FORM 10-Q
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20459
[X] QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the quarterly period ended June 30, 2003
or
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
Commission File Number 333-31931
NORTH ATLANTIC TRADING COMPANY, INC.
-----------------------------------------------------
(Exact name of Registrant as Specified in its Charter)
DELAWARE 13-3961898
------------------------------- ----------------
(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification No.)
257 Park Avenue South, New York, New York 10010-7304
- ----------------------------------------- ----------
(Address of Principal Executive Offices) (Zip Code)
(212) 253-8185
--------------------------------------------------
(Registrant's Telephone Number, Including Area Code)
Unchanged
(Former name, Former Address and Former Fiscal Year,
if Changed Since Last Report)
Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ].
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [ X].
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date: 528,241 shares of common stock,
$.01 par value, as of August 6, 2003.
PART I
FINANCIAL INFORMATION
Item 1. Financial Statements
NORTH ATLANTIC TRADING COMPANY, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands except share data)
(unaudited)
June 30, December 31,
2003 2002
---------------- ----------------
Current assets:
Cash $ 354 $ 805
Accounts receivable, net 6,813 7,651
Inventories 42,746 40,818
Income taxes receivable 910 887
Other current assets 4,159 3,457
---------------- ----------------
Total current assets 54,982 53,618
Property, plant and equipment, net 5,469 5,158
Deferred income taxes 33,181 24,916
Deferred financing costs 1,949 2,642
Goodwill 123,557 123,557
Other assets 3,778 3,703
---------------- ----------------
Total assets $ 222,916 $ 213,594
================ ================
Current liabilities:
Accounts payable $ 2,375 $ 2,868
Accrued expenses 3,148 2,429
Deferred income taxes 10,552 10,552
Revolving credit facility 9,500 5,500
Accrued litigation 18,600 -
Senior Notes 155,000 -
----------------
Total current liabilities 199,175 21,349
Long-term debt - 155,000
Other long-term liabilities 12,793 12,793
Total liabilities 211,968 189,142
Commitments and contingencies
Preferred Stock, (mandatory redemption value of
$61,304 and $57,805, respectively) 61,304 57,805
Stockholders' Deficit:
Common stock, voting, $.01 par value authorized shares, 750,000;
issued and outstanding shares, 528,241 5 5
Common stock, nonvoting, $.01 par value; authorized shares,
750,000; issued and outstanding shares, -0- - -
Additional paid-in capital 9,232 9,246
Loans to stockholders for stock purchase (160) (157)
Accumulated other comprehensive income (loss) (1,125) (1,125)
Accumulated deficit (58,308) (41,322)
---------------- ----------------
Total stockholders' deficit (50,356) (33,353)
---------------- ----------------
Total liabilities and stockholders' deficit $ 222,916 $ 213,594
================ ================
The accompanying notes are an integral part of the unaudited condensed
consolidated financial statements.
2
NORTH ATLANTIC TRADING COMPANY, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands except per share amounts)
(unaudited)
Three months Three Months
Ended Ended
June 30, 2003 June 30, 2002
---------------- ----------------
Net sales $ 30,251 $ 18,218
Cost of sales 12,755 8,530
---------------- ----------------
Gross profit 17,496 9,688
Selling, general and administrative expenses 7,364 5,854
---------------- ----------------
Operating income 10,132 3,834
Interest expense and financing costs, net 4,671 4,677
Other expense 21,681 333
---------------- ----------------
Income (loss) before income tax benefit (16,220) (1,176)
Income tax benefit (6,164) (447)
---------------- ----------------
Net income (loss) (10,056) (729)
Preferred stock dividends (1,766) (1,846)
---------------- ----------------
Net loss applicable to common shares $ (11,822) $ (2,575)
================ ================
Basic and Diluted earnings per common share:
Net income (loss) $ (19.04) $ (1.38)
Preferred stock dividends (3.34) (3.50)
---------------- ----------------
Net loss applicable to common shares $ (22.38) $ (4.88)
================ ================
Weighted average common shares outstanding:
Basic 528.2 528.2
Diluted 528.2 528.2
The accompanying notes are an integral part of the unaudited condensed
consolidated financial statements.
3
NORTH ATLANTIC TRADING COMPANY, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands except per share amounts)
(unaudited)
Six months Six Months
Ended Ended
June 30, 2003 June 30, 2002
---------------- ----------------
Net sales $ 44,500 $ 40,170
Cost of sales 20,454 17,199
---------------- ----------------
Gross profit 24,046 22,971
Selling, general and administrative expenses 14,466 11,653
---------------- ----------------
Operating income 9,580 11,318
Interest expense and financing costs, net 9,313 9,398
Other expense 22,018 694
---------------- ----------------
Income (loss) before income tax expense (benefit) (21,751) 1,226
Income tax expense benefit (8,265) 466
---------------- ----------------
Net income (loss) (13,486) 760
Preferred stock dividends (3,500) (3,639)
---------------- ----------------
Net loss applicable to common shares $ (16,986) $ (2,879)
================ ================
Basic and Diluted earnings per common share:
Net income (loss) $ (25.53) $ 1.44
Preferred stock dividends (6.63) (6.89)
---------------- ----------------
Net loss applicable to common shares $ (32.16) $ (5.45)
================ ================
Weighted average common shares outstanding:
Basic 528.2 528.2
Diluted 528.2 528.2
The accompanying notes are an integral part of the unaudited condensed
consolidated financial statements.
4
NORTH ATLANTIC TRADING COMPANY, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)
Six months Six Months
Ended Ended
June 30, 2003 June 30, 2002
---------------- ----------------
Cash flows from operating activities:
Net income (loss) $ (13,486) $ 760
Adjustments to reconcile net income (loss)
to net cash provided by (used in) operating activities:
Depreciation 250 350
Amortization of deferred financing costs 693 693
Deferred income taxes (8,265) 466
Changes in operating assets and liabilities:
Accounts receivable, net 838 (609)
Inventories (1,928) 228
Other current assets (725) (201)
Other assets (75) (118)
Accounts payable (493) (222)
Accrued expenses and other 719 (1,010)
Accrued litigation 18,600 -
---------------- ----------------
Net cash provided by (used in) operating activities (3,872) 337
---------------- ----------------
Cash flows from investing activities:
Capital expenditures (561) (209)
Net cash provided by (used in) investing activities (561) (209)
---------------- ----------------
Cash flows from financing activities:
Proceeds from revolving credit facility 4,000 5,000
Payments on term loans -- (6,250)
Other (18) (8)
---------------- ----------------
Net cash provided by (used in) financing activities 3,982 (1,258)
---------------- ----------------
Net decrease in cash (451) (1,130)
Cash, beginning of period 805 1,130
---------------- ----------------
Cash, end of period $ 354 $ -
================ ================
The accompanying notes are an integral part of the unaudited condensed
consolidated financial statements.
5
NORTH ATLANTIC TRADING COMPANY, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
1. ORGANIZATION
These condensed consolidated financial statements should be read in conjunction
with the financial statements and related notes thereto included in North
Atlantic Trading Company, Inc.'s (the "Company's") Annual Report on Form 10-K
for the year ended December 31, 2002.
The accompanying condensed consolidated financial statements are presented in
accordance with the requirements of Form 10-Q and, accordingly, do not include
all the disclosures normally required by generally accepted accounting
principles. The condensed consolidated financial statements have been prepared
in accordance with the Company's customary accounting practices and have not
been audited. In the opinion of management, all adjustments necessary to fairly
present the results of operations for the reported interim periods have been
recorded and were of a normal and recurring nature. The year-end balance sheet
data was derived from audited financial statements, but does not include all
disclosures required by generally accepted accounting principles.
The accompanying condensed consolidated financial statements have been prepared
assuming the Company will continue as a going concern, which indicates that the
Company will be able to realize its assets and liquidate its liabilities in the
normal course of business. The Company's 11% Senior Notes ("the Notes") mature
on June 15, 2004, and as such, have been classified as a current liability in
the condensed consolidated balance sheet. The Company's senior secured bank loan
facilities include a revolving credit facility that matures on December 31, 2003
and a term loan that matures on March 31, 2004. In addition, the Company's 12%
Senior Exchange Payment-in-Kind Preferred Stock ("Preferred Stock") is subject
to mandatory redemption on June 15, 2005. It is the Company's intention to
refinance the Senior Notes and senior secured bank loan facilities prior to
their scheduled maturities and to redeem the Preferred Stock prior to the date
of mandatory redemption. Although the Company believes it will successfully
refinance such obligations, there can be no assurance such refinancing will be
obtained. In the event the Company is not able to effect such refinancing, its
ability to continue to operate as a going concern cannot be assured. The
Condensed Consolidated Financial Statements do not include any adjustments that
might result from the occurrence of this contingency.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:
REVENUE RECOGNITION: The Company recognizes revenues and the related costs upon
transfer of title and risk of loss to the customer.
SHIPPING COSTS: The Company records shipping costs incurred as a component of
selling, general and administrative expenses. Shipping costs were $0.7 million
and $0.6 million for the three months ended June 30, 2003 and 2002,
respectively, and $1.3 million and $1.3 million for the six months ended June
30, 2003 and 2002, respectively.
The accompanying notes are an integral part of the unaudited condensed
consolidated financial statements.
6
MASTER SETTLEMENT AGREEMENT ESCROW ACCOUNT: Pursuant to the Master Settlement
Agreement (the "MSA") entered into in November 1998 by most states (represented
by their attorneys general acting through the National Association of Attorneys
General) and subsequent states' statutes, a "cigarette manufacturer" (which is
defined to include a manufacturer of make-your-own cigarette tobacco) has the
option of either becoming a signatory to the MSA or opening, funding, and
maintaining an escrow account to have funds available for certain potential
tobacco-related liabilities, with sub-accounts on behalf of each settling state.
The Company has chosen to open and fund an escrow account as its method of
compliance. It is the Company's policy to record amounts on deposit in the
escrow account for prior years, as well as cash-on-hand to fund its projected
deposit based on its monthly sales for the current year, as an Other asset. Each
year's obligation is required to be deposited in the escrow account by April 15
of the following year. The Company deposited $0.9 million on April 15, 2003 for
its 2002 sales activity. As of June 30, 2003, the Company has recorded total
escrow deposits as an Other asset of $2.1 million.
3. INVENTORIES
Inventories are stated at the lower of cost or market. Cost is determined on the
last-in, first-out ("LIFO") method. Leaf tobacco is presented in current assets
in accordance with standard industry practice, notwithstanding the fact that
such tobaccos are carried longer than one year for the purpose of curing.
The impact of LIFO increased the net loss of the Company by $0.4 million and
$0.3 million for the three months ended June 30, 2003 and 2002, respectively,
and $0.5 million and $0.5 million for the six months ended June 30, 2003 and
2002, respectively.
The components of inventories are as follows (in thousands):
6/30/03 12/31/02
--------- ---------
Raw materials and work in process $4,012 $3,111
Leaf tobacco 8,867 10,328
Finished goods - loose leaf tobacco 4,196 4,174
Finished goods - MYO products 7,515 4,722
Other 851 728
--------- ---------
25,441 23,063
LIFO reserve 17,305 17,755
--------- ---------
$42,746 $40,818
========= =========
4. PROVISION FOR INCOME TAXES
The provision for income taxes for the six months ended June 30, 2003 and June
30, 2002 was computed based on the estimated annual effective income tax rate of
38%.
5. PARENT-ONLY FINANCIAL INFORMATION
North Atlantic Trading Company, Inc. is a holding company with no operating
assets, rather its assets consist primarily of its investment in subsidiaries,
deferred income tax assets related to the differences between the book and tax
The accompanying notes are an integral part of the unaudited condensed
consolidated financial statements.
7
basis of its investment in National Tobacco Company, L.P., a subsidiary of the
Company, and deferred financing costs related to its debt. All of the Company's
subsidiaries are wholly-owned and guarantee the Company's debt on a full,
unconditional and joint and several basis. In management's opinion, separate
financial statements of the subsidiaries are not meaningful and are not included
herein. The following represents unaudited parent-only summarized financial
information of North Atlantic Trading Company, Inc. (in thousands):
6/30/03 12/31/02
---------- ----------
Current assets $ - $ -
Noncurrent assets 184,907 189,129
Current liabilities 172,440 10,732
Noncurrent liabilities - 155,000
Redeemable preferred stock 61,303 57,805
For the three months ended June 30: 2003 2002
--------- ----------
Equity in earnings of subsidiaries $ (14,670) $ 3,100
Interest expense (4,706) (4,720)
Income tax benefit 9,127 914
---------- ----------
Net income (loss) before preferred stock dividends $ (10,249) $ (706)
For the six months ended June 30: 2003 2002
---------- ----------
Equity in earnings of subsidiaries $ (14,493) $ 8,304
Interest expense (9,374) (9,475)
Income tax benefit 10,390 1,974
---------- ----------
Net income (loss) before preferred stock dividends $ (13,477) $ 803
========== ==========
6. FINANCIAL INSTRUMENTS
The Company occasionally uses short-term forward currency contracts to hedge the
risk in foreign currency exchange rates. In accordance with the provisions of
SFAS No. 133, "Accounting for Derivative Financial Instruments and Hedging
Activities," the Company's policy is to designate its forward currency contracts
as cash flow hedges of its anticipated purchases in Euros. As of June 30, 2003,
the Company had no outstanding forward currency contracts.
The accompanying notes are an integral part of the unaudited condensed
consolidated financial statements.
8
7. RECONCILIATION OF INCOME (LOSS) PER COMMON SHARE
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS):
THREE MONTHS ENDED JUNE 30, 2003
- --------------------------------
Income Shares Per Share
(Numerator) (Denominator) Amount
-------------- -------------- --------------
Basic and Diluted:
Net loss $ (10,056)
Less: preferred stock dividends (1,766)
--------------
Net loss applicable to common shares $ (11,822) 528,241 $ (22.38)
============== ============== ==============
THREE MONTHS ENDED JUNE 30, 2002
- --------------------------------
Income Shares Per Share
(Numerator) (Denominator) Amount
-------------- -------------- --------------
Basic and Diluted:
Net loss $ (729)
Less: preferred stock dividends (1,846)
--------------
Net loss applicable to common shares $ (2,575) 528,241 $ (4.88)
============== ============== ==============
SIX MONTHS ENDED JUNE 30. 2003
- ------------------------------
Income Shares Per Share
(Numerator) (Denominator) Amount
-------------- -------------- --------------
Basic and Diluted:
Net loss $ (13,486)
Less: preferred stock dividends (3,500)
--------------
Net loss applicable to common shares $ (16,986) 528,241 $ (32.16)
============== ============== ==============
SIX MONTHS ENDED JUNE 30, 2002
- ------------------------------
Income Shares Per Share
(Numerator) (Denominator) Amount
-------------- -------------- --------------
Basic and Diluted:
Net income $ 760
Less: preferred stock dividends (3,639)
--------------
Net loss applicable to common shares $ (2,879) 528,241 $ (5.45)
============== ============== ==============
The calculations are based on the weighted average number of shares of common
stock outstanding during the respective periods. Common stock equivalent shares
from warrants, representing 81,200 and 63,500 shares for the three months and
six months periods ended June 30, 2003 and 2002, respectively, and common stock
equivalent shares from stock options, representing 95,300 and 61,800 shares, for
the three months and six months ended June 30, 2003 and 2002, respectively, were
excluded from the computations as their effects were antidilutive.
8. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In June 2001, the Financial Accounting Standards Board ("FASB"), issued
Statement No. 142, "Goodwill and Other Intangible Assets" ("SFAS 142"). SFAS 142
requires that goodwill no longer be amortized to earnings, but instead be
reviewed at least annually for impairment using a two-step process. The first
step is a test for potential impairment, and the second measures the amount of
impairment, if any. Upon adopting SFAS 142 on January 1, 2002, the Company
ceased amortizing goodwill. In completing the required first step of the
transitional impairment test for 2003, the Company incurred no impairment.
Subsequent impairments, if any, will be classified as an operating expense. In
addition, SFAS 142 specifies the types of acquired intangible assets that are
required to be recognized and reported separately from goodwill.
The accompanying notes are an integral part of the unaudited condensed
consolidated financial statements.
9
In August 2001, the FASB issued Statement No. 143, "Accounting for Asset
Retirement Obligations" ("SFAS 143"). SFAS 143 requires that obligations
associated with the retirement of a tangible long-lived asset be recorded as a
liability when those obligations are incurred, with the amount of the liability
initially measured at fair value. Upon initially recognizing a liability for an
asset-retirement obligation ("ARO"), an entity must capitalize the cost by
recognizing an increase in the carrying amount of the related long-lived asset.
Over time, the liability is accreted to its present value each period, and the
capitalized cost is depreciated over the useful life of the related asset. Upon
settlement of the liability, an entity either settles the obligation for its
recorded amount or incurs a gain or loss upon settlement. The Company adopted
the provisions of SFAS 143 effective January 1, 2003. SFAS 143 did not have an
impact on the Company's financial statements.
In April 2002, the FASB issued Statement No. 145, "Rescission of FASB Statements
No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical
Corrections" ("SFAS 145"). SFAS 145 eliminates the automatic classification of
gain or loss on extinguishment of debt as an extraordinary item of income and
requires that such gain or loss be evaluated for extraordinary classification
under the criteria of Accounting Principles Board Opinion No. 30, "Reporting
Results of Operations." This Statement also requires sales-leaseback accounting
for certain lease modifications that have economic effects that are similar to
sales-leaseback transactions, and makes various other technical corrections to
existing pronouncements. This Statement became effective for the Company on
January 1, 2003. The adoption of SFAS 145 did not have an impact on the
Company's financial statements.
In July 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated
with Exit or Disposal Activities" ("SFAS 146"). SFAS 146 sets forth various
modifications to existing accounting guidance which prescribes the conditions
which must be met in order for costs associated with contract terminations,
facility consolidations, employee relocations and terminations to be accrued and
recorded as liabilities in financial statements. The provisions of SFAS 146, as
related to exit or disposal activities, are effective for transactions occurring
after December 31, 2002. To date, the adoption of SFAS 146 does not have an
impact on the Company's financial statements.
In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based
Compensation-Transition and Disclosure" ("SFAS 148"). SFAS 148 amends SFAS 123
providing alternative methods of transition for a voluntary change to the fair
value based method of accounting for stock-based employee compensation. SFAS 148
also amends the disclosure requirements of SFAS 123 and requires additional
disclosures in annual and interim financial statements regarding the method of
accounting for stock-based employee compensation and the effect of the method
used in determining financial results. The Company accounts for stock-based
compensation in accordance with SFAS No. 123. Therefore, SFAS 148 does not have
an impact on the Company's financial statements.
The accompanying notes are an integral part of the unaudited condensed
consolidated financial statements.
10
In November 2002, the FASB issued Financial Accounting Standards Board
Interpretation No. 45, Guarantor's Accounting and Disclosure Requirements for
Guarantees, Including Indirect Guarantees of Indebtedness of Others, and
interpretation of FASB Statements No. 5, 57, and 107 and Rescission of FASB
Interpretations No. 34 ("FIN 45"). FIN 45 requires that, upon issuance of a
guarantee, the entity must recognize a liability for the fair value of the
obligation it assumes under that guarantee. FIN 45 requires disclosure about
each guarantee even if the likelihood of the guarantor's having to make any
payments under the guarantee is remote. The provisions for initial recognition
and measurement are effective on a prospective basis for guarantees that are
issued or modified after December 31, 2002. The adoption of the recognition
provision of FIN 45 did not have an impact on the Company's financial
statements. The disclosure provisions of FIN 45 were effective for the Company's
December 31, 2002 audited financial statements.
In January 2003, the FASB issued Financial Accounting Standards Board
Interpretation No. 46, Consolidation of Variable Interest Entities, an
Interpretation of ARB No. 51 ("FIN 46"). FIN 46 requires certain variable
interest entities to be consolidated by the primary beneficiary of the entity if
the equity investors in the entity do not have the characteristics of a
controlling financial interest or do not have sufficient equity at risk for the
entity to finance its activities without additional subordinated financial
support from other parties. FIN 46 is effective immediately for all new variable
interest entities created or acquired after January 31, 2003. For variable
interest entities created or acquired prior to February 1, 2003, the provisions
of FIN 46 must be applied for the first interim or annual period beginning after
June 15, 2003. As the Company does not currently hold any variable interest
entities, FIN 46 does not currently have an impact on the Company's financial
statements.
In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial
Instruments with Characteristics of both Liabilities and Equity" (SFAS 150").
SFAS 150 establishes standards for how an issuer classifies and measures certain
financial instruments with characteristics of both liabilities and equity. The
provisions of SFAS 150 apply immediately to all financial instruments entered
into or modified after May 31, 2003, and otherwise is effective at the beginning
of the first interim period beginning after June 15, 2003. In accordance with
the foregoing, the Company is currently assessing the impact of the adoption of
SFAS 150 on its financial statements.
9. TERMINATED ASSET PURCHASE AGREEMENT
On February 18, 2003, the Company entered into an asset purchase agreement (the
"Star Cigarette Asset Purchase Agreement") with Star Scientific, Inc. ("Star
Scientific"), and Star Tobacco, Inc., a wholly-owned subsidiary of Star
Scientific ("Star Tobacco" and, together with Star Scientific, "Star"). Pursuant
to the Star Cigarette Asset Purchase Agreement, the Company was to purchase
substantially all of the assets of Star relating to the manufacturing, marketing
The accompanying notes are an integral part of the unaudited condensed
consolidated financial statements.
11
and distribution of four discount cigarette brands in the United States (the
"Star Cigarette Assets"). The purchase price for the Star Cigarette Assets was
to have been $80.0 million in cash, subject to certain closing adjustments and
the assumption of certain liabilities related to the Star Cigarette Assets.
On July 15, 2003, the Company and Star reached a mutual agreement to terminate
the Star Cigarette Asset Purchase Agreement. Pursuant to the termination
agreement, Star Scientific retained a $2.0 million earnest money deposit that
had been placed into escrow by the Company and the parties executed releases of
any liabilities arising out of the Star Cigarette Asset Purchase Agreement.
Through June 30, 2003, the Company incurred $2.9 million of direct costs,
including the $2.0 million earnest money deposit referred to above, in
connection with this transaction. These costs have been expensed during the
quarter ended June 30, 2003 and are included in Other expenses.
10. CONTINGENCIES
Except as described below, there have not been any significant developments with
respect to legal proceedings and pending litigation or any change to the
Company's position as previously disclosed in the Company's Form 10-K for the
year ended December 31, 2002.
Illinois Complaint.
- -------------------
On July 8, 2003, following a four day trial, the jury returned a verdict in
favor of Republic Tobacco, Inc. on defamation claims of $8.4 million in general
damages and $10.2 million in punitive damages. On July 23, 2003, the Company
filed a post-trial motion seeking to set aside the verdict, a new trial or, in
the alternative, a reduction in damages. On July 30, 2003, the Court set a
briefing schedule allowing Republic to file their response on August 8, 2003 and
the Company to file its counter response on August 22, 2003. The Company's
motion is scheduled to be argued on September 10, 2003. On August 1, 2003, the
Company posted a judgment bond in the amount of $18.8 million with the U.S.
District Court. If the Company does not obtain the relief requested in its
post-trial motion, the Company expects to appeal. The Company continues to
believe that it has viable defenses to Republic's claims, including those
relating to fair comment privilege and the innocent construction rule and that,
if the judgment is not reversed in its entirety, the amount thereof should be
substantially reduced. There can be no assurance, however, that the Company will
prevail in obtaining relief pursuant to its post-trial motion or on appeal.
Pursuant to the provisions of SFAS No. 5, "Accounting for Contingencies," the
Company accrued $18.6 million in Other expense in the Condensed Consolidated
Statement of Operations.
Minnesota Complaint.
- --------------------
All of the plaintiff's claims for personal injury against the Company have been
dismissed, and the Court denied the plaintiff's motion for reconsideration.
Plaintiff has filed notice to appeal these dismissals and the parties are in the
process of submitting briefs with respect thereto.
The accompanying notes are an integral part of the unaudited condensed
consolidated financial statements.
12
Texas Infringing Products Litigation.
- -------------------------------------
On June 27, 2003, the Court found Import Warehouse and Ravi Bhatia in contempt
of court for violating an existing injunction barring those parties from
distributing infringing Zig-Zag(TM) cigarette paper products. The Court
requested that the Company and Bollore, SA (the Company's co-plaintiff in the
case) file a submission detailing the damages incurred. The Company and Bollore
filed their submission on July 25, 2003 which reports damages of $2.4 million.
Import Warehouse and Mr. Bhatia are preparing their response.
California Infringing Products Litigation.
- ------------------------------------------
In addition to the judgment previously entered in Bollore, S.A. and the
Company's (the "plaintiffs'") favor in the amount of $1.7 million, on March 27,
2003, the Court ordered Downey Wholesale Inc. and Fadel El-Shahawi (the
"defendants'") to pay plaintiffs $751,000 in attorneys' fees and expenses. The
defendants filed a motion to appeal and the Court has postponed the briefing
schedule relating thereto pending a Court-sponsored mediation. The mediation is
scheduled to begin on October 29, 2003.
11. PREFERRED STOCK
On July 1, 2002 the Company initiated a consent solicitation (the "Consent
Solicitation") from registered holders of its 12% Senior Exchange
Payment-in-Kind Preferred Stock, par value $0.01 per share ("Preferred Stock"),
for certain amendments to the certificate of incorporation of the Company which
would amend the terms of the Preferred Stock. The proposed amendments required
the consent of the holders of a majority of the issued and outstanding shares of
common stock of the Company and the consent of the holders of a majority of the
issued and outstanding shares of Preferred Stock. Consent by the holders of a
majority of the Company's outstanding common stock was executed on June 28,
2002. On July 29, 2002, the Consent Solicitation was successfully completed,
with the Company receiving consents from the holders of more than 99% of the
outstanding shares of Preferred Stock.
The amendments to the Preferred Stock, among other things: (i) accelerated the
mandatory redemption date of the Preferred Stock from June 15, 2007 to June 15,
2005, (ii) reduced the liquidation preference from $25.00 to $22.00 per share,
which will lower the Company's cost of redeeming the Preferred Stock and will
lower the amount of dividends payable thereon (which dividends are equal to 12%
of the liquidation preference per annum), (iii) eliminated any redemption
premium, which will lower the Company's potential cost of redeeming the
Preferred Stock prior to June 15, 2005, (iv) reduced the repurchase price that
the Company must offer the holders of Preferred Stock upon a change of control
from 101% to 100% of the liquidation preference, which will lower the Company's
potential cost of any such repurchase obligation, (v) permitted future dividends
to be paid through the issuance of additional shares of preferred stock, which
The accompanying notes are an integral part of the unaudited condensed
consolidated financial statements.
13
will provide the Company with greater flexibility in financing its operations,
and (vi) included a definition for the term "Permitted Investments", which
definition was inadvertently omitted from the Certificate of Designation
pursuant to which the Preferred Stock was created.
As consideration for these amendments, the Company paid each registered holder
of Preferred Stock that consented thereto $0.40 per share in cash. A total of
$1.0 million in consent fees was paid during 2002. The Company paid an
additional $0.2 million in legal and other fees related to the Consent
Solicitation during 2002.
The Company has recorded the Preferred Stock at its current value in the
accompanying Condensed Consolidated Balance Sheet. The Company has sufficient
authorized and unissued shares of Preferred Stock to make its dividend payments
through the issuance of additional shares. For the June 15, 2003 dividend
payments, the Company chose to make these payments in-kind.
Persons affiliated with the initial purchases of the Preferred Stock were also
issued warrants, with an original fair value of $0.7 million, to purchase 19,050
shares of common stock of the Company for $0.01 per share, exercisable
immediately. The original fair value of these warrants has been recorded in
equity, with a corresponding amount capitalized and included in deferred
financing costs.
12. SEGMENT INFORMATION
In accordance with SFAS No. 131, "Disclosures about Segments of an Enterprise
and Related Information", the Company has two reportable segments. The smokeless
tobacco segment manufactures smokeless tobacco products that are distributed
primarily through wholesale and food distributors in the United States. The
make-your-own segment imports and distributes premium cigarette papers and
contract manufactures and distributes cigarette tobaccos and related products
primarily through wholesale distributors in the United States.
The accounting policies of the segments are the same as those of the Company.
Segment data includes a charge allocating all corporate costs to each operating
segment. Eliminations and Other include the assets of the Company not assigned
to segments and the elimination of intercompany accounts between segments. The
Company evaluates the performance of its segments and allocates resources to
them based on earnings before interest, taxes, depreciation, amortization,
certain non-cash charges and other income and expenses (Adjusted EBITDA).
The accompanying notes are an integral part of the unaudited condensed
consolidated financial statements.
14
The table below presents financial information about reported segments as of and
for the three months and six months ended June 30, 2003 and 2002, respectively
(in thousands):
FOR THE THREE MONTHS ENDED: SMOKELESS ELIMINATIONS
JUNE 30, 2003 TOBACCO MAKE-YOUR-OWN AND OTHER TOTAL
- -------------------------- ----------- --------------- -------------- ---------
Net Sales $ 9,396 $ 20,855 $ - $ 30,251
Operating Income 2,190 7,942 - 10,132
Adjusted EBITDA 2,691 8,092 - 10,783
Assets 63,369 260,175 (100,628) 222,916
JUNE 30, 2002
- --------------------------
Net Sales $ 10,226 $ 7,992 $ - $ 18,218
Operating Income 2,278 1,556 - 3,834
Adjusted EBITDA 3,103 1,706 - 4,809
Assets 65,777 241,680 (93,626) 213,831
FOR THE THREE MONTHS ENDED: SMOKELESS ELIMINATIONS
JUNE 30, 2003 TOBACCO MAKE-YOUR-OWN AND OTHER TOTAL
- -------------------------- ------------ --------------- -------------- --------
Net Sales $ 17,618 $ 26,882 $ - $ 44,500
Operating Income 3,768 5,812 - 9,580
Adjusted EBITDA 4,869 6,112 - 10,981
Assets 63,369 260,175 (100,628) 222,916
JUNE 30, 2002
Net Sales $ 19,055 $ 21,115 $ - $ 40,170
Operating Income 4,218 7,100 - 11,318
Adjusted EBITDA 5,718 7,400 - 13,118
Assets 65,777 241,680 (93,626) 213,831
The table set forth below is a reconciliation of the Company's Net income (loss)
to Adjusted EBITDA for the three months and six months ended June 30, 2003 and
2002, respectively (in thousands):
FOR THE THREE MONTHS ENDED: FOR THE SIX MONTHS ENDED:
JUNE 30 JUNE 30
-------------------------- ------------------------
2003 2002 2003 2002
Net income (loss) $ (10,056) $ (729) $ (13,486) $ 760
Interest expense, net and amortization
of deferred financing fees 4,671 4,677 9,313 9,398
Income tax expense (benefit) (6,164) (447) (8,265) 466
Depreciation 125 175 250 350
Other expense 21,681 333 22,018 694
LIFO adjustment 325 350 450 700
Stock option compensation expense 67 25 117 50
Postretirement/Pension expense 134 425 584 700
----------- ---------- ---------- ---------
Adjusted EBITDA $ 10,783 $ 4,809 $ 10,981 $ 13,118
=========== ========== ========== =========
13. SUBSEQUENT EVENT
As described in Note 10 with respect to the Illinois Complaint, the Company, in
order to protect its rights, was required to post an $18.8 million judgment
bond. This was accomplished by obtaining a $19.0 million Tranche B Term Loan
pursuant to a July 31, 2003 amendment to the Loan Agreement. This Term Loan will
bear interest at variable rates based, at the Company's option, on prime rates
or LIBOR. Interest will be payable monthly and its maturity date is March 31,
2004. All terms and conditions of the current Revolving Credit Facility remain
in place except the committed amount, which was reduced to $15.0 million.
The accompanying notes are an integral part of the unaudited condensed
consolidated financial statements.
15
ITEM 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Subsequent Events
- -----------------
Subsequent to the close of the quarter ended June 30, 2003, the Company reported
significant two events:
As detailed in Note 9 to the Condensed Consolidated Financial Statements, the
Star Cigarette Asset Purchase Agreement, pursuant to which the Company was to
purchase Star's cigarette business, was terminated on July 15, 2003 by mutual
agreement of the parties. Pursuant to the termination agreement, Star retained a
$2.0 million earnest money deposit and the parties executed releases of any
liabilities arising out of the Star Cigarette Asset Purchase Agreement. Through
June 30, 2003, the Company incurred approximately $2.9 million of direct costs,
including such earnest money deposit, in connection with this transaction. These
costs have been expensed in the Condensed Consolidated Statement of Operations
during the quarter ended June 30, 2003 and are included in Other expense.
As detailed in Note 10 to the Condensed Consolidated Financial Statements with
respect to the Illinois Complaint, on July 8, 2003, after a four day trial, the
jury returned a verdict in favor of Republic Tobacco on defamation claims of
$8.4 million in general damages and $10.2 million in punitive damages. On July
23, 2003, the Company filed a post-trial motion seeking to set aside the
verdict, a new trial or, in the alternative, a reduction in damages. On July 30,
2003, the Court set a briefing schedule allowing Republic to file their response
on or before August 8, 2003 and the Company to file its counter response on or
before August 22, 2003. The Company's motion is scheduled to be argued on
September 10, 2003. On August 1, 2003, the Company posted a judgment bond of
$18.8 million with the U.S. District Court. If the Company does not obtain the
relief requested in its post-trial motion, the Company expects to appeal. The
Company continues to believe that it has viable defenses to Republic's claims,
including those relating to fair comment privilege and the innocent construction
rule and that, if the judgment is not reversed in its entirety, the amount
thereof should be substantially reduced. There can be no assurance, however,
that the Company will prevail in obtaining relief pursuant to its post-trial
motion or on appeal. Pursuant to the provisions of SFAS No. 5, "Accounting for
Contingencies," the Company accrued $18.6 million in Other expense in the
Condensed Consolidated Statement of Operations.
General
- -------
The Company competes in two distinct markets: (1) the smokeless tobacco market
and (2) the Make-Your-Own ("MYO") cigarette market. The smokeless tobacco market
includes the loose leaf chewing tobacco sector, and the MYO cigarette market is
comprised of the MYO premium cigarette papers sector and the MYO cigarette
The accompanying notes are an integral part of the unaudited condensed
consolidated financial statements.
16
tobaccos and related products sector. The Company manufactures and markets loose
leaf chewing tobacco and imports and distributes MYO premium cigarette papers,
and contract manufactures and markets MYO cigarette tobaccos and related
products.
RESULTS OF OPERATIONS
COMPARISON OF THREE MONTHS ENDED JUNE 30, 2003 AND 2002
Net Sales. Net sales for the three months ended June 30, 2003 were $30.3
million, an increase of $12.1 million or 66.5% from the corresponding period of
the prior year.
Net sales of the smokeless tobacco segment for the current period decreased $0.8
million or 7.8% from the corresponding period of the prior year. This segment's
aggregate case volume for the current period decreased by 14.8% as compared to
the prior period. This decrease is attributable to increased discounting from
other loose leaf competitors, growth of the moist snuff value brands and
discounting activity by moist snuff manufacturers, as well as a continuing
industry-wide decline in the loose leaf sector of the smokeless tobacco segment.
The impact of the declining volume of the Company's smokeless tobacco segment
was partially offset by a price increase of 5% instituted in the fourth quarter
of 2002.
Net sales of the Company's MYO segment increased $12.9 million or 161.3% in
comparison to the corresponding period of the prior year. Within the MYO
segment, premium cigarette paper sales increased $10.1 million or 171.2% from
the corresponding period of the prior year. This increase was attributable to
the fact that a sales promotion of premium cigarette paper for the variety
wholesale class of trade was conducted during the fiscal quarter ended June 30,
2003 but not during the prior fiscal quarter. In 2002, a similar sales promotion
was conducted during the fiscal quarter ended March 31, but not in the fiscal
quarter ended June 30. The Company had sought to change its pricing strategy in
2003 by changing its promotional strategy. No promotion was conducted in the
first fiscal quarter of 2003 and, as a result, the variety wholesale class of
trade delayed their purchases. Seeking to address their concerns, a promotion
for this class of trade was conducted in the fiscal quarter ended June 30, 2003.
The MYO cigarette tobaccos and related products' sales continued their growth
trend, increasing $2.8 million or 133.3% in comparison to the corresponding
period of the prior year, which reflects increased consumer demand for MYO
products and increased distribution. This growth was achieved despite a
continuing out-of-stock situation with respect to the Company's cigarette tube
products. This out-of-stock situation, which resulted in lost or delayed sales
of $0.4 million during the fiscal quarter ended June 30, 2003, is expected to be
remedied during the fiscal quarter ending September 30, 2003.
Gross Profit. Gross profit for the three months ended June 30, 2003 totaled
$17.5 million, an increase of $7.8 million or 80.4% from the corresponding
period of the prior year due primarily to the increase in premium cigarette
paper sales as described above.
The accompanying notes are an integral part of the unaudited condensed
consolidated financial statements.
17
Gross profit of the smokeless tobacco segment declined $0.2 million or 4.1% from
the corresponding period of the prior year as the result of lower aggregate case
volume. Gross margin for this segment increased to 50.0% of net sales for the
current period from 48.0% in the corresponding period of the prior year due
principally to the manufacturer's price increase.
Due to the significant sales increases of premium cigarette papers, gross profit
of the MYO segment for the current period increased $8.0 million or 166.7%, as
compared to the prior period. The gross margin for the MYO segment increased to
61.5% of net sales for the current period in comparison to 60.0% for the prior
period. This increase in gross margin was due principally to the significant
sales increase in the higher margin MYO premium cigarette paper sector, offset
by the growth in the lower margin MYO cigarette tobacco and related products
sector and a weakened US dollar as compared with the Euro.
Selling, General, and Administrative Expenses. Selling, general, and
administrative expenses for the three months ended June 30, 2003 were $7.4
million, an increase of $1.5 million or 25.4% compared to the corresponding
period of the prior year. As previously reported, during the second quarter of
2002, the Company undertook a review of its sales and marketing organization and
its activities. Based on this review, the Company initiated a concentrated
effort to expand and redirect its sales efforts with increased emphasis on the
large chain convenience stores which have significant tobacco sales and,
accordingly, represent significant growth opportunities for the Company.
Further, as a component of this initiative, the Company's focus was to expand
the distribution of its higher margin products. This initiative has resulted in
increased sales and marketing expenses of $0.8 million during the second quarter
of 2003 in comparison to the prior year. The remaining $0.7 million increase
relates principally to increased compensation expenses, including fringe
benefits, and new product development expenses associated with the development
of a Zig-Zag(TM) premium cigarette brand.
Interest Expense and Financing Costs. Interest expense and financing costs for
the three months ended June 30, 2003 totaled $4.7 million and were unchanged
from the corresponding period of the prior year.
Other Expense. Other expense totaled $21.7 million for the three months ended
June 30, 2003 as compared to $0.3 million during the corresponding period of the
prior year. This increase resulted from the expensing of costs of $2.9 million
associated with the termination of the Star Cigarette Asset Purchase Agreement
and $18.6 million associated with the verdict in the Illinois Complaint, as
described in Notes 9 and 10, respectively, to the Condensed Consolidated
Financial Statements.
Income Tax Benefit. Income tax benefit was $6.2 million for the three months
ended June 30, 2003, compared to a benefit of $0.4 million for the corresponding
period of the prior year, due primarily to the Other expense of $21.7 million
described above. The effective income tax rate for both periods was 38%.
The accompanying notes are an integral part of the unaudited condensed
consolidated financial statements.
18
Net Loss. Due to the factors described above, net loss for the three months
ended June 30, 2003 was $10.1 million compared to a net loss of $0.7 million for
the corresponding period of the prior year.
COMPARISON OF SIX MONTHS ENDED JUNE 30, 2003 AND 2002
Net Sales. Net sales for the six months ended June 30, 2003 were $44.5 million,
an increase of $4.3 million or 10.7% from the corresponding period of the prior
year.
Net sales of the smokeless tobacco segment for the current period decreased $1.5
million or 7.9% from the corresponding period of the prior year. The aggregate
case volume for this segment for the current period decreased by 11.0%, as
compared to the prior period. This decrease was due to increased discounting
from other loose leaf competitors, growth of the moist snuff value brands and
discounting activity by moist snuff manufacturers, as well as a continuing
industry-wide decline in the loose leaf sector of the smokeless tobacco segment.
The impact of the declining volume of the Company's smokeless tobacco segment
was partially offset by a price increase of 5% instituted in the fourth quarter
of 2002.
Net sales of the Company's MYO segment increased $5.8 million or 27.5% in
comparison to the corresponding period of the prior year. Within the MYO
segment, premium cigarette paper sales increased $2.8 million or 17.5% from the
corresponding period of the prior year. This increase was due to higher premium
cigarette paper sales resulting from enhanced sales promotion activities. The
MYO cigarette tobaccos and related products sales increased by $3.0 million or
59.4% in comparison to the corresponding period of the prior year, which
reflects increased consumer demand for MYO products and increased distribution.
These sales increases were achieved despite a continuing out-of-stock situation
with respect to the Company's cigarette tube products. This out-of-stock
situation, which resulted in lost or delayed sales of $0.4 million, is expected
to be remedied during the fiscal quarter ending September 30, 2003.
Gross Profit. Gross profit for the six months ended June 30, 2003 totaled $24.0
million, an increase of $1.0 million or 4.3% from the corresponding period of
the prior year due to the increase in premium cigarette paper sales described
above.
Gross profit of the smokeless tobacco segment decreased $0.4 million or 4.3%
from the corresponding period of the prior year resulting from lower aggregate
case volumes. Gross margin for this segment increased to 51.1% of net sales for
the current period from 49.2% in the corresponding period of the prior year due
principally to the manufacturer's price increase.
Gross profit of the MYO segment for the current period increased $1.4 million or
10.3%, as compared to the prior period. The gross margin of the MYO segment
declined to 55.8% of net sales for the current period in comparison to 64.5% for
the prior period. This reduction in gross margin was due principally to the
sales mix resulting from the higher relative growth in the lower margin MYO
cigarette tobacco and related products sector as compared to the lower relative
growth in the higher margin premium cigarette paper sector. A stronger Euro in
comparison to the US dollar has also resulted in a lower margin as compared to
the same period of the prior year.
The accompanying notes are an integral part of the unaudited condensed
consolidated financial statements.
19
Selling, General, and Administrative Expenses. Selling, general, and
administrative expenses for the six months ended June 30, 2003 were $14.4
million, an increase of $2.7 million or 23.1% compared to the corresponding
period of the prior year. As previously reported, during the second quarter of
2002, the Company undertook a review of its sales and marketing organization and
their activities. Based on this review, the Company initiated a concentrated
effort to expand and redirect its sales efforts with increased emphasis on the
large chain convenience stores, which have significant tobacco sales and,
accordingly, represent significant growth opportunities for the Company.
Further, as a component of this initiative, the Company's focus was to expand
its distribution of its higher margin products. This initiative has resulted in
increased sales and marketing expenses of $1.6 million in comparison to the
corresponding period of the prior year. The remaining $1.1 million increase
relates principally to increased compensation expenses, including fringe
benefits, professional fees and new product development expenses associated with
the development of a Zig-Zag(TM) premium cigarette brand.
Interest Expense and Financing Costs. Interest expense and financing costs were
$9.3 million, a decrease of $0.1 million or 1.1% for the six months ended June
30, 2003 as compared to the corresponding period of the prior year. This
reduction was due principally to a lower average outstanding loan balance.
Other Expense. Other expense was $22.0 million for the six months ended June 30,
2003 as compared to $0.7 million during the corresponding period of the prior
year. This increase resulted from the expensing of costs of $2.9 million
associated with the termination of the Star Cigarette Asset Purchase Agreement
and $18.6 million associated with the verdict in the Illinois Complaint, as
described in Notes 9 and 10, respectively, to the Condensed Consolidated
Financial Statements.
Income Tax Benefit (Expense). Income tax benefit was $8.3 million for the six
months ended June 30, 2003 compared to an expense of $0.5 million for the
corresponding period of the prior year due primarily to the Other expense of
$22.0 million described above. The effective income tax rate for both periods
was 38%.
Net Income (Loss). Due to the factors described above, the net loss for the six
months ended June 30, 2003 was $13.5 million compared to net income of $0.8
million for the corresponding period of the prior year.
LIQUIDITY AND CAPITAL REQUIREMENTS
At June 30, 2003, the Company had a working capital deficit of $144.2 million as
compared to positive working capital of $32.3 million at December 31, 2002. The
lower working capital position was primarily the result of (i) a
reclassification to include the Senior Notes (as defined below), which mature on
June 15, 2004, as current liabilities; and (ii) the accrual of $18.6 million as
accrued litigation in current liabilities in the Condensed Consolidated Balance
Sheet. Excluding the effects of the Senior Notes reclassification and the
The accompanying notes are an integral part of the unaudited condensed
consolidated financial statements.
20
accrued litigation, working capital declined $2.9 million, which resulted
principally from an increase in borrowings under the revolving credit facility
under the Loan Agreement referred to below (the "Revolving Credit Facility") to
finance increased inventories and other operating expenses. The Company expects
to continue to fund its seasonal working capital requirements through its
operating cash flows and, if needed, borrowings under the Revolving Credit
Facility. As of June 30, 2003, the Company had availability of $9.2 million
under the Revolving Credit Facility. As more fully described below, the
Revolving Credit Facility was reduced from $20 million to $15 million on July
31, 2003 and, as of August 6, 2003, the current availability under that facility
is $5.2 million.
The Company is currently operating under a Loan Agreement, dated December 31,
2000, with Bank One, N.A. ("Bank One") as Agent and the banks named therein (as
amended from time to time, the "Loan Agreement"). Borrowings under the Loan
Agreement bear interest at variable rates based, at the Company's option, on
prime rates or LIBOR. On December 31, 2002, the Company entered into an
Amendment to the Loan Agreement with Bank One in which the Revolving Credit
Facility was increased to $20.0 million and extended to December 31, 2003. All
terms of the original Loan Agreement remain in place except for the Fixed Charge
Covenant, which was replaced with an Interest Coverage Covenant. The Company's
obligations under the Loan Agreement are guaranteed by its subsidiaries. As of
June 30, 2003, the interest rate on borrowings under the Loan Agreement was
3.48%.
As described in Note 10 to the Condensed Consolidated Financial Statements with
respect to the Illinois Complaint, the Company, in order to protect its rights,
was required to post an $18.8 million judgment bond. This was accomplished by
obtaining a $19.0 million Tranche B Term Loan pursuant to a July 31, 2003
amendment to the Loan Agreement. This Term Loan will bear interest at variable
rates based, at the Company's option, on prime rates or LIBOR. Interest will be
payable monthly and its maturity date is March 31, 2004. All terms and
conditions of the current Revolving Credit Facility remain in place except the
amount, which was reduced to $15.0 million. It is the Company's intention to
refinance its obligations under the Loan Agreement prior to their maturity. The
ability to do so will depend, among other things, on the financial performance
of the Company and the availability of funds from the capital markets. Although
the Company believes it will be able to effect such a refinancing, there can be
no assurance that such a refinancing will be obtained.
On June 25, 1997, the Company issued $155.0 million of 11% Senior Notes due June
15, 2004 (the "Senior Notes"). The Notes bear interest at the fixed rate of 11%
per annum, payable semiannually on June 15 and December 15. Because the Senior
Notes mature on June 15, 2004, they have been classified as a current liability
in the Condensed Consolidated Balance Sheet. It is the Company's intention to
refinance the Senior Notes prior to their maturity. The ability to do so will
depend, among other things, on the financial performance of the Company and the
availability of funds from the capital markets. Although the Company believes it
will successfully refinance the Senior Notes, there can be no assurance such
refinancing will be obtained. In the event the Company is not able to refinance
The accompanying notes are an integral part of the unaudited condensed
consolidated financial statements.
21
the Senior Notes, its ability to continue as a going concern cannot be assured.
The Condensed Consolidated Financial Statements do not include any adjustments
that might result from the occurrence of this contingency.
The Loan Agreement and the Senior Notes include cross default provisions and
limit the incurrence of additional indebtedness, dividends, transactions with
affiliates, asset sales, acquisitions, mergers, prepayments of indebtedness,
liens and encumbrances, and other matters. At June 30, 2003, the Company was in
compliance with all provisions of the Loan Agreement and Senior Notes.
On July 29, 2002, the Company successfully completed a consent solicitation (the
"Consent Solicitation") from registered holders of its 12% Senior Exchange
Payment-in-Kind Preferred Stock, par value $0.01 per share ("Preferred Stock"),
for certain amendments to the certificate of incorporation of the Company
relating to the terms of the Preferred Stock. See Note 11 to the Financial
Statements for information concerning changes to the terms of the Preferred
Stock.
As a result of amendments to the Company's certificate of incorporation
resulting from the Consent Solicitation, among other things, dividends on the
Company's Preferred Stock are payable either in cash or through the issuance of
additional shares of Preferred Stock. The Company has sufficient authorized and
unissued shares of Preferred Stock to make its dividend payments through the
issuance of additional shares. For the June 15, 2003 dividend payments, the
Company chose to make these payments in-kind.
The Company believes that, in general, it maintains adequate inventories based
on its historical and projected future sales activity and that it will be able
to source its inventory requirements for the foreseeable future. In the event
that growth in any area outstrips the Company's projections, the Company will
likely incur a temporary out-of-stock situation, which will result in a loss of
sales. This occurred within the six months period ended June 30, 2003, as the
demand for cigarette tubes exceeded available supply, resulting in lost or
delayed sales of $0.4 million.
The Company believes that any effect of inflation at current levels will
continue to be minimal. Historically, the Company has been able to increase
prices at a rate equal to or greater than that of inflation and believes that it
will continue to be able to do so for the foreseeable future. In addition, the
Company has been able to maintain a relatively stable variable cost structure
for its products due, in part, to its successful procurement and reformulation
activities with regard to its tobacco products and, in part, to its existing
contractual agreement for the purchase of its premium cigarette papers.
Given its current operations, the Company believes that its capital expenditure
requirements for 2003 will be $1.3 million. For the six months ended June 30,
2003, the Company had funded capital expenditures of $0.6 million.
The accompanying notes are an integral part of the unaudited condensed
consolidated financial statements.
22
FORWARD-LOOKING STATEMENTS
The Company cautions the reader that certain statements in the Management's
Discussion and Analysis of Financial Condition and Results of Operations section
as well as elsewhere in this Form 10-Q are "forward-looking statements" within
the meaning of the Private Securities Litigation Reform Act of 1995, including
but not limited to those statements regarding: (i) our intentions with respect
to the litigation with Republic Tobacco and our expectations regarding the
ultimate outcome of such litigation; (ii) our ability to refinance obligations
under the Loan Agreement; (iii) our ability to refinance the Senior Notes; (iv)
our ability to redeem the Preferred Stock; (v) our ability to source inventory
requirements; (vi) our belief that we will be able to continue to increase
prices at a rate equal to or greater than inflation; and (vii) our ability to
satisfy our capital requirements. Forward-looking statements are not guarantees
of future performance. They involve risks, uncertainties and other important
factors, including the risks discussed below. The Company's actual future
results, performance or achievement of results may differ materially from any
such results, performance or achievement implied by these statements. Among the
factors that could effect the Company's actual results and could cause results
to differ from those anticipated in the forward-looking statements contained
herein is the Company's ability to implement its business strategy successfully,
which will be dependent on business, financial, and other factors beyond the
Company's control, including, among others, federal, state and/or local
regulations and taxes; competitive pressures; prevailing changes in consumer
preferences; the ultimate outcome of the litigation with Republic Tobacco;
consumer acceptance of new product introductions and other marketing
initiatives; market acceptance of the Company's distribution programs for
Zig-Zag(R) premium cigarette papers; access to sufficient quantities of raw
material or inventory to meet any sudden increase in demand; disruption to
historical wholesale ordering patterns; product liability litigation; and any
disruption in access to capital necessary to achieve the Company's business
strategy.
The Company cautions the reader not to put undue reliance on any forward-looking
statements. In addition, the Company does not have any intention or obligation
to update the forward-looking statements in this document. The Company claims
the protection of the safe harbor for forward-looking statements contained in
Section 21E of the Securities Exchange Act of 1934.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
There have not been any significant changes with respect to quantitative and
qualitative disclosures about market risk from that previously disclosed in the
Company's Form 10-K for the year ended December 31, 2002.
ITEM 4. CONTROLS AND PROCEDURES.
The Company's management evaluated, with the participation of the Company's
principal executive and principal financial officers, the effectiveness of the
Company's disclosure controls and procedures (as defined in Rules 13a-15(e) and
15d-15(e) under the Securities Exchange Act of 1934, as amended (the "Exchange
Act")), as of June 30, 2003. Based on their evaluation, the Company's principal
The accompanying notes are an integral part of the unaudited condensed
consolidated financial statements.
23
executive and principal financial officers concluded that the Company's
disclosure controls and procedures were effective as of June 30, 2003.
There has been no change in the Company's internal control over financial
reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act)
that occurred during the Company's fiscal quarter ended June 30, 2003, that has
materially affected, or is reasonably likely to materially affect, the Company's
internal control over financial reporting.
PART II
OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
-----------------
Except as described below, there have not been any significant developments with
respect to legal proceedings and pending litigation or any change to the
Company's position as previously disclosed in the Company's Form 10-K for the
year ended December 31, 2002.
Illinois Complaints.
- --------------------
On July 8, 2003, following a four day trial, the jury returned a verdict in
favor of Republic Tobacco, Inc. on defamation claims of $8.4 million in general
damages and $10.2 million in punitive damages. On July 23, 2003, the Company
filed a post-trial motion seeking to set aside the verdict, a new trial or, in
the alternative, a reduction in damages. On July 30, 2003, the Court set a
briefing schedule allowing Republic to file their response on August 8, 2003 and
the Company to file its counter response on August 22, 2003. The Company's
motion is scheduled to be argued on September 10, 2003. On August 1, 2003, the
Company posted a judgment bond in the amount of $18.8 million with the U.S.
District Court. If the Company does not obtain the relief requested in its
post-trial motion, the Company expects to appeal. The Company continues to
believe that it has viable defenses to Republic's claims, including those
relating to fair comment privilege and the innocent construction rule and that,
if the judgment is not reversed in its entirety, the amount thereof should be
substantially reduced. There can be no assurance, however, that the Company will
prevail in obtaining relief pursuant to its post-trial motion or on appeal.
Pursuant to the provisions of SFAS No. 5, "Accounting for Contingencies," the
Company accrued $18.6 million in Other expense in the Condensed Consolidated
Statement of Operations.
Minnesota Complaint.
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All of the plaintiff's claims for personal injury against the Company have been
dismissed, and the Court denied the plaintiff's motion for reconsideration.
Plaintiff has filed notice to appeal these dismissals and the parties are in the
process of submitting briefs with respect thereto.
The accompanying notes are an integral part of the unaudited condensed
consolidated financial statements.
24
Texas Infringing Products Litigation.
- -------------------------------------
On June 27, 2003, the Court found Import Warehouse and Ravi Bhatia in contempt
of court for violating an existing injunction barring those parties from
distributing infringing Zig-Zag(TM) cigarette paper products. The Court
requested that the Company and Bollore, SA (the Company's co-plaintiff in the
case) file a submission detailing the damages incurred. The Company and Bollore
filed their submission on July 25, 2003 which reports damages of $2.4 million.
Import Warehouse and Mr. Bhatia are preparing their response.
California Infringing Products Litigation.
- ------------------------------------------
In addition to the judgment previously entered in Bollore, S.A. and the
Company's (the "plaintiffs'") favor in the amount of $1.7 million, on March 27,
2003, the Court ordered Downey Wholesale Inc. and Fadel El-Shahawi (the
"defendants'") to pay plaintiffs $751,000 in attorneys' fees and expenses. The
defendants filed a motion to appeal and the Court has postponed the briefing
schedule relating thereto pending a Court-sponsored mediation. The mediation is
scheduled to begin on October 29, 2003.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
a. Exhibits.
10.1 2003A Amendment to Loan Documents, dated as of July 31,
2003, by and among North Atlantic Trading Company, Inc.,
National Tobacco Company, L.P., North Atlantic Operating
Company, Inc., National Tobacco Finance Corporation, Bank
One, NA, successor to Bank One, Kentucky N.A., as agent bank
and the various lending institutions named therein,
Guggenheim Investment Management, LLC, as agent for the
Class B Lenders named therein.
10.2 Subordination Agreement, dated as of July 31, 2003, by and
among North Atlantic Trading Company, Inc., National Tobacco
Company, L.P., North Atlantic Operating Company, Inc.,
National Tobacco Finance Corporation, Bank One, NA,
successor to Bank One, Kentucky N.A., as agent bank and the
various lending institutions named therein, Guggenheim
Investment Management, LLC, as agent for the Class B Lenders
named therein.
31.1 Certification of Chief Executive Officer Pursuant to Section
302 of the Sarbanes-Oxley Act of 2002.
31.2 Certification of Chief Financial Officer Pursuant to Section
302 of the Sarbanes-Oxley Act of 2002.
32.1 Certification by the Chief Executive Officer pursuant to 18
U.S.C.ss. 1350, as adopted by Section 906 of the
Sarbanes-Oxley Act of 2002.
32.2 Certification by the Chief Financial Officer pursuant to 18
U.S.C.ss. 1350, as adopted by Section 906 of the
Sarbanes-Oxley Act of 2002.
b. Reports on Form 8-K.
(i) Form 8-K filed on July 11, 2003, reporting under Item 5
"Other Events" and including a copy of the press release
announcing the jury verdict in the Republic Litigation as an
Exhibit under Item 7 "Financial Statements, Pro Forma
Information and Exhibits."
(ii) Form 8-K filed on July 17, 2003, reporting under Item 5
"Other Events" and including a copy of the Termination
Agreement between Star and the Company, the mutual releases
executed by Star and the Company and the press release
announcing the termination of the Star Cigarette Asset
Purchase Agreement as Exhibits under Item 7 "Financial
Statements, Pro Forma Information and Exhibits."
The accompanying notes are an integral part of the unaudited condensed
consolidated financial statements.
25
SIGNATURES
The Company has duly caused this report to be signed on its behalf by
the undersigned thereunto duly authorized.
NORTH ATLANTIC TRADING COMPANY, INC.
Date: August 8, 2003 /s/ Thomas F. Helms, Jr.
---------------------------------------
Thomas F. Helms, Jr.
Chief Executive Officer
/s/ David I. Brunson
---------------------------------------
David I. Brunson
Chief Financial Officer
The accompanying notes are an integral part of the unaudited condensed
consolidated financial statements.
26