Our current business plan eliminates certain low margin private label and Galaxy
imitation business from our sales mix. The elimination of these low margin items
and the elimination of excess overhead that was part of our former manufacturing
operations should continue to result in higher gross margins with lower
operating costs and produce positive cash flows from operations in fiscal 2007.
With the reduction in overall debt and property taxes, we expect to see annual
interest savings in excess of $800,000 in fiscal 2007. Additionally, we
anticipate improved gross margins to provide over $1 million in additional cash
in fiscal 2007.
As a result of the successful refinancing of the $2.4 million short-term notes
and credit available for our receivables financing and the positive cash flow
that we are currently experiencing from operations, we believe that we have
sufficient cash resources to meet our current liquidity needs.
27
Operating and Investing Activities
We completed the sale of substantially all of our manufacturing and production
equipment and fully implemented the outsourcing of our production to Schreiber
in December 2005. Without the cash-flow burden of carrying inventory and higher
operating expenses due to excess plant capacity, we are experiencing improved
cash flows from operations from the higher margins and faster collections on
accounts receivable. We are continually reviewing our accounts receivable
collection practices in order to maximize cash flow from operations.
Cash used in investing activities primarily related to additional security
deposits that we paid in the first quarter of fiscal 2007 for our leased
facilities and a small amount of proceeds received on the sale of our remaining
assets held for sale. In the first quarter of fiscal 2006, cash used in
investing activities primarily related to our purchase of office and
manufacturing equipment. We do not anticipate any large capital expenditures
during fiscal 2007. However, it may be necessary to pay additional deposits or
leasehold improvements when we move our administrative offices in the third
quarter of fiscal 2007.
Financing Activities
6-Months Ended September 30, 2006 2005
- --------------------------------------- ---------- ----------
Net borrowings (payments) on line of
credit and bank overdrafts (519,820) (1,052,424)
Issuances of debt 1,200,000 1,200,000
Payments of debt and capital leases (1,408,607) (825,422)
Issuances of stock -- 1,743,421
---------- ----------
Cash used in financing activities (728,427) 1,065,575
========== ==========
Debt Financing
Secured Borrowings
On June 23, 2006, we entered into a Receivables Purchase Agreement with Systran
Financial Services Corporation, a subsidiary of Textron Financial Corporation
("Systran"), whereby Systran will provide financing to our Company through
advances against certain trade receivable invoices due to our Company (the
"Systran Agreement"). The Systran Agreement is secured by our accounts
receivable and all other assets. Generally, subject to a maximum principal
amount of $3,500,000 which can be borrowed under the Systran Agreement, the
amount available for borrowing is equal to 85% of our eligible accounts
receivable invoices less a dilution reserve and any required fixed dollar
reserves. The dilution and fixed dollar reserves have been initially set at 7%
and $100,000, respectively. Advances under the Systran Agreement bear interest
at a variable rate equal to the prime rate plus 1.5% per annum (9.75% on
September 30, 2006). We paid a one-time closing fee of $35,000 and are also
obligated to pay a $1,500 monthly service fee. The initial term of the Systran
Agreement ends on June 23, 2009 and may renew automatically for consecutive
twelve-month terms unless terminated sooner.
On June 23, 2006, Systran advanced $2,379,262 under the Systran Agreement of
which $1,839,086 was used to pay in full and terminate our obligations under our
line of credit with Textron Financial Corporation which was to terminate on June
27, 2006.
Related Party Notes Payable
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. In October 2005, pursuant to several Note and Warrant Purchase
Agreements dated September 28, 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. The combined total of these loans was
$2,400,000. The loans were evidenced by unsecured promissory notes (the "Notes")
held by the above referenced parties (the "Note Holders"). The Notes required
monthly interest-only payments at 3% above the bank prime rate of interest per
the Federal Reserve Bank and matured on June 15, 2006.
We did not have the short-term liquidity to pay our related party Note Holders
on the $2.4 million Notes that matured on June 15, 2006 in accordance with their
original terms. We received a letter on June 20, 2006 from all the Note Holders,
other than Mr. DeLuca, notifying the Company that its failure to pay the amounts
due and owing on the maturity date constitutes a default under $1.2 million of
the Notes held by those Note Holders. Pursuant to the terms of the Notes, since
we did not cure the default within 10 days after receipt of the notice of
default, we were obligated to pay interest at the default rate of 8% above the
Prime Rate beginning July 1, 2006. We amortized the final $126,979 of debt
discount costs related to the above transaction in the three months ended June
30, 2006.
28
Pursuant to a Note Purchase Agreement dated July 19, 2006, we issued a new
unsecured convertible note for $2,685,104 (the "Convertible Note") to Mr.
DeLuca. The proceeds from the Convertible Note were used to repay or refinance
the above mentioned $2.4 million Notes that matured on June 15, 2006 and a
$285,104 registration rights penalty owed to Mr. DeLuca. The Convertible Note
accrues interest at 12.5% per annum. No interest or principal payments are
required under the Convertible Note until its maturity on October 19, 2007.
Principal, together with any accrued and unpaid interest, on the Convertible
Note is convertible at any time prior to payment into shares of our common stock
at a conversion price of $0.35 per share. The market price of our common stock
as quoted on the OTC on July 19, 2006 was $0.28. As additional consideration for
making the loan, we issued Mr. DeLuca a warrant (the "Warrant") to purchase up
to 200,000 shares of our common stock at an exercise price equal to $0.35 per
share. The Warrant is fully vested and can be exercised on or before the
expiration date of July 19, 2009. In July 2006, we recorded the $18,000 fair
value of the Warrant as a discount to debt that will be amortized from July 2006
through October 2007.
Recent Accounting Pronouncements
In July 2006, the FASB issued Interpretation No. 48, "Accounting for Uncertainty
in Income Taxes - An Interpretation of FASB Statement No. 109" ("FIN 48"). FIN
48 provides guidance on the financial statement recognition and measurement of a
tax position taken or expected to be taken in a tax return. FIN 48 also provides
guidance on derecognition, classification, interest and penalties, accounting in
interim periods, disclosures, and transition. FIN 48 is effective for fiscal
years beginning after December 15, 2006. We are currently evaluating the impact
of this standard on our financial statements.
In September 2006, the FASB issued SFAS 157, "Fair Value Measurements." SFAS 157
simplifies and codifies guidance on fair value measurements under generally
accepted accounting principles. This standard defines fair value, establishes a
framework for measuring fair value and prescribes expanded disclosures about
fair value measurements. SFAS 157 is effective for financial statements issued
for fiscal years beginning after November 15, 2007, and interim periods within
those fiscal years, with early adoption permitted. We are currently evaluating
the effect, if any, the adoption of SFAS 157 will have on our financial
condition, results of operations and cash flows.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Our exposure to market risk results primarily from fluctuations in interest
rates. The interest rate on our outstanding debt to Systran as of September 30,
2006 is floating and based on the prevailing market interest rate. 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, 2006 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 $14,000 per
year or $3,500 per quarter.
Our sales during the quarters ended September 30, 2006 and 2005, 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. 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, 2006, 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 we
record, process, summarize and report 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. During the quarter ended September 30, 2006, there
were no changes in our internal controls over financial reporting or in other
factors that materially affected, or are reasonably likely to materially affect
those controls.
29
PART II. OTHER INFORMATION
Item 1A. Risk Factors
Statements other than historical information contained in this Form 10-Q are
considered "forward-looking statements" as defined under the Private Securities
Litigation Reform Act of 1995. 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," "could," "should," "potential," or "continue" or the negative or
variations of these words or similar expressions are intended to identify
forward-looking statements. Although we believe that these forward-looking
statements are reasonable at the time they are made, 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 statement as a result of a variety of factors as set
forth below. We are not required and 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.
In addition to the other information in this Form 10-Q and risk factors
previously disclosed in our Annual Report on Form 10-K for the year ended March
31, 2006, the following are some of the factors as of November 10, 2006, that
could cause our Company's actual results to differ materially from the expected
results described in or underlying our Company's forward-looking statements.
These factors should be considered carefully while evaluating our business and
prospects. If any of the following risks actually occur, they could seriously
harm our business, financial condition, results of operations or cash flows.
We have incurred significant losses.
We have incurred substantial losses in recent years and, as a result, have a
stockholders deficit of $2,919,365 as of September 30, 2006. Losses for the
years ended March 31, 2006, 2005 and 2004 were $24,148,553, $3,859,783 and
$3,299,277, respectively. We received a report from our independent accountants
relating to our audited financial statements as of March 31, 2006 containing a
paragraph stating that because we were then in default of our notes payable, had
suffered recurring losses from operations and at March 31, 2006 had deficiencies
in working capital and equity, there was substantive doubt as to our ability to
continue as a going concern. Our ability to continue as a going concern depended
upon successfully obtaining sufficient cash resources to refinance our $2.4
million of unsecured notes payable that matured on June 15, 2006 and obtaining
positive cash flow from operations to sustain normal business operations.
Pursuant to a Note Purchase Agreement dated July 19, 2006, we issued a new
unsecured convertible note for $2,685,104.17 (the "Convertible Note") to
Frederick A. DeLuca, a greater than 10% shareholder. The proceeds from the
Convertible Note were used to repay or refinance $2,400,000 in unsecured
promissory notes that matured on June 15, 2006 (including one such note in the
principal amount of $1,200,000 owned by Mr. DeLuca) and a $285,104.17
registration rights penalty owed to Mr. DeLuca. The Convertible Note accrues
interest at 12.5% per annum. No interest or principal payments are required
under the Convertible Note until its maturity on October 19, 2007. Principal,
together with any accrued and unpaid interest, on the Convertible Note is
convertible at any time prior to payment into shares of our common stock at a
conversion price of $0.35 per share. The market price of our common stock as
quoted on the OTC on July 19, 2006 was $0.28. As additional consideration for
making the loan, we issued Mr. DeLuca a warrant (the "Warrant") to purchase up
to 200,000 shares of our common stock at an exercise price equal to $0.35 per
share. The Warrant is fully vested and can be exercised on or before the
expiration date of July 19, 2009.
Our current business plan eliminates certain low margin private label and Galaxy
imitation business from our sales mix. The elimination of these low margin items
and the elimination of excess overhead that was part of our former manufacturing
operations should continue to result in higher gross margins with lower
operating costs and produce positive cash flows from operations in fiscal 2007.
As a result of the successful refinancing of the $2.4 million short-term notes
and line of credit for our receivables financing and the positive cash flow that
we are currently experiencing from operations, we believe that we have
sufficient cash resources to meet our current liquidity needs.
We may be required to pay substantial penalties under our Supply Agreement and
may not have the ability to do so.
The initial term of the Supply Agreement with Schreiber 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). If we
30
do not exercise our first option to extend the term, then we will be obligated
to pay Schreiber $1,500,000. If we exercise our first option to extend the term,
but do not exercise our second option to extend the term, then we will be
obligated to pay Schreiber $750,000.
Additionally, the Supply Agreement provided for a contingent short-fall payment
obligation up to $8,700,000 by our Company if a specified production level was
not met during the one-year period from September 1, 2006 to August 31, 2007. If
a contingent short-fall payment was 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 exceeded the specified target level of
production, if any. The short-fall payment is based on formula that calculates
the payment as follows: ((required pounds shipped - actual pounds shipped) /
required pounds shipped) * $8,700,000. In November 2006, the Supply Agreement
was amended so that the short-fall payment obligation would not be measured
until September 1, 2009 to August 31, 2010 and the target level of production
was reduced by approximately 22%. Although we have significantly improved our
gross margins by discontinuing production of low margin products, our total
sales (and the corresponding volume of our products being produced) have been
substantially reduced. We will need to greatly increase our present production
volume before the measuring period from September 1, 2009 to August 31, 2010 in
order to avoid a substantial shortfall payment. Based on our present production
volume, the estimated short-fall payment could exceed $5,200,000.
In either event, we may not have the ability to pay the required payments and
Schreiber may use its contractual rights in order to collect and may cease
production and shipment of our products. Such an action would have a material
adverse affect on the liquidity and financial condition of our Company and it is
unlikely that we would be able to continue as a going concern.
A private investor owns a large percentage of the outstanding shares, which
could materially limit the ownership rights of investors.
As of November 10, 2006, Frederick DeLuca, a private investor, owned
approximately 23% of our outstanding common stock and held warrants and a
convertible note which, if exercised with accrued and unpaid interest on the
convertible note as of such date and assuming the exercise of no other
outstanding options or warrants, would give him ownership of approximately 48%
of our outstanding common stock. Investors who purchase common stock in our
Company may be unable to elect any specific members of the board of directors or
exercise significant control over us or our business as a result of Mr. Deluca's
ownership. Additionally, Mr. DeLuca may be able to exercise significant
influence over our policies and Board composition.
Stockholders may experience further dilution.
We have a substantial number of outstanding options, warrants and a convertible
note to acquire shares of common stock. As of November 10, 2006, we have a total
of 14,609,853 shares reserved for issuance upon exercise of options, warrants
and a convertible note that we have granted. Of this total, 8,172,734 are
exercisable securities that are "in the money." "In the money" generally means
that the current market price of the common stock is above the exercise price of
the shares subject to the option, warrant or note conversion. The issuance of
common stock upon the exercise of these options and warrants or note conversion
could adversely affect the market price of the common stock or result in
substantial dilution to our existing stockholders. In addition, any future
securities issuances by our Company, could result in the issuance, or potential
issuance, of a significant amount of equity securities that will cause
substantial dilution to our stockholders, particularly given the current low
trading price of our common stock.
Because we sell food products, we face the risk of exposure to product liability
claims.
We, like any other seller of food products, face the risk of exposure to product
liability claims in the event that our manufacturer's quality control procedures
fail and the consumption of our products causes injury or illness. In July 2006,
we initiated a voluntary product recall on one of our Vegan products after we
discovered that the product produced by a sub-manufacturer may contain traces of
undeclared milk ingredients. The recall was limited to our Vegan Parmesan Flavor
Soy Topping with expiration codes between April 2007 and May 2007 of which we
had sold approximately $65,000. With respect to product liability claims, our
insurance may not continue to be available at a reasonable cost, or, if
available, may not be adequate to cover liabilities. We generally seek
contractual indemnification and insurance coverage from parties supplying us
products, but this indemnification or insurance coverage is limited, as a
practical matter, to the creditworthiness of the indemnifying party, and their
carriers, if any, as well as the limits of any insurance provided by suppliers.
If we do not have adequate insurance or contractual indemnification available,
product liability claims relating to defective products could have a material
adverse effect on our financial condition, results of operations and cash flows.
31
ITEM 4. Submission of Matters to a Vote of Security Holders
The Company held its annual stockholder meeting on September 29, 2006. As of the
record date on August 8, 2006, there were 17,109,910 shares of common stock
issued, outstanding and eligible to vote. In this meeting, the shareholders
voted on and approved the following proposals:
1. To elect five directors for a term of one year each, until the next
annual meeting of stockholders and until their successors are
elected and qualify. The board members were voted in with the
following number of votes for their election:
Votes Cast Votes
Director FOR WITHHELD
--------------------------------------------
David H. Lipka 12,871,661 764,657
Michael E. Broll 12,878,951 757,367
Peter J. Jungsberger 12,894,231 742,087
Robert S. Mohel 12,894,680 741,638
Angelo S. Morini 13,057,176 579,142
2. To approve the Galaxy Nutritional Foods, Inc. 2006 Stock Incentive
Plan. The vote tabulation for this proposal was as follows: VOTES
CAST FOR - 6,181,368; VOTES CAST AGAINST - 3,202,371; ABSTENTIONS -
602,877; BROKER NON-VOTES - 3,649,702.
3. To ratify the retention of Cross, Fernandez and Riley, L.L.P. as the
independent registered public accounting firm of the Company for the
fiscal year ending March 31, 2007. The vote tabulation for this
proposal was as follows: VOTES CAST FOR - 12,995,740; VOTES CAST
AGAINST - 34,729; ABSTENTIONS - 605,849; BROKER NON-VOTES - none.
32
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.)
* 4.18 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.)
* 4.27 Warrant to Purchase Securities of Galaxy Nutritional Foods, Inc.
dated July 19, 2006 in favor of Frederick A. DeLuca (Filed as
Exhibit 4.27 on Form 8-K filed July 25, 2006.)
* 4.28 Convertible Note in the principal amount of $2,685,104.17 dated as
of July 19, 2006 by Galaxy Nutritional Foods, Inc. in favor of
Frederick A. DeLuca (Filed as Exhibit 4.26 on Form 8-K filed July
25, 2006.)
* 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.)
33
* 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.)
* 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. Portions of the Supply
Agreement have been omitted as indicated by asterisks pursuant to a
request for confidential treatment in accordance with Section
552(b)(4) of the Freedom of Information Act ("FOIA"), 5 U.S.C.
552(b)(4) (Filed as Exhibit 10.19 on Form 8-K filed July 6, 2005.)
34
* 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.)
* 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 as Exhibit 10.27 on Form 10-Q for the
fiscal quarter ended September 30, 2005.)
* 10.28 Fifth Amendment to Loan and Security Agreement dated November 14,
2005 between Galaxy Nutritional Foods, Inc. and Textron Financial
Corporation (Filed as Exhibit 10.28 on Form 10-Q for the fiscal
quarter ended September 30, 2005.)
* 10.29 Sixth Amendment to Loan and Security Agreement dated May 26, 2006
between Galaxy Nutritional Foods, Inc. and Textron Financial
Corporation (Filed as Exhibit 10.29 on Form 8-K filed June 1,
2006.)
* 10.30 Receivables Purchase Agreement, together with Addendum, dated June
23, 2006 between Galaxy Nutritional Foods, Inc. and Systran
Financial Services Corporation (Filed as Exhibit 10.30 on Form 8-K
filed June 29, 2006.)
* 10.31 Note Purchase Agreement dated July 19, 2006 between Galaxy
Nutritional Foods, Inc. and Frederick A. DeLuca (Filed as Exhibit
10.31 on Form 8-K filed July 25, 2006.)
* 10.32 Termination Agreement dated July 31, 2006 between Galaxy
Nutritional Foods, Inc. and CLP Industrial Properties (Filed as
Exhibit 10.32 on Form 8-K filed August 3, 2006.)
* 10.33 Non-plan Option to Purchase Securities of Galaxy Nutritional Foods,
Inc. dated August 7, 2006 in favor of Peter J. Jungsberger (Filed
as Exhibit 10.33 on Form 10-Q for the fiscal quarter ended June 30,
2006.)
* 10.34 Non-plan Option to Purchase Securities of Galaxy Nutritional Foods,
Inc. dated August 7, 2006 in favor of Robert S. Mohel (Filed as
Exhibit 10.34 on Form 10-Q for the fiscal quarter ended June 30,
2006.)
* 10.35 Non-plan Option to Purchase Securities of Galaxy Nutritional Foods,
Inc. dated August 17, 2006 in favor of David H. Lipka (Filed as
Exhibit 10.35 on Form 8-K filed August 21, 2006.)
* 10.36 Non-plan Option to Purchase Securities of Galaxy Nutritional Foods,
Inc. dated August 17, 2006 in favor of Michael E. Broll (Filed as
Exhibit 10.36 on Form 8-K filed August 21, 2006.)
* 10.37 Non-plan Option to Purchase Securities of Galaxy Nutritional Foods,
Inc. dated August 17, 2006 in favor of Angelo S. Morini (Filed as
Exhibit 10.37 on Form 8-K filed August 21, 2006.)
35
* 10.38 Sublease Agreement dated October 3, 2006 between Galaxy Nutritional
Foods, Inc. and Oracle Corporation (Filed as Exhibit 10.38 on Form
8-K filed October 10, 2006.)
10.39 Letter Agreement accepted November 9, 2006 between Galaxy
Nutritional Foods, Inc. and Schreiber Foods, Inc. amending the
Supply Agreement dated June 30, 2005 between the parties. Portions
of the Letter Agreement have been omitted as indicated by asterisks
pursuant to a request for confidential treatment in accordance with
Section 552(b)(4) of the Freedom of Information Act ("FOIA"), 5
U.S.C. 552(b)(4) (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.
36
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, 2006 /s/ Michael E. Broll
----------------------------------------
Michael E. Broll
Chief Executive Officer
(Principal Executive Officer)
Date: November 14, 2006 /s/ Salvatore J. Furnari
----------------------------------------
Salvatore J. Furnari
Chief Financial Officer
(Principal Accounting and Financial
Officer)
37