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 September 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 [X] No [ ].
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 November 10, 2003.
PART I.
FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
NORTH ATLANTIC TRADING COMPANY, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(amounts in thousands except share data)
(unaudited)
September 30, December 31,
2003 2002
---------------- ----------------
Current assets:
Cash $ 34 $ 805
Accounts receivable, net 9,245 7,651
Inventories 42,374 40,818
Income taxes receivable 910 887
Other current assets 4,478 3,457
---------------- ----------------
Total current assets 57,041 53,618
Property, plant and equipment, net 6,104 5,158
Deferred income taxes 31,918 24,916
Deferred financing costs 1,603 2,642
Goodwill 123,557 123,557
Other assets 4,571 3,703
---------------- ----------------
Total assets $ 224,794 $ 213,594
================ ================
Current liabilities:
Accounts payable $ 2,949 $ 2,868
Accrued expenses 7,023 2,429
Deferred income taxes 10,552 10,552
Revolving credit facility 4,500 5,500
Senior secured term loan 19,000 -
Senior Notes 155,000 -
Total current liabilities 199,024 21,349
Senior Notes - 155,000
Other long-term liabilities 12,436 12,793
---------------- ----------------
Total liabilities 211,460 189,142
---------------- ----------------
Commitments and contingencies
Preferred Stock, (mandatory redemption value of $63,143 and $57,805,
respectively) 63,143 57,805
---------------- ----------------
2
September 30, December 31,
2003 2002
---------------- ----------------
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 9,553 9,246
Loans to stockholders for stock purchases (166) (157)
Accumulated other comprehensive loss (1,125) (1,125)
Accumulated deficit (58,076) (41,322)
---------------- ----------------
Total stockholders' deficit (49,809) (33,353)
---------------- ----------------
Total liabilities and stockholders' deficit $ 224,794 $ 213,594
================ ================
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
(amounts in thousands except per share data)
(unaudited)
Three months Three months
Ended Ended
September 30, 2003 September 30, 2002
------------------ ------------------
Net sales $ 28,718 $ 26,014
Cost of sales 11,836 10,537
------------------ ------------------
Gross profit 16,882 15,477
Selling, general and administrative expenses 7,886 6,302
------------------ ------------------
Operating income 8,996 9,175
Interest expense and financing costs, net 4,817 4,676
Other expense 839 681
------------------ ------------------
Income before income tax expense 3,340 3,818
Income tax expense 1,269 1,451
------------------ ------------------
Net income 2,071 2,367
Preferred stock dividends (1,839) (1,630)
Net gain on restructuring of preferred stock - 5,448
------------------ ------------------
Net income applicable to common shares $ 232 $ 6,185
================== ==================
Basic earnings per common share:
Net income $ 3.92 $ 4.48
Preferred stock dividends (3.48) (3.09)
Net gain on restructuring of preferred stock - 10.32
------------------ ------------------
Net income applicable to common shares $ 0.44 $ 11.71
================== ==================
Diluted earnings per common share:
Net income $ 3.36 $ 3.62
Preferred stock dividends (2.98) (2.50)
Net gain on restructuring of preferred stock - 8.34
------------------ ------------------
Net income applicable to common shares $ 0.38 $ 9.46
================== ==================
4
Three months Three months
Ended Ended
September 30, 2003 September 30, 2002
------------------ ------------------
Weighted average common shares outstanding:
Basic 528.2 528.2
Diluted 616.8 653.5
The accompanying notes are an integral part of the
unaudited condensed consolidated financial statements.
5
NORTH ATLANTIC TRADING COMPANY, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(amounts in thousands except per share data)
(unaudited)
Nine months Nine months
Ended Ended
September 30, 2003 September 30, 2002
------------------ ------------------
Net sales $ 73,218 $ 66,184
Cost of sales 32,290 27,736
------------------ ------------------
Gross profit 40,928 38,448
Selling, general and administrative expenses 22,352 17,955
------------------ ------------------
Operating income 18,576 20,493
Interest expense and financing costs, net 14,130 14,074
Other expense 22,857 1,375
------------------ ------------------
Income (loss) before income tax expense (benefit) (18,411) 5,044
Income tax expense (benefit) (6,996) 1,917
------------------ ------------------
Net income (loss) (11,415) 3,127
Preferred stock dividends (5,339) (5,270)
Net gain on restructuring of preferred stock - 5,448
------------------ ------------------
Net income (loss) applicable to common shares $ (16,754) $ 3,305
================== ==================
Basic and Diluted earnings per common share:
Net income (loss) $ (21.61) $ 5.92
Preferred stock dividends (10.11) (9.98)
Net gain on restructuring of preferred stock - 10.32
------------------ ------------------
Net income (loss) applicable to common shares $ (31.72) $ 6.26
================== ==================
Basic and Diluted earnings per common share:
Net income (loss) $ (21.61) $ 4.79
Preferred stock dividends (10.11) (8.07)
Net gain on restructuring of preferred stock - 8.34
------------------ ------------------
Net income (loss) applicable to common shares $ (31.72) $ 5.06
================== ==================
6
Nine months Nine months
Ended Ended
September 30, 2003 September 30, 2002
------------------ ------------------
Weighted average common shares outstanding:
Basic 528.2 528.2
Diluted 528.2 653.5
The accompanying notes are an integral part of the
unaudited condensed consolidated financial statements.
7
NORTH ATLANTIC TRADING COMPANY, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(amounts in thousands)
(unaudited)
Nine months Nine months
Ended Ended
September 30, 2003 September 30, 2002
------------------ ------------------
Cash flows from operating activities:
Net income (loss) $ (11,415) $ 3,127
Adjustments to reconcile net income (loss) to net cash provided by (used
in) operating activities:
Depreciation 375 525
Amortization of deferred financing costs 1,039 1,039
Deferred income taxes (7,002) 1,917
Changes in operating assets and liabilities:
Accounts receivable, net (1,594) (1,968)
Inventories (1,556) 1,326
Other current assets (1,044) (1,202)
Other assets (868) (580)
Accounts payable 81 (1,150)
Accrued expenses and other 4,594 3,631
Other Long-Term Liabilities (357) -
------------------ ------------------
Net cash provided by (used in) operating activities (17,747) 6,665
------------------ ------------------
Cash flows from investing activities:
Capital expenditures (1,321) (386)
------------------ ------------------
Net cash provided by (used in) investing activities (1,321) (386)
------------------ ------------------
Cash flows from financing activities:
Proceeds (payments to) from revolving credit facility (1,000) 3,500
Payments on term loans - (9,375)
Consent Solicitation expense - (1,166)
Senior Secured Term Loan 19,000 -
Other 297 (6)
------------------ ------------------
Net cash provided by (used in) financing activities 18,297 (7,047)
------------------ ------------------
Net decrease in cash (771) (768)
Cash, beginning of period 805 1,130
------------------ ------------------
Cash, end of period $ 34 $ 362
================== ==================
The accompanying notes are an integral part of the
unaudited condensed consolidated financial statements.
8
NORTH ATLANTIC TRADING COMPANY, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
1. BASIS OF PRESENTATION
These Condensed Consolidated Financial Statements should be read in conjunction
with the consolidated 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 (the "Preferred Stock") is
subject to mandatory redemption on June 15, 2005. It is the Company's intention
to refinance the 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 September 30, 2003 and 2002,
respectively, and $2.0 million and $1.9 million for the nine months ended
September 30, 2003 and 2002, respectively.
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
9
General) and subsequent states' statutes, a "cigarette manufacturer" (which is
defined to include a manufacturer of cigarettes as well as 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 September 30, 2003, the
Company has recorded total escrow deposits as an Other asset of $2.9 million,
including $0.9 million relative to sales recognized during the nine months ended
September 30, 2003.
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 decreased the net income of the Company by $0.1 million for
the three months ended September 30, 2003 and increased the net loss of the
Company by $0.2 million for the three months ended September 30, 2002. The
impact of LIFO increased the net loss of the Company by $0.4 million and $0.7
million for the nine months ended September 30, 2003 and 2002, respectively.
The components of inventories are as follows (amounts in thousands):
9/30/03 12/31/02
---------------- ----------------
Raw materials and work in process $ 4,378 $ 3,111
Leaf tobacco 8,357 10,328
Finished goods - loose leaf tobacco 4,571 4,174
Finished goods - MYO products 6,716 4,722
Finished goods - premium cigarettes 148 -
Other 849 728
---------------- ----------------
25,019 23,063
LIFO reserve 17,355 17,755
---------------- ----------------
$ 42,374 $ 40,818
================ ================
4. PROVISION FOR INCOME TAXES
The provision for income taxes for the nine months ended September 30, 2003 and
September 30, 2002 was computed based on the estimated annual effective income
tax rate of 38%.
10
5. PARENT-ONLY FINANCIAL INFORMATION
North Atlantic Trading Company, Inc. is a holding company with no operating
assets. Its assets consist primarily of its investment in subsidiaries, deferred
income tax assets related to the differences between the book and tax 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, therefore, are
not included herein. The following represents unaudited parent-only summarized
financial information of North Atlantic Trading Company, Inc. (amounts in
thousands):
9/30/03 12/31/02
---------------- ----------------
Noncurrent assets................................... $ 205,869 $ 189,129
Current liabilities................................. 190,697 10,732
Noncurrent liabilities.............................. - 155,000
Redeemable preferred stock.......................... 63,143 57,805
For the three months ended September 30: 2003 2002
---------------- ----------------
Equity in earnings of subsidiaries $ 6,005 $ 5,869
Interest expense (4,857) (4,709)
Income tax benefit 947 1,222
---------------- ----------------
Net income before preferred stock dividends $ 2,095 $ 2,382
================ ================
For the nine months ended September 30: 2003 2002
---------------- ----------------
Equity in earnings of subsidiaries $ (8,677) $ 14,173
Interest expense (14,231) (14,185)
Income tax benefit 11,337 3,196
---------------- ----------------
Net income (loss) before preferred stock
dividends $ (11,571) $ 3,184
================ ================
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 September 30,
2003, the Company had no outstanding forward currency contracts.
11
7. RECONCILIATION OF INCOME (LOSS) PER COMMON SHARE
(dollars in thousands, except per share amounts):
THREE MONTHS ENDED SEPTEMBER 30, 2003
- -------------------------------------
Income Shares Per Share
(Numerator) (Denominator) Amount
--------------- ----------------- --------------
Basic:
Net income $ 2,071
Less: preferred stock dividends (1,839)
---------------
Net income applicable to common shares $ 232 528,241 $ 0.44
=============== ================= ==============
Diluted:
Net income $ 2,071
Less: preferred stock dividends (1,839)
---------------
Net income applicable to common shares $ 232 616,783 $ 0.38
=============== ================= ==============
THREE MONTHS ENDED SEPTEMBER 30, 2002
- -------------------------------------
Income Shares Per Share
(Numerator) (Denominator) Amount
--------------- ----------------- --------------
Basic:
Net income $ 2,367
Less: preferred stock dividends (1,630)
Plus: net gain on restructuring of preferred stock 5,448
---------------
Net income applicable to common shares $ 6,185 528,241 $ 11.71
=============== ================= ==============
Diluted:
Net income $ 2,367
Less: preferred stock dividends (1,630)
Plus: net gain on restructuring of preferred stock 5,448
---------------
Net income applicable to common shares $ 6,185 653,541 $ 9.46
=============== ================= ==============
NINE MONTHS ENDED SEPTEMBER 30, 2003
- ------------------------------------
Income Shares Per Share
(Numerator) (Denominator) Amount
--------------- ----------------- --------------
Basic and Diluted:
Net loss $ (11,415)
Less: preferred stock dividends (5,339)
---------------
Net loss applicable to common shares $ (16,754) 528,241 $ (31.72)
=============== ================= ==============
12
NINE MONTHS ENDED SEPTEMBER 30, 2002
- ------------------------------------
Income Shares Per Share
(Numerator) (Denominator) Amount
--------------- ----------------- --------------
Basic:
Net income $ 3,127
Less: preferred stock dividends (5,270)
Plus: net gain on restructuring of preferred stock 5,448
---------------
Net income applicable to common shares $ 3,305 528,241 $ 6.26
=============== ================= ==============
Diluted:
Net income $ 3,127
Less: preferred stock dividends (5,270)
Plus: net gain on restructuring of preferred stock 5,448
---------------
Net income applicable to common shares $ 3,305 653,541 $ 5.06
=============== ================= ==============
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 81,211 shares for the nine months period ended
September 30, 2003 were excluded from the diluted per share computations as
their effects were antidilutive. Common stock equivalent shares from stock
options representing 28,915 and 97,867 shares for the three and nine months
period ended September 30, 2003, respectively, were excluded from the diluted
per share 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 2002, 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.
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.
13
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 has not had 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.
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
14
support from other parties. For all variable interest entities, the provisions
of FIN 46, as amended by FASB Staff Position 46-6, must be applied for the first
interim or annual period ending after December 15, 2003. As the Company does not
hold any variable interest entities, FIN 46 does not 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 relating to mandatorily redeemable non-controlling
interests associated with finite-lived subsidiaries, as amended by FASB Staff
Position 150-3, has been deferred, for an indefinite period. The provisions of
SFAS 150 relating to all other financial instruments 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. The implementation of SFAS 150 is delayed for nonpublic companies to
fiscal periods beginning after December 15, 2003. In accordance with the
foregoing, the Company is 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
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.
The Company incurred $3.1 million of direct costs, including the $2.0 million
earnest money deposit referred to above, in connection with this transaction.
These costs were expensed during the quarter ended June 30, 2003 and are
included in Other Expenses in the Condensed Consolidated Statements of
Operations.
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 Annual Report on
Form 10-K for the year ended December 31, 2002 and the Company's Quarterly
15
Reports on Form 10-Q for the fiscal quarters ended March 31, 2003 and June 30,
2003.
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. Arguments of these
briefs were scheduled for September 10, 2003, but were postponed by the Court. A
new date has not been established by the Court. On August 1, 2003, the Company
posted a judgment bond in the amount of $18.8 million with the U.S. District
Court. This was accomplished by obtaining a $19.0 million Senior secured term
loan pursuant to a July 31, 2003 amendment to the Loan Agreement. 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.
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 appealed the dismissal. Briefing has been completed. Although no
date has been set for oral arguments, the Company anticipates that such
arguments will likely be scheduled for either December 2003 or February 2004.
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(R) cigarette paper products. The Court requested
that the Company and Bollore, S.A. (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 reported and requested damages of $2.4
million. Briefing has been completed and the parties are awaiting the decision
of the Court.
California Infringing Products Litigation.
- ------------------------------------------
In addition to the judgment previously entered in favor of Bollore, S.A. and the
Company (the "plaintiffs'") 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 notice of appeal and the Court postponed the briefing schedule relating
thereto pending Court-sponsored mediation which was held on October 30, 2003.
During the course of the mediation, the parties agreed to settle the case for
the sum of $1.5 million, to be divided equally by the plaintiffs, and a
16
permanent injunction against the sale of infringing Zig-Zag(R) premium cigarette
paper products by defendants.
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
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 was recorded in equity,
with a corresponding amount recorded as a discount to the preferred stock.
17
12. SEGMENT INFORMATION
In accordance with SFAS No. 131, "Disclosures about Segments of an Enterprise
and Related Information", the Company has three reportable segments. The
smokeless tobacco segment manufactures smokeless tobacco products that are
distributed nationally primarily through wholesale and food distributors in the
United States. The make-your-own segment imports and distributes nationally
premium cigarette papers and contract manufactures and distributes nationally
cigarette tobaccos and related products, primarily through wholesale
distributors in the United States. The premium cigarette segment contract
manufactures and distributes premium manufactured cigarettes through wholesale
distributors in selected areas of 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 the smokeless
tobacco and make-your-own segments based on percentage of net sales.
Eliminations and Other include the assets of the Company not assigned to
segments and the elimination of inter-company 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 table below presents financial information about reported segments as of and
for the three months and nine months ended September 30, 2003 and 2002,
respectively (amounts in thousands). Certain amounts relating to 2002 have been
reclassified to conform to the 2003 presentation.
SMOKELESS PREMIUM
FOR THE THREE MONTHS ENDED: TOBACCO MAKE-YOUR-OWN MANUFACTURED ELIMINATIONS
SEPTEMBER 30, 2003 PRODUCTS TOBACCO PRODUCTS CIGARETTES AND OTHER TOTAL
- ------------------------------- ----------- ---------------- -------------- ------------ -------------
Net Sales $ 9,097 $ 19,595 $ 26 $ - $ 28,718
Operating Income 3,075 7,498 (1,577) - 8,996
Adjusted EBITDA 3,581 7,745 (1,577) - 9,749
Assets 64,785 264,761 1,508 (106,260) 224,794
SEPTEMBER 30, 2002
- -------------------------------
Net Sales $ 8,743 $ 17,271 $ - $ - $ 26,014
Operating Income 1,404 7,771 - - 9,175
Adjusted EBITDA 2,079 7,921 - - 10,000
Assets 66,409 245,765 - (98,051) 214,123
SMOKELESS PREMIUM
FOR THE NINE MONTHS ENDED: TOBACCO MAKE-YOUR-OWN MANUFACTURED ELIMINATIONS
SEPTEMBER 30, 2003 PRODUCTS TOBACCO PRODUCTS CIGARETTES AND OTHER TOTAL
- ------------------------------- ----------- ---------------- -------------- ------------ -------------
Net Sales $ 26,715 $ 46,477 $ 26 $ - $ 73,218
Operating Income 6,843 13,310 (1,577) - 18,576
Adjusted EBITDA 8,466 13,857 (1,577) - 20,746
Assets 64,785 264,761 1,508 (106,260) 224,794
18
SEPTEMBER 30, 2002
- -------------------------------
Net Sales $ 27,798 $ 38,386 $ - $ - $ 66,184
Operating Income 5,622 14,871 - - 20,493
Adjusted EBITDA 7,797 15,321 - - 23,118
Assets 66,409 245,764 - (98,051) 214,123
The following table is a reconciliation of the Company's Net income (loss) to
Adjusted EBITDA for the three months and nine months ended September 30, 2003
and 2002, respectively (amounts in thousands):
FOR THE THREE MONTHS ENDED: FOR THE NINE MONTHS ENDED:
SEPTEMBER 30 SEPTEMBER 30
-------------------------------------- --------------------------------------
2003 2002 2002 2002
-------------- -------------- -------------- --------------
Net income (loss) $ 2,071 $ 2,367 $ (11,415) $ 3,127
Interest expense, net and amortization of
deferred financing fees 4,817 4,676 14,130 14,074
Income tax expense (benefit) 1,269 1,451 (6,996) 1,917
Depreciation 125 175 375 525
Other expense 839 681 22,857 1,375
LIFO adjustment (50) 350 400 1,200
Stock option compensation expense 184 25 307 75
Postretirement/Pension expense 494 275 1,088 825
-------------- -------------- -------------- --------------
Adjusted EBITDA $ 9,749 $ 10,000 $ 20,746 $ 23,118
============== ============== ============== ==============
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
The Company competes in three distinct markets: (1) the smokeless tobacco
market; (2) the Make-Your-Own ("MYO") cigarette market; and (3) the manufactured
cigarette market. The smokeless tobacco market includes the loose leaf chewing
tobacco sector; the MYO cigarette market is comprised of the MYO premium
cigarette papers sector and the MYO cigarette tobaccos and related products
sector; and the manufactured cigarette market includes the Company's premium
quality manufactured cigarettes. The Company manufactures and markets loose leaf
chewing tobacco; imports and distributes MYO premium cigarette papers; contract
manufactures and markets MYO cigarette tobaccos and related products; and
contract manufactures and distributes premium quality manufactured cigarettes
through wholesale distributors in selected areas in the United States.
RESULTS OF OPERATIONS
COMPARISON OF THREE MONTHS ENDED SEPTEMBER 30, 2003 AND 2002
Net Sales. Consolidated net sales for the three months ended September 30, 2003
were $28.7 million, an increase of $2.7 million or 10.4% from the corresponding
period of the prior year.
Net sales of the smokeless tobacco segment for the current period increased $0.4
million or 4.6% from the corresponding period of the prior year. For the current
period, this segment's aggregate case volume decreased by 5.3% 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
19
discounting activity by moist snuff manufacturers, as well as to a continuing
industry-wide decline in sales volume 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 two price increases of approximately 5%
each, one instituted in the fourth quarter of 2002 and one instituted in the
third quarter of 2003.
Net sales of the Company's MYO segment increased $2.3 million or 13.3% in
comparison to the corresponding period of the prior year. Within the MYO
segment, premium cigarette paper sales increased $1.7 million or 12.4% from the
corresponding period of the prior year. This increase was attributable to a
successful sales promotion of premium cigarette papers for the variety wholesale
class of trade which was conducted during the fiscal quarter ended September 30,
2003.
The MYO cigarette tobaccos and related products' net sales continued their
growth trend, increasing $0.6 million or 17.1% in comparison to the
corresponding period of the prior year, reflecting 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 $0.2 million during the fiscal quarter ended September 30, 2003, is expected
to be remedied during the fourth quarter of 2003.
Sales of premium quality manufactured cigarettes commenced late in the third
quarter of 2003. To date, initial operations have not been significant.
Gross Profit. Consolidated gross profit for the three months ended September 30,
2003 totaled $16.9 million, an increase of $1.4 million or 9.0% from the
corresponding period of the prior year due primarily to higher profit margins in
the smokeless tobacco segment and an increase in premium cigarette paper net
sales.
Gross profit of the smokeless tobacco segment increased $1.1 million or 26.2%
from the corresponding period of the prior year. Gross margin for this segment
increased to 58.2% of net sales for the current period from 48.3% in the
corresponding period of the prior year due principally to the Company's price
increases.
Gross profit of the MYO segment for the current period increased $0.3 million or
2.7%, as compared to the prior period. The gross margin for the MYO segment
decreased to 59.2% of net sales for the current period in comparison to 65.3%
for the prior period. This reduction in gross margin was due principally to
higher cost of goods sold with respect to MYO premium cigarette papers resulting
from a stronger Euro in comparison to the U.S. dollar.
Selling, General, and Administrative Expenses. Selling, general, and
administrative expenses for the three months ended September 30, 2003 were $7.9
million, an increase of $1.6 million or 25.4% compared to the corresponding
period of the prior year. This increase substantially relates to the
commencement of operations in the Premium Quality manufactured cigarette
segment.
Interest Expense and Financing Costs. Interest expense and financing costs for
the three months ended September 30, 2003 totaled $4.8 million, an increase of
$0.1 million or 2.1% compared to the corresponding period of the prior year.
This increase relates to higher overall debt balances due to the need to fund an
20
$18.8 million judgment bond in connection with certain litigation with Republic
Tobacco, Inc. as described in Part II, Item 1, under "Legal Proceedings."
Other Expense. Other expense totaled $0.8 million for the three months ended
September 30, 2003 relating to funding expenses associated with the judgment
bond, referenced above. Other expense in 2002 totaled $0.7 million for the three
months ended September 30, 2002, representing legal, investigative and related
expenses with respect to the Texas and California Infringing Products
Litigations involving Zig-Zag(R) premium cigarette papers, which are detailed in
Part II, Item 1 under "Legal Proceedings."
Income Tax Expense. Income tax expense was $1.3 million for the three months
ended September 30, 2003, compared to $1.5 million for the corresponding period
of the prior year. The effective income tax rate for both periods was 38%.
Net Income. Due to the factors described above, net income for the three months
ended September 30, 2003 was $2.1 million compared to $2.4 million for the
corresponding period of the prior year.
COMPARISON OF NINE MONTHS ENDED SEPTEMBER 30, 2003 AND 2002
Net Sales. Consolidated net sales for the nine months ended September 30, 2003
were $73.2 million, an increase of $6.9 million or 10.4% from the corresponding
period of the prior year.
Net sales of the smokeless tobacco segment for the current period decreased $1.1
million or 4.0% from the corresponding period of the prior year. For the current
period, the aggregate case volume for this segment decreased by 9.2%, 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 to a continuing
industry-wide decline in sales volume 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 two price increases of approximately 5%
each, one instituted in the fourth quarter of 2002 and one instituted in the
third quarter of 2003.
Net sales of the Company's MYO segment increased $8.0 million or 20.8% in
comparison to the corresponding period of the prior year. Within the MYO
segment, premium cigarette paper sales increased $3.7 million or 12.9% 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 $4.3 million or
48.3% 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 $0.2 million during the
nine months ended September 30, 2003, is expected to be remedied during the
fourth quarter of 2003.
Sales of premium quality manufactured cigarettes commenced late in the third
quarter of 2003. To date, initial operations have not been significant.
21
Gross Profit. Consolidated gross profit for the nine months ended September 30,
2003 totaled $40.9 million, an increase of $2.4 million or 6.2% from the
corresponding period of the prior year due to the increases in net sales of
premium cigarette papers and MYO cigarette tobaccos and related products, as
described above.
Gross profit of the smokeless tobacco segment increased $0.7 million or 5.1%
from the corresponding period of the prior year. Gross margin for this segment
increased to 53.6% of net sales for the current period from 48.9% in the
corresponding period of the prior year due principally to the Company's price
increases coupled with lower LIFO expense.
Gross profit of the MYO segment for the current period increased $1.7 million or
6.8%, as compared to the prior period. The gross margin of the MYO segment
declined to 57.2% of net sales for the current period in comparison to 64.7% for
the prior period. This reduction in gross margin was due principally to higher
cost of goods with respect MYO premium cigarette papers resulting from a
stronger Euro in comparison to the U.S. dollar.
Selling, General, and Administrative Expenses. Selling, general, and
administrative expenses for the nine months ended September 30, 2003 were $22.3
million, an increase of $4.3 million or 23.9% compared to the corresponding
period of the prior year. As 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 $2.2 million in comparison to the corresponding period
of the prior year. In addition, the commencement of operations in the Premium
manufactured cigarette segment increased expenses by $1.6 million during the
nine months ending September 30, 2003 as compared with the corresponding period
of the prior year.
Interest Expense and Financing Costs. Interest expense and financing costs for
the nine months ended September 30, 2003 totaled $14.1 million and were
unchanged from the prior period.
Other Expense. Other expense was $22.9 million for the nine months ended
September 30, 2003. This resulted from the expensing of costs of $3.1 million
associated with the termination of the Star Cigarette Asset Purchase Agreement
and $18.8 million associated with a judgment rendered against the Company in
connection with the litigation with Republic Tobacco, Inc., as described in Part
II, Item 1 under "Legal Proceedings." Other expense in 2002 totaled $1.4 million
representing legal, investigative and related expenses with respect to the Texas
and California Infringing Products Litigations involving Zig-Zag(R) premium
cigarette papers which are detailed in Part II, Item 1 under "Legal
Proceedings."
Income Tax Benefit (Expense). Income tax benefit was $7.0 million for the nine
months ended September 30, 2003 compared to an expense of $1.9 million for the
corresponding period of the prior year due primarily to Other Expense of $22.9
million described above. The effective income tax rate for both periods was 38%.
22
Net Income (Loss). Due to the factors described above, net loss for the nine
months ended September 30, 2003 was $11.4 million compared to net income of $3.1
million for the corresponding period of the prior year.
LIQUIDITY AND CAPITAL REQUIREMENTS
At September 30, 2003, the Company had a working capital deficit of $142.0
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 incurrence of a $19.0
million Senior secured term loan used to fund the judgment bond relative to the
Illinois Complaint as described in Note 10 of the Condensed Consolidated
Financial Statements. In addition to the effects of the Senior Notes
reclassification and the Senior secured term loan, working capital declined $0.3
million, which resulted principally from purchases of property, plant and
equipment. The Company expects to continue to fund its seasonal working capital
requirements through its operating cash flows and, if needed, borrowings under
the Loan Agreement referred to below (the "Revolving Credit Facility"). As of
September 30, 2003, the Company had additional availability of $9.2 million
under the Revolving Credit Facility.
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 the maturity thereof was extended to
December 31, 2003. All other 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 September 30, 2003, the interest rate on
borrowings under the Loan Agreement was 3.47%.
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. Under the amendment to
the Loan Agreement, all terms and conditions of the Revolving Credit Facility
remain in place except for the amount, which was reduced to $15.0 million on
July 31, 2003. 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. In the event the Company is not able to effect the
refinancing, 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 that contingency.
23
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 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 Company's ability to incur additional indebtedness, pay dividends,
enter into certain types of transactions with affiliates, sell certain assets or
merge with or into other companies, make certain investments, incur liens and
engage in other businesses, among other things. At September 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
un-issued 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 during the nine month period ended September 30, 2003, as
the demand for cigarette tubes exceeded available supply, resulting in lost or
delayed sales of $0.2 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 from
Bollore, S.A.
24
Given its current operations, the Company believes that its capital expenditure
requirements for 2003 will be approximately $1.8 million. For the nine months
ended September 30, 2003, the Company had funded capital expenditures of $1.3
million.
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 affect 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 Zig-Zag(R) premium cigarette introduction 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
25
Act")), as of September 30, 2003. Based on their evaluation, the Company's
principal executive and principal financial officers concluded that the
Company's disclosure controls and procedures were effective as of September 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 September 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 Annual Report on
Form 10-K for the year ended December 31, 2002 and the Company's Quarterly
Reports on Form 10-Q for the fiscal quarters ended March 31, 2003 and June 30,
2003.
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. Arguments of these
briefs were scheduled for September 10, 2003, but were postponed by the Court. A
new date has not been established by the Court. On August 1, 2003, the Company
posted a judgment bond in the amount of $18.8 million with the U.S. District
Court. This was accomplished by obtaining a $19.0 million Senior secured term
loan pursuant to a July 31, 2003 amendment to the Loan Agreement. 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.
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 appealed the dismissal. Briefing has been completed. Although no
date has been set for oral arguments, the Company anticipates that such
arguments will likely be scheduled for either December 2003 or February 2004.
26
Texas Infringing Products Litigation.
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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(R) cigarette paper products. The Court requested
that the Company and Bollore, S.A. (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 reported and requested damages of $2.4
million. Briefing has been completed and the parties are awaiting the decision
of the Court.
California Infringing Products Litigation.
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In addition to the judgment previously entered in favor of Bollore, S.A. and the
Company (the "plaintiffs'") 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 notice of appeal and the Court postponed the briefing schedule relating
thereto pending Court-sponsored mediation which was held on October 30, 2003.
During the course of the mediation, the parties agreed to settle the case for
the sum of $1.5 million, to be divided equally by the plaintiffs, and a
permanent injunction against the sale of infringing Zig-Zag(R) premium cigarette
paper products by defendants.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
a. Exhibits
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."
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SIGNATURES
Pursuant to the terms of the Securities Exchange Act of 1934, the
Company has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
NORTH ATLANTIC TRADING COMPANY, INC.
/s/ Thomas F. Helms, Jr.
-------------------------------------
Date: November 12, 2003 Thomas F. Helms, Jr.
Chief Executive Officer
/s/ David I. Brunson
-------------------------------------
David I. Brunson
Chief Financial Officer
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