(Mark One)
/X/ QUARTERLY REPORT PURSUANT TO
SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For
the quarterly period ended April 2, 2005
OR
/ / TRANSITION REPORT PURSUANT TO
SECTION 13 or 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For
the transition period from _______ to _______
Commission File Number 0-24620
DARLING INTERNATIONAL INC.
(Exact name of
registrant as specified in its charter)
| DELAWARE | 36-2495346 |
| (State or other jurisdiction | (I.R.S. Employer |
| of incorporation or
organization) |
Identification No.) |
| 251 O'Connor Ridge Blvd., Suite 300 Irving, Texas (Address of principal executive offices) |
75038 (Zip Code) |
Registrant's telephone number, including area code: (972) 717-0300
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 / /
There were 63,914,336 shares of common stock, $0.01 par value, outstanding at May 4, 2005.
Page 1
DARLING INTERNATIONAL INC. AND SUBSIDIARIES
FORM 10-Q FOR THE THREE MONTHS ENDED APRIL 2, 2005
TABLE OF CONTENTS
PART I: FINANCIAL INFORMATION
| Item 1. FINANCIAL STATEMENTS | |||
| Consolidated Balance Sheets April 2, 2005 (unaudited) and January 1, 2005 |
3 | ||
| Consolidated Statements of Operations (unaudited) Three Months Ended April 2, 2005 and April 3, 2004 |
4 | ||
| Consolidated Statements of Cash Flows (unaudited) Three Months Ended April 2, 2005 and April 3, 2004 |
5 | ||
| Notes to Consolidated Financial Statements
(unaudited) |
6 | ||
| Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS |
15 | ||
| Item 3.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK |
29 | ||
| Item 4. CONTROLS AND PROCEDURES
|
30 | ||
PART II: OTHER INFORMATION
| Item 6.
EXHIBITS AND REPORTS ON FORM 8-K |
31 | |
| Signatures | 32 |
Page 2
DARLING INTERNATIONAL INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
April 2, 2005 and January 1, 2005
(in thousands, except shares and per share data)
April 2, January 1,
2005 2005
----------- ----------
(unaudited)
ASSETS
- ------
Current assets:
Cash and cash equivalents ................................... $ 38,617 $ 37,249
Restricted cash ............................................. 2,370 2,379
Accounts receivable ......................................... 23,520 26,675
Inventories ................................................. 7,591 6,000
Prepaid expenses ............................................ 3,252 3,740
Deferred income taxes ....................................... 4,224 4,080
Assets held for sale ........................................ 833 837
Other ....................................................... 6 13
------- -------
Total current assets .............................. 80,413 80,973
Property, plant and equipment, less accumulated depreciation
of $168,238 at April 2, 2005 and $166,353 at January 1, 2005 .. 75,671 75,398
Collection routes and contracts, less accumulated amortization of
$30,132 at April 2, 2005 and $29,163 at January 1, 2005 ....... 15,041 16,006
Goodwill, less accumulated amortization of $1,077 at April 2, 2005
and January 1, 2005 ........................................... 4,429 4,429
Deferred loan costs .............................................. 3,375 3,565
Other assets ..................................................... 2,712 2,438
------- -------
$181,641 $182,809
======= =======
LIABILITIES AND STOCKHOLDERS' EQUITY
- ------------------------------------
Current liabilities:
Current portion of long-term debt ........................... $ 5,029 $ 5,030
Accounts payable, principally trade ......................... 8,363 8,144
Accrued expenses ............................................ 29,291 28,005
Accrued interest ............................................ 57 192
------- -------
Total current liabilities ......................... 42,740 41,371
Long-term debt, net .............................................. 47,022 49,528
Other non-current liabilities .................................... 20,332 20,197
Deferred income taxes ............................................ 3,190 4,478
------- -------
Total liabilities ................................. 113,284 115,574
------- -------
Stockholders' equity:
Common stock, $0.01 par value; 100,000,000 shares authorized;
63,925,336 and 63,918,346 shares issued and outstanding at
April 2, 2005 and at January 1, 2005, respectively ....... 639 639
Additional paid-in capital .................................. 77,396 77,393
Treasury stock, at cost; 21,000 shares at April 2, 2005 and
January 1, 2005 .......................................... (172) (172)
Accumulated other comprehensive loss ........................ (7,134) (7,331)
Accumulated deficit ......................................... (2,372) (3,294)
------- -------
Total stockholders' equity ........................ 68,357 67,235
------- -------
Commitments and contingencies .................................... $181,641 $182,809
======= =======
The accompanying notes are an integral part of these consolidated financial statements.
Page 3
DARLING INTERNATIONAL INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
Three Months Ended April 2, 2005 and April 3, 2004
(in thousands, except per share data)
(unaudited)
April 2, April 3,
2005 2004
---------- ----------
Net sales $71,353 $77,540
Costs and expenses:
Cost of sales and operating expenses 56,109 58,094
Selling, general and administrative expenses 8,700 8,987
Depreciation and amortization 3,771 3,772
------- -------
Total costs and expenses 68,580 70,853
------- -------
Operating income 2,773 6,687
------- -------
Other income/(expense):
Interest expense (1,584) (1,760)
Other, net 200 1,395
------- -------
Total other income/(expense) (1,384) (365)
------- -------
Income from continuing operations before income taxes 1,389 6,322
Income taxes 473 2,408
------- -------
Income from continuing operations 916 3,914
Income from discontinued operations, net of tax 6 21
------- -------
Net income $ 922 $ 3,935
======= =======
Basic and diluted income per share:
Continuing operations $ 0.01 $ 0.06
Discontinued operations - -
------- -------
Total $ 0.01 $ 0.06
======= =======
The accompanying notes are an integral part of these consolidated financial statements.
Page 4
DARLING INTERNATIONAL INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
Three months ended April 2, 2005 and April 3, 2004
(in thousands)
(unaudited)
April 2, April 3,
2005 2004
----------- ----------
Cash flows from operating activities:
Income from continuing operations $ 916 $ 3,914
Adjustments to reconcile income from continuing operations to
net cash provided by operating activities:
Depreciation and amortization 3,771 3,772
Gain on disposal of property, plant, equipment and other assets (132) (257)
Gain on early extinguishment of debt - (1,306)
Deferred taxes (1,432) -
Changes in operating assets and liabilities:
Restricted cash 9 9
Accounts receivable 3,155 1,653
Inventories and prepaid expenses (1,103) (25)
Accounts payable and accrued expenses 1,505 226
Accrued interest (135) (283)
Other 282 (129)
-------- --------
Net cash provided by continuing operating activities 6,836 7,574
Net cash provided by discontinued operations 6 23
-------- --------
Net cash provided by operating activities 6,842 7,597
-------- --------
Cash flows from investing activities:
Capital expenditures (3,118) (1,514)
Intangible expenditures (4) -
Gross proceeds from disposal of property, plant and equipment
and other assets 178 349
-------- --------
Net cash used by investing activities (2,944) (1,165)
-------- --------
Cash flows from financing activities:
Proceeds from debt - 92,302
Payments on debt (2,507) (85,820)
Deferred loan costs (7) (112)
Contract payments (19) (95)
Issuance of common stock 3 80
-------- --------
Net cash provided/(used) by financing activities (2,530) 6,355
-------- --------
Net increase in cash and cash equivalents 1,368 12,787
Cash and cash equivalents at beginning of period 37,249 24,803
-------- --------
Cash and cash equivalents at end of period $ 38,617 $ 37,590
======== ========
Supplemental disclosure of cash flow information:
Cash paid during the period for:
Interest $ 1,519 $ 1,761
======== ========
Income taxes, net of refunds $ 205 $ 1,366
======== ========
The accompanying notes are an integral part of these consolidated financial statements.
Page 5
DARLING INTERNATIONAL INC. AND SUBSIDIARIES
Notes to Consolidated Financial
Statements
April 2, 2005
(unaudited)
| (1) | General |
| The accompanying consolidated financial statements for the three month periods ended April 2, 2005 and April 3, 2004 have been prepared in accordance with generally accepted accounting principles in the United States of America by Darling International Inc. (the “Company”) without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). The information furnished herein reflects all adjustments (consisting only of normal recurring accruals) which are, in the opinion of management, necessary to present a fair statement of the financial position and operating results of the Company as of and for the respective periods. However, these operating results are not necessarily indicative of the results expected for a full fiscal year. Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with generally accepted accounting principles have been omitted pursuant to such rules and regulations. However, management of the Company believes, to the best of their knowledge, that the disclosures herein are adequate to make the information presented not misleading. The accompanying consolidated financial statements should be read in conjunction with the audited consolidated financial statements contained in the Company’s Form 10-K for the fiscal year ended January 1, 2005. |
| (2) | Summary of Significant Accounting Policies |
| (a) | Basis of Presentation |
| The consolidated financial statements include the accounts of the Company and its subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation. |
| (b) | Fiscal Periods |
| The Company has a 52/53 week fiscal year ending on the Saturday nearest December 31. Fiscal periods for the consolidated financial statements included herein are as of April 2, 2005, and include the 13 weeks ended April 2, 2005, and the 13 weeks ended April 3, 2004. |
| (c) | Earnings Per Share |
| Basic income per common share is computed by dividing net earnings attributable to outstanding common stock by the weighted average number of common shares outstanding during the period. Diluted income per common share is computed by dividing net earnings attributable to outstanding common stock by the weighted average number of common shares outstanding during the period increased by dilutive common equivalent shares (stock options) determined using the treasury stock method, based on the average market price exceeding the exercise price of the stock options. |
Page 6
| Pro forma treasury shares represent the shares which potentially may be reacquired by the Company as treasury shares from the proceeds of option shares for which the contractual exercise price is less than the market price (“in the money”), based upon a reacquisition price equal to the average market price of the Company’s common shares during the period presented. |
| Net Income per Common Share
(in thousands, except per share data) |
|||||||||
| Three Months Ended |
|||||||||
| April 2, 2005 |
April 3 2004 |
||||||||
| Income |
Shares |
Per Share |
Income |
Shares |
Per Share |
||||
| Income from continuing operations |
$916 |
63,901 |
$0.01 |
$3,914 |
63,721 |
$0.06 |
|||
| Income from discontinued operations, net of tax |
6 |
|
- |
21 |
|
- |
|||
| Basic: Net income |
922 |
63,901 |
0.01 |
3,935 |
63,721 |
0.06 |
|||
| Effect of dilutive securities: Add: Option shares in the money |
|
1,007 |
|
|
1,095 |
|
|||
| Less: Pro forma treasury shares | (341) |
(512) |
|||||||
| Diluted: Net income |
$922 |
64,567 |
$0.01 |
$3,935 |
64,304 |
$0.06 |
|||
| For the three months ended April 2, 2005 and April 3, 2004, respectively, 281,000 and 95,418 outstanding stock options were excluded from diluted income per common share as the effect was not dilutive. |
| (d) | Accounting for Stock-Based Compensation |
| The Company accounts for its stock option plan in accordance with the provisions of Accounting Principles Board (“APB”) Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations. As such, compensation expense is recorded on the date of grant only if the current market price of the underlying stock exceeds the exercise price. Statement of Financial Accounting Standards (“SFAS”) No. 123, Accounting for Stock-Based Compensation, permits entities to recognize as expense over the vesting period the fair value of all stock-based awards on the date of grant. Alternatively, SFAS No. 123 allows entities to continue to apply the provisions of APB Opinion No. 25 and provide pro forma net income and pro forma earnings per share disclosures for employee stock option grants made in 1995 and future years as if the fair-value-based method defined in SFAS No. 123 had been applied. The Company has elected to continue to apply the provisions of APB Opinion No. 25 and provide the pro forma disclosure provisions of SFAS No. 123. |
| The following table illustrates the pro forma effect on net income and income per share if the fair value-based method had been applied to all outstanding and invested awards in each period. |
| Three
Months Ended |
|||||||||
| April 2,
2005 |
April 3, 2004 |
||||||||
| Amount |
Per Share |
Amount |
Per Share |
||||||
| |
Reported net income |
$922 |
|
$0.01 |
|
$3,935 |
|
$ 0.06 |
|
| Deduct total stock-based employee compensation expense determined under fair-value-based method for all rewards, net of tax | (97) |
- |
(82) |
- - |
|||||
| Pro forma effect | $825
|
|
$0.01
|
|
$3,853
|
|
$0.06
|
||
Page 7
| (e) | Discontinued Operations |
| At a scheduled meeting held during the fourth quarter of 2004, the Company’s board of directors approved a plan for the Company to dispose of its operations at London, Ontario, Canada. Results of operations of the London facility were previously included in results of the Company’s rendering segment, and have been reclassified to income/(loss) from discontinued operations in the accompanying consolidated statements of operations, as discussed elsewhere herein. |
| (3) | Contingencies LITIGATION |
| The
Company is a party to several lawsuits, claims and loss contingencies incidental to its
business, including assertions by certain regulatory agencies related to air, wastewater,
and storm water discharges from the Company’s processing facilities. Self Insured Risks The Company purchases its workers compensation, auto and general liability insurance on a retrospective basis. The Company estimates and accrues its expected ultimate costs related to claims occurring during each fiscal year and carries this accrual as a reserve until such claims are paid by the Company. As a result of the matters discussed above, the Company has established loss reserves for insurance, environmental and litigation matters. At April 2, 2005 and January 1, 2005, the reserves for insurance, environmental and litigation contingencies reflected on the balance sheet in accrued expenses and other non-current liabilities were approximately $15.5 million and $13.9 million, respectively. Management of the Company believes these reserves for contingencies are reasonable and sufficient based upon present governmental regulations and information currently available to management; however, there can be no assurance that final costs related to these matters will not exceed current estimates. The Company believes that any additional liability relative to such lawsuits and claims which may not be covered by insurance would not likely have a material adverse effect on the Company’s financial position, although it could potentially have a material impact on the results of operations in any one year. |
| (4) | Business Segments |
| The
Company operates on a worldwide basis within two industry segments: Rendering and
Restaurant Services. The measure of segment profit or loss includes all revenues,
operating expenses (excluding certain amortization of intangibles), and selling, general
and administrative expenses incurred at all operating locations and excludes general
corporate expenses. During the first quarter of Fiscal 2005, the Company increased the
allocation of plant operating expenses and both plant and corporate selling, general and
administrative expense to the Restaurant Services segment, which resulted in additional
expense of $1.1 million allocated to this segment. Included in corporate activities are general corporate expenses and the amortization of intangibles. Assets of corporate activities include cash, unallocated prepaid expenses, deferred tax assets, prepaid pension, and miscellaneous other assets. |
Page 8
| Rendering Rendering consists of the collection and processing of animal by-products from butcher shops, grocery stores, food service industry and independent meat and poultry processors, converting these into products such as useable oils and proteins utilized by the agricultural and oleochemical industries. Restaurant Services Restaurant Services consists of the collection of used cooking oils from food service establishments and recycling them into similar products such as high-energy animal feed ingredients and industrial oils. Restaurant Services also provides grease trap servicing. |
| Business Segment Net Sales (in thousands): |
| Three Months
Ended |
|||||
| April 2, 2005 |
April 3, 2004 |
||||
| Rendering: | |||||
| Trade | $44,359 | $49,176 | |||
| Intersegment | 4,880
|
5,327
|
|||
| 49,239
|
54,503
|
||||
| Restaurant Services: | |||||
| Trade | 26,994 | 28,364 | |||
| Intersegment | 2,482
|
2,761
|
|||
| 29,476
|
31,125
|
||||
| Eliminations | (7,362)
|
(8,088)
|
|||
| Total | $71,353
|
$77,540
|
|||
| Business Segment Profit/(Loss) (in thousands): |
| Three Months Ended
|
|||||
| April 2, 2005 |
April 3, 2004 |
||||
| Rendering | $4,502 | $6,098 | |||
| Restaurant Services | 3,720 | 6,298 | |||
| Corporate | (5,722) | (6,722) | |||
| Interest expense | (1,584)
|
(1,760)
|
|||
| Income from continuing operations | $ 916
|
$3,914
|
|||
| Certain assets are not attributable to a single operating segment but instead relate to multiple operating segments operating out of individual locations. These assets are utilized by both the Rendering and Restaurant Services business segments and are identified in the category called Combined Rendering/Restaurant Services. Depreciation of Combined Rendering/Restaurant Services assets is allocated based upon management’s estimate of the percentage of corresponding activity attributed to each segment. |
Page 9
| Business Segment Assets (in thousands): |
| April 2, 2005 |
January 1, 2005 |
||||
| Rendering | $46,941 | $46,995 | |||
| Restaurant Services | 17,123 | 15,355 | |||
| Combined Rendering/Restaurant Services | 62,303 | 63,894 | |||
| Corporate | 55,274
|
56,565
|
|||
| Total | $181,641
|
$182,809
|
| (5) | Income Taxes |
| The
Company has provided income taxes for the three-month period ended April 2, 2005 and April
3, 2004, based on its estimate of the effective tax rate for the entire 2005 and 2004
fiscal years. In determining whether its deferred tax assets are more likely to be recoverable, than not recoverable, the Company assessed its ability to carryback net operating losses, scheduled reversals of future taxable and deductible amounts, tax planning strategies, and the extent of evidence currently available to support projections of future taxable income. The Company is unable to carryback any of its net operating losses and recent favorable operating results do not provide sufficient historical evidence at this time of sustained future profitability sufficient to result in taxable income against which certain net operating losses can be carried forward and utilized. |
| (6) | Financing (a) Refinancing –Senior Credit Agreement The Company entered into a new Senior Credit Agreement with new lenders on April 2, 2004, and entered into a new lender acknowledgement on May 28, 2004, that increased the committed amount as permitted by the Senior Credit Agreement. The refinancing replaces the prior Amended and Restated Credit Agreement executed on May 13, 2002. The new Senior Credit Agreement provides for $75 million in financing facilities, has a term of five years, maturing on April 2, 2009, and bears interest at a rate which may be based upon either prime or LIBOR, or a combination of both rates plus a margin which may be adjusted quarterly based upon the Company’s leverage ratios. The new Senior Credit Agreement provides for a $25.0 million Term Loan Facility, with scheduled amortization of $1.25 million each quarter during the five-year agreement. Additionally, the new Senior Credit Agreement provides for a $50 million Revolver Facility which includes a $25.0 million Letter of Credit sub-facility. At April 2, 2005, the interest rate for the $17.0 million balance of the term loan was based upon a three-month LIBOR rate of 3.05% per annum, plus a margin of 2.50% per annum for a total of 5.55% per annum. |
Page 10
|
The
refinancing provides increased availability and liquidity, an extended term, lower
interest rates, and more flexible capital investment limitations than the prior Amended
and Restated Credit Agreement. Restrictive covenants in the Company’s new Senior
Credit Agreement permit the Company, within limitations defined in the new Senior Credit
Agreement, to incur additional indebtedness; issue additional capital or preferred stock;
pay dividends; redeem common shares as treasury stock; create liens; merge, consolidate,
or acquire other businesses; sell and dispose of assets; and make investments; and
requires the maintenance of certain minimum financial ratios. On April 2, 2004, proceeds of the new Term Loan Facility were used to pay off the outstanding balance of the prior Amended and Restated Credit Agreement of approximately $18.0 million. Additional proceeds were used for other general corporate and working capital purposes. The terms of the new Senior Credit Agreement required the Company to redeem the Company’s preferred stock during the second quarter of 2004. As such, the remaining proceeds and cash on hand were used to redeem the Company’s preferred stock at face value of $10.0 million plus accumulated preferred dividends of approximately $1.2 million, for a total aggregate consideration of $11.2 million. The preferred stock had a carrying value of approximately $9.5 million at April 3, 2004. Consequently, redemption of the preferred stock and accumulated dividends resulted in a loss on extinguishment of the preferred stock of approximately $1.7 million, which was included in other expense during the second quarter of 2004. On May 13, 2002, the Company consummated a recapitalization and executed the prior Amended and Restated Credit Agreement with its lenders. The prior Amended and Restated Credit Agreement reflects the effect of applying the provisions of Statement of Financial Accounting Standards No. 15, Accounting by Debtors and Creditors for Troubled Debt Restructurings (“SFAS No. 15”). SFAS No. 15 requires that the previously existing amount of debt owed by the Company to the lenders be reduced by the fair value of the equity interest granted and that no gain from restructuring the Company’s bank debt be recognized. As a result, the carrying amount of the debt of $20.6 million exceeded its contractual amount of $18.3 million by $2.3 million at January 3, 2004. The outstanding balance of the prior Amended and Restated Credit Agreement at April 2, 2004 of approximately $20.1 million was reduced to zero through a payment of approximately $18.0 million in cash proceeds from the new Senior Credit Agreement. The remaining balance related to the SFAS 15 effect of approximately $2.1 million was recorded as a gain on early retirement of debt, included in other income in the operating statement, net of related deferred loan costs of approximately $0.8 million, also extinguished upon payment of the related debt, which resulted in a net gain on early retirement of debt of approximately $1.3 million recorded in the first quarter of Fiscal 2004. |
| (b)
Senior Subordinated Notes On December 31, 2003, the Company issued Senior Subordinated Notes in the principal amount of $35,000,000 and applied the net proceeds of such issuance to reduce the outstanding term loan portion of its prior Amended and Restated Credit Agreement executed on May 13, 2002. The Senior Subordinated Notes have a term of six years, maturing on December 31, 2009. Beginning June 1, 2006, the Company may prepay the outstanding principal amount of the Senior Subordinated Notes in whole or in part, plus accrued and unpaid interest, plus a prepayment fee of 5.5%, which declines each year after this date. Interest accrues on the outstanding principal balance of the Senior Subordinated Notes at an annual rate of 12% that is payable quarterly in arrears. Restrictive covenants in the Senior Subordinated Notes permit the Company, within limitations defined in the Senior Subordinated Notes, to incur additional indebtedness and to pay cash dividends. |
Page 11
| The Company’s new Senior Credit Agreement, Senior Subordinated Notes, and prior Amended and Restated Credit Agreement consisted of the following elements at April 2, 2005 and January 1, 2005, respectively (in thousands): |
| April 2, 2005 |
January 1, 2005 |
||||
| Senior Credit Agreement: | |||||
| Term Loan | $ 17,000
|
$ 19,500
|
|||
| Revolving Credit Facility: | |||||
| Maximum availability | $ 50,000 | $ 50,000 | |||
| Borrowings outstanding | - | - | |||
| Letters of credit issued | 12,072 |
13,700 |
|||
| Availability | $ 37,928
|
$ 36,300
|
|||
| Senior Subordinated Notes Payable: | $ 35,000
|
$ 35,000
|
| Substantially all of the Company's assets are either pledged or mortgaged as collateral for borrowings under the new Senior Credit Agreement. The new Senior Credit Agreement contains certain terms and covenants which permit the incurrence of additional indebtedness, the payment of cash dividends, the retention of certain proceeds from sales of assets, and capital expenditures, within limitations defined by the new Senior Credit Agreement, and requires the maintenance of certain minimum financial ratios, including: minimum fixed charge coverage ratio, maximum leverage ratio, and minimum tangible net worth, each as defined in the new Senior Credit Agreement. The Company is currently in compliance with all of the covenants contained in the new Senior Credit Agreement. At April 2, 2005, the Company had unrestricted cash of $38.6 million, compared to unrestricted cash of $37.2 million at January 1, 2005. |
| (7) | Derivative Instruments |
| The
Company makes limited use of derivative instruments to manage cash flow risks related to
natural gas expense. The Company does not use derivative instruments for trading purposes. At April 2, 2005, the Company had forward purchase agreements in place for purchases of approximately $0.5 million of natural gas. These agreements have no net settlement provisions and the Company intends to take physical delivery, which it has done under similar forward purchase agreements, during Fiscal 2004 and the first three months of Fiscal 2005. Accordingly, the agreements are not subject to the requirements of Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities (“SFAS No. 133”), because they qualify as normal purchases as defined in the standard. |
| (8) | Comprehensive Income |
| The Company follows the provisions of Statement of Financial Accounting Standards No. 130, Reporting Comprehensive Income (“SFAS 130”). SFAS 130 establishes standards for reporting and presentation of comprehensive income or loss and its components. Total comprehensive income for the three months ended April 2, 2005, and April 3, 2004, was $1.1 million and $3.9 million, respectively. |
| (9) | Revenue Recognition |
| The Company recognizes revenue on sales when products are shipped and the customer takes ownership and assumes risk of loss. Collection fees are recognized in the month the service is provided. |
Page 12
| (10) | Assets Held for Sale and Discontinued Operations |
| Assets held for sale consist of the following (in thousands): |
| April 2, 2005 |
|
January 1, 2005 |
|||
| Petaluma, CA | $ 497 | $ 497 | |||
| Tyler, TX | 183 | 183 | |||
| Sunnyside, WA | 129 | 133 | |||
| London, Ontario Canada | 24 |
24 |
|||
| $833 |
$837 |
| Assets held for sale are carried at the lower of cost, less accumulated depreciation, or fair value. The assets are expected to be sold within the next twelve months and are classified as current assets. These assets were previously utilized in rendering operations. At a meeting held during the fourth quarter of 2004, the Company’s board of directors approved a plan for the Company to dispose of its operation at London, Ontario, Canada. Results of operations of the London facility were previously included in results of the Company’s rendering segment, and have been reclassified to income/(loss) from discontinued operations in the accompanying consolidated statements of operations. The Sunnyside, Washington sale was completed on April 8, 2005 and the Tyler, Texas sale was completed on May 6, 2005. Revenue, costs and expenses, net of applicable taxes of the London location are as follows (in thousands): |
| Three Months Ended
|
|||||
| April 2, 2005 |
April 3, 2004 |
||||
| Net sales | $ - |
$ 183 |
|||
| Cost of sales and operating expenses | - | 125 | |||
| Selling, general and administrative expenses | - | 31 | |||
| Depreciation and amortization | - |
2 |
|||
| Total costs and expenses | - | 158 | |||
| Operating and pre-tax income, now classified as income from discontinued operations |
- |
25 |
|||
| Other income/(expense) | 10 |
- |
|||
| Income before income taxes | 10 |
25 |
|||
| Income tax expense | (4) |
(4) |
|||
| Income from discontinued operations, net of tax |
$ 6 |
$ 21 |
|||
| (11) | Employee Benefit Plans |
| The Company has retirement and pension plans covering substantially all of its employees. Most retirement benefits are provided by the Company under separate final-pay noncontributory pension plans for all salaried and hourly employees (excluding those covered by union-sponsored plans) who meet service and age requirements. Benefits are based principally on length of service and earnings patterns during the five years preceding retirement. |
Page 13
| Net pension cost for the three months ended April 2, 2005 and April 3, 2004 includes the following components (in thousands): |
| April 2, 2005 |
April 3, 2004 |
||||
| Service cost | $ 500 | $ 438 | |||
| Interest cost | 1,052 | 996 | |||
| Expected return on plan assets | (1,095) | (1,009) | |||
| Amortization of prior service cost | 35 | 35 | |||
| Amortization of net loss | 316 |
217 |
|||
| Net pension cost | $ 808
|
$ 677
|
| Contributions The Company’s funding policy for employee benefit pension plans is to contribute annually not less than the minimum amount required nor more than the maximum amount that can be deducted for federal income tax purposes. Contributions are intended to provide not only for benefits attributed to service to date, but also for those expected to be earned in the future. The Company previously disclosed in its financial statements for the year ended January 1, 2005, that it expected to contribute $1.9 million to its pension plan in Fiscal 2005. Based on current actuarial estimates, the Company expects to contribute $3.1 million to its pension plan in the next twelve months in order to meet funding requirements, which is included in current accrued expenses on the Company’s balance sheet at April 2, 2005. |
Page 14
| Item 2. | MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS |
The following Management’s Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements that involve risks and uncertainties. The Company’s actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors, including those set forth below under the heading “Forward Looking Statements” and elsewhere in this report, and under the heading “Risk Factors” in the Company’s Annual Report on Form 10-K for the year ended January 1, 2005, and in the Company’s other public filings with the SEC.
The following discussion should be read in conjunction with the historical consolidated financial statements and notes thereto.
Overview
Darling International Inc. is a leading provider of rendering, recycling and recovery solutions to the nation’s food industry. The Company collects and recycles animal by-products and used cooking oil from food service establishments and provides grease trap cleaning services to many of the same establishments. The Company processes such raw materials at 24 facilities located throughout the United States, into finished products such as protein (primarily meat and bone meal, “MBM”), tallow (primarily bleachable fancy tallow, “BFT”), and yellow grease (“YG”). The Company sells these products nationally and internationally, primarily to producers of oleo-chemicals, soaps, pet foods, and livestock feed, for use as ingredients in their products or for further processing. The Company’s operations are organized into two segments: Rendering and Restaurant Services. The accompanying consolidated financial statements should be read in conjunction with the audited consolidated financial statements contained in the Company’s Form 10-K for the fiscal year ended January 1, 2005.
Major challenges faced by the Company during the first quarter of Fiscal 2005 included reduced raw material supplies, lower finished product prices and high relative prices for diesel fuel and natural gas. The anticipated new government regulations pertaining to Bovine Spongiform Encephalopathy (“BSE”), which were not implemented in the first quarter of Fiscal 2005, contributed to an environment of uncertainty regarding the impact of those regulations. Export markets in foreign countries for U.S. produced finished beef products and other cattle by-products continued to be closed throughout the first quarter of 2005.
Operating income decreased by $3.9 million in the first quarter of Fiscal 2005 compared to the first quarter of Fiscal 2004. The challenges faced by the Company indicate there can be no assurance that operating results achieved by the Company in the first quarter of Fiscal 2005 are indicative of future operating performance of the Company.
Summary of Critical Issues Faced by the Company During the First Quarter of 2005
Page 15
Summary of Critical Issues and Known Trends Faced by the Company in 2005 and Thereafter
Page 16
| 3. | As a result of the BSE case, many foreign countries closed their borders to U.S. beef products, including MBM. As of April 30, 2005, many foreign countries continued to refuse shipments of U.S. produced MBM. Despite the MBM market price fluctuations that occurred during Fiscal 2004 and the first quarter of Fiscal 2005, the Company does not anticipate the need to make significant changes in its business plan or daily operations at this time. The Company’s management monitors market conditions and prices for its finished products on a daily basis. If market conditions or prices were to significantly change, the Company’s management would evaluate and implement such measures, if any, that it deems necessary to respond to the change in market conditions. On larger formula-based pricing suppliers, the indexing of finished product price to raw material cost effectively fixes the gross margin on finished product sales at a stable level, providing some protection to the Company from price declines. |
These challenges indicate there can be no assurance that operating results of the Company achieved in the first quarter of Fiscal 2005 are indicative of future operating performance of the Company.
Page 17
Results of Operations
Three Months Ended April 2, 2005 Compared to Three Months Ended April 3, 2004
Summary of Key Factors Impacting First Quarter 2005 Results:
Principal factors which contributed to a $3.9 million (58.5%) decrease in operating income, which are discussed in greater detail in the following section, were:
These decreases were partially offset by:
Summary of Key Indicators of 2005 Performance:
Principal indicators which management routinely monitors and compares to previous periods as an indicator of problems or improvements in operating results include:
These indicators and their importance are discussed below in greater detail.
Prices for finished product commodities that the Company produces are quoted each business day on the Jacobsen index, an established trading exchange price publisher. These finished products are MBM, BFT, and YG. The prices quoted are for delivery of the finished product at a specified location. These prices are relevant because they provide an indication of a component of revenue and achievement of business plan benchmarks on a daily basis. The Company’s actual sales prices for its finished products may vary from the Jacobsen index because the Company’s finished products are delivered to multiple locations in different geographic locations which utilize different price indexes. Average Jacobsen prices (at the specified delivery point) for the first quarter of Fiscal 2005 compared to average Jacobsen prices for the first quarter of Fiscal 2004 follow:
| |
Avg. Price 1st Quarter 2005 |
Avg. Price 1st Quarter 2004 |
Decrease |
% Decrease |
|||||||||||||
| MBM (Illinois) | $152.99 /ton | $184.68 /ton | ($31.69) /ton | (17.2)% | |||||||||||||
| BFT (Chicago) | $ 17.05 /cwt | $ 19.27 /cwt | ($2.22) /cwt | (11.5)% | |||||||||||||
| YG (Illinois) | $ 14.50 /cwt | $ 15.27 /cwt | ($0.77) /cwt | (5.0)% | |||||||||||||
Page 18
The decreases in average price of the finished products the Company sells had an unfavorable impact on revenue which was partially offset by a positive impact to the Company’s raw material cost, due to formula pricing arrangements which compute raw material cost, based upon the price of finished product.
Raw material volume represents the quantity (pounds) of raw material collected from suppliers, including beef, pork, poultry, and used cooking oils. Raw material volumes provide an indication of future production of finished products available for sale and are a component of potential future revenue.
Finished product production volumes are the end result of the Company’s production processes, and directly impact goods available for sale, and thus become an important component of sales revenue. Yield on production is a ratio of production volume (pounds) divided by raw material volume (pounds), and provides an indication of effectiveness of the Company’s production process. Factors impacting yield on production include quality of raw material and warm weather during summer months, which rapidly degrades raw material.
The Company charges collection fees which are included in net sales in order to offset a portion of the expense incurred in collecting raw material. Each month the Company monitors both the collection fee charged suppliers, which is included in net sales, and collection expense, which is included in cost of sales. The monitoring of collection fees and collection expense provides an indication of achievement of the Company’s business plan.
Net Sales. The Company collects and processes animal by-products (fat, bones and offal) and used restaurant cooking oil to produce finished products of MBM, BFT and YG. Sales are significantly affected by finished goods prices, quality of raw material and volume of raw material. Net sales include the sales of produced finished goods, collection fees, grease trap services and finished goods purchased for resale.
During the first quarter of Fiscal 2005, net sales decreased by $6.1 million (7.9%) to $71.4 million as compared to $77.5 million during the first quarter of Fiscal 2004. The decrease in net sales was primarily due to the following (in millions of dollars):
|
Rendering |
|
Restaurant Services |
|
Corporate |
|
Total |
|
|||
| Lower finished goods prices | $ (3.7) | $ (1.3) | $ - | $ (5.0) | ||||||
| Lower raw material volume | (1.8) | (0.8) | - | (2.6) | ||||||
| Lower yields on production | (0.9) | - | - | (0.9) | ||||||
| Other sales decreases | (0.3) | 0.1 | - | (0.2) | ||||||
| Improved recovery of collection expense | 0.8 | 0.6 | - | 1.4 | ||||||
| Purchase of finished product for resale |
1.2 |
- - |
- |
1.2 |
||||||
|
$ (4.7) |
$ (1.4) |
$ - |
$ (6.1) |
Cost of Sales and Operating Expenses. Cost of sales and operating expenses include cost of raw material, the cost of product purchased for resale, and the cost to collect and process the raw material. The Company utilizes both fixed and formula pricing methods for the purchase of raw materials. Fixed prices are adjusted where possible for changes in competition and significant changes in finished goods market conditions, while raw materials purchased under formula prices are correlated with specific finished goods prices.
During the first quarter of Fiscal 2005, cost of sales and operating expenses decreased $2.0 million (3.4%) to $56.1 million as compared to $58.1 million during the first quarter of Fiscal 2004. The decrease in cost of sales and operating expenses was primarily due to the following (in millions of dollars):
Page 19
|
Rendering |
|
Restaurant Services |
|
Corporate |
|
Total |
|
|||
| Lower raw material prices | $ (3.7) | $ (0.3) | $ - | $ (4.0) | ||||||
| Lower raw material volume | (0.5) | (0.2) | - | (0.7) | ||||||
| Payroll and related benefits | (0.7) | 0.5 | - | (0.2) | ||||||
| Higher energy costs, primarily natural gas | 0.7 | 0.6 | 0.1 | 1.4 | ||||||
| Purchases of finished product for resale | 1.2 | - - | - | 1.2 | ||||||
| Other expenses |
(0.1) |
0.4 |
- |
0.3 |
||||||
|
$ (3.1) |
$ 1.0 |
$ 0.1 |
$ (2.0) |
Selling, General and Administrative Expenses. Selling, general and administrative expenses were $8.7 million during the first quarter of Fiscal 2005, a $0.3 million decrease (3.3%) from $9.0 million during the first quarter of Fiscal 2004, primarily due to the following (in millions of dollars):
|
Rendering |
|
Restaurant Services |
|
Corporate |
|
Total |
|
|||
| Settlement on claim | $ - | $ - | $ (0.2) | $ (0.2) | ||||||
| Lower legal expense | - | - | (0.1) | (0.1) | ||||||
| Other expense decreases |
- - |
0.1 |
(0.1) |
- |
||||||
|
$ - |
$ 0.1 |
$ (0.4) |
$ (0.3) |
Depreciation and Amortization. Depreciation and amortization charges were $3.8 million during the first quarter of Fiscal 2005 unchanged from $3.8 million during the first quarter of Fiscal 2004.
Interest Expense. Interest expense was $1.6 million during the first quarter of Fiscal 2005 compared to $1.8 million during the first quarter of Fiscal 2004, a decrease of $0.2 million, primarily due to the following (in millions of dollars):
|
Rendering |
|
Restaurant Services |
|
Corporate |
|
Total |
|
|||
| Increased interest expense on the new Senior Credit Agreement | $ - | $ - | $ 0.2 | $ 0.2 | ||||||
| Other decreases | - | - | (0.1) | (0.1) | ||||||
| Decrease in preferred stock dividends and accretion |
- - |
- - |
(0.3) |
(0.3) |
||||||
|
$ - |
$ - |
$ (0.2) |
$ (0.2) |
Page 20
Other Income/Expense. Other income was $0.2 million in the first quarter of Fiscal 2005, a decrease of $1.2 million as compared to other income of $1.4 million in the first quarter of Fiscal 2004. The decrease in other income in the first quarter of Fiscal 2005 is primarily due to the following (in millions of dollars):
|
Rendering |
|
Restaurant Services |
|
Corporate |
|
Total |
|
|||
| Decrease in gain on extinguishment of bank debt | $ - | $ - | $ (1.3) | $ (1.3) | ||||||
| Decrease in gain on disposal of assets | - | - | (0.2) | (0.2) | ||||||
| Increase in interest income | - | - | 0.2 | 0.2 | ||||||
| Decrease in other expense |
- - |
- - |
0.1 |
0.1 |
||||||
|
$ - |
$ - |
$ (1.2) |
$ (1.2) |
Interest income increased by $0.2 million in the first quarter of 2005 as a result of the investment of the cash on the balance sheet and other income included a gain on the sale of equipment of $0.1 million.
Included in Other Income in Fiscal 2004 was a gain on extinguishment of debt of $1.3 million, which resulted from retirement of debt with a carrying value of $20.1 million with a cash payment of $18.0 million, due to SFAS 15 accounting, net of related deferred loan costs of $0.8 million also extinguished upon payment of the debt. Also included in other income in the first quarter of Fiscal 2004 was a gain on the sale of property and equipment of approximately $0.3 million, which included the sale of the Company’s land in Oklahoma City, OK, which was sold for a sales price of approximately $0.3 million and had a net book value at the time of sale of less than $0.1 million.
Income Taxes. The Company recorded income tax expense of $0.5 million for the first quarter of Fiscal 2005, compared to income tax expense of $2.4 million recorded in the first quarter of Fiscal 2004, a decrease of $1.9 million (79.2%), primarily due to the decreased pre-tax earnings of the Company in Fiscal 2005.
Discontinued Operations. The Company recorded a profit from discontinued operations, net of applicable taxes, related to closure and sale of certain assets of the Company’s London, Ontario, Canadian subsidiary in the first quarter of Fiscal 2005, compared to income from discontinued operations in the first quarter of Fiscal 2004.
FINANCING, LIQUIDITY AND CAPITAL RESOURCES
On April 2, 2004, the Company entered into a new Senior Credit Agreement with new lenders, and entered into a new lender acknowledgement on May 28, 2004, that increased the committed amount as permitted by the Senior Credit Agreement. This refinancing replaces the prior Amended and Restated Credit Agreement executed on May 13, 2002, which is summarized below. The principal components of the refinancing consist of the following.
Page 21
On December 31, 2003, the Company issued Senior Subordinated Notes in the amount of $35.0 million and applied the net proceeds to the reduction of the outstanding term loan of its then outstanding prior Amended and Restated Credit Agreement executed on May 13, 2002. The Senior Subordinated Notes have a term of six years, maturing on December 31, 2009. Beginning June 1, 2006, the Company may prepay the outstanding principal amount of the Senior Subordinated Notes in whole or in part, plus accrued and unpaid interest, plus a prepayment fee of 5.5%, which declines each year after this date. Interest accrues on the outstanding principal balance of the Senior Subordinated Notes at an annual rate of 12%, payable quarterly in arrears. Restrictive covenants in the Senior Subordinated Notes permit the Company, within limitations defined in the Senior Subordinated Notes, to incur additional indebtedness and to pay cash dividends.
The Company’s new Senior Credit Agreement and Senior Subordinated Notes consist of the following elements at April 2, 2005 (in thousands):
| Senior Credit Agreement: | |||
| Term Loan | $ 17,000
|
||
| Revolving Credit Facility: | |||
| Maximum availability | $ 50,000 | ||
| Borrowings outstanding | - | ||
| Letters of credit issued | 12,072 |
||
| Availability | $ 37,928
|
||
| Senior Subordinated Notes Payable: | $ 35,000
|
Substantially all of the Company’s assets are either pledged or mortgaged as collateral for borrowings under the new Senior Credit Agreement. The new Senior Credit Agreement contains certain terms and covenants, which permit the incurrence of additional indebtedness, the payment of cash dividends, the retention of certain proceeds from sales of assets, and capital expenditures, within limitations defined by the new Senior Credit Agreement, and requires the maintenance of certain minimum financial ratios, including: minimum fixed charge coverage ratio; maximum leverage ratio, and minimum tangible net worth ratio, each as defined in the new Senior Credit Agreement. The Company is currently in compliance with all of the covenants contained in the new Senior Credit Agreement.
Page 22
The classification of long-term debt in the accompanying April 2, 2005 consolidated balance sheet is based on the contractual repayment terms of the debt issued under the Senior Subordinated Notes and the new Senior Credit Agreement.
On April 2, 2005, the Company had working capital of $37.7 million and its working capital ratio was 1.88 to 1 compared to working capital of $39.6 million and a working capital ratio of 1.96 to 1 on January 1, 2005. At April 2, 2005, the Company had unrestricted cash of $38.6 million and funds available under the revolving credit facility of $37.9 million, compared to unrestricted cash of $37.2 million and funds available under the revolving credit facility of $36.3 million at January 1, 2005.
Net cash provided by continuing operating activities was $6.8 million and $7.6 million for the first quarter ended April 2, 2005 and April 3, 2004, respectively, a decrease of $0.8 million, primarily due to lower income from continuing operations, an increase in inventory partially offset by an increase in accounts payable and accrued expenses and proceeds from accounts receivable. Cash used by investing activities was $2.9 million for the first three months of Fiscal 2005, compared to $1.2 million for the first three months of Fiscal 2004, an increase of $1.7 million, primarily due to higher capital investment in the first quarter of Fiscal 2005. Net cash used by financing activities was $2.5 million for the three months ended April 2, 2005, compared to cash provided of $6.4 million for the three months ended April 3, 2004, an increase of cash used of $8.9 million, principally due to proceeds from the Company’s new Senior Credit Agreement, consummated on April 2, 2004.
The Company made capital expenditures of $3.1 million during the first three months of Fiscal 2005, compared to capital expenditures of $1.5 million in the first three months of Fiscal 2004, for a net increase of $1.6 million primarily due to timing of planned capital investment between the two years. Capital expenditures related to compliance with environmental regulations were $0.4 million and $0.1 million for the three months ended April 2, 2005 and April 3, 2004, respectively.
Based upon the underlying terms of the new Senior Credit Agreement, approximately $5.0 million in current debt, which is included in current liabilities on the Company’s balance sheet at April 2, 2005, will be due during the next twelve months, consisting of scheduled installment payments of $1.25 million due each quarter.
Based upon the annual actuarial estimate, current accruals, and claims paid during the first three months of Fiscal 2005, the Company has accrued approximately $5.4 million it expects will become due during the next twelve months in order to meet obligations related to the Company’s self insurance reserves and accrued insurance which are included in current accrued expenses at April 2, 2005. The self insurance reserve is composed of estimated liability for claims arising for workers’ compensation, and for auto liability and general liability claims. The self insurance reserve liability is determined annually, based upon a third party actuarial estimate. The actuarial estimate may vary from year to year, due to changes in cost of health care, the pending number of claims, or other factors beyond the control of management of the Company. No assurance can be given that the Company’s funding obligations under its self insurance reserve will not increase in the future.
Page 23
Based upon current actuarial estimates, the Company expects to pay approximately $3.1 million in order to meet minimum pension funding requirements during the next twelve months, which will reduce current accrued compensation and benefit expenses. The minimum pension funding requirements are determined annually, based upon a third party actuarial estimate. The actuarial estimate may vary from year to year, due to fluctuations in return on investments or other factors beyond the control of management of the Company or the administrator of the Company’s pension funds. No assurance can be given that the minimum pension funding requirements will not increase in the future.
The Company’s management believes that cash flows from operating activities at the current level in Fiscal 2005, unrestricted cash, and funds available under the new Senior Credit Agreement should be sufficient to meet the Company’s working capital needs and capital expenditures for at least the next twelve months. The impact on cash flows from operations in Fiscal 2005 of the occurrence of BSE in the United States or elsewhere, lower raw material volumes available to the Company due to weak margins in the meat processing industry, regulations by government agencies, the impact on export markets, and the impact on market prices for the Company’s finished products is not known at this time. These factors, coupled with high prices for natural gas and diesel fuel, among others, could either positively or negatively impact the Company’s results of operations in 2005 and thereafter. The Company cannot provide assurance that the cash flows from operating activities generated in the first quarter of Fiscal 2005 are indicative of the future cash flows from operating activities which will be generated by the Company’s operations. The Company reviews the appropriate use of unrestricted cash periodically. Although no decision has been made as to non-ordinary course cash usages at this time, potential usages could include opportunistic capital expenditures or investments in response to governmental regulations relating to BSE, and/or acquisitions, as well as suitable cash conservation to withstand adverse commodity cycles.
The current economic environment in the Company’s markets has the potential to adversely impact its liquidity in a variety of ways, including through reduced sales, potential inventory buildup, or higher operating costs.
The principal products that the Company sells are commodities, the prices of which are quoted on established commodity markets and are subject to volatile changes. Although the current market prices of these commodities are stable, a further decline in these prices has the potential to adversely impact the Company’s liquidity. A disruption in international sales, a decline in commodities prices, or a rise in energy prices resulting from the recent war with Iraq and the subsequent political instability and uncertainty, has the potential to adversely impact the Company’s liquidity. There can be no assurance that a decline in commodities prices, a rise in energy prices, a slowdown in the U.S. or international economy, or other factors, including political instability in the Middle East or elsewhere, and the macroeconomic effects of those events, will not cause the Company to fail to meet management’s expectations, or otherwise result in liquidity concerns.
OFF BALANCE SHEET OBLIGATIONS
Based upon the underlying purchase agreements, the Company has commitments to purchase $3.2 million of finished products and natural gas during the next twelve months, which are not included in liabilities on the Company’s balance sheet at April 2, 2005. These purchase agreements are entered into in the normal course of the Company’s business and are not subject to derivative accounting. The commitments will be recorded on the balance sheet of the Company when delivery of these commodities occurs and ownership passes to the Company during Fiscal 2005, in accordance with accounting principles generally accepted in the United States.
Based upon the underlying lease agreements, the Company expects to pay approximately $6.7 million in operating lease obligations during the next twelve months which are not included in liabilities on the Company’s balance sheet at April 2, 2005. These lease obligations are included in cost of sales or selling, general, and administrative expense as the underlying lease obligation comes due, in accordance with accounting principles generally accepted in the United States.
Page 24
CRITICAL ACCOUNTING POLICIES
The Company follows certain significant accounting policies when preparing its consolidated financial statements. A complete summary of these policies is included in Note 1 to the Consolidated Financial Statements included in this report.
Certain of the policies require management to make significant and subjective estimates or assumptions which may deviate from actual results. In particular, management makes estimates regarding estimates of bad debt expense, valuation of inventories, estimates of useful life of long-lived assets related to depreciation and amortization expense, estimates regarding fair value of the Company’s reporting units and future cash flows with respect to assessing potential impairment of both long-lived assets and goodwill, estimates of liability with respect to medical insurance liability, self-insurance, environmental, and litigation reserves, pension liability, estimates of income tax expense, and estimates of pro-forma expense related to stock options granted. Each of these estimates is discussed in greater detail in the following discussion.
Accounts Receivable and Allowance for Doubtful Accounts
In accordance with SFAS No. 5, Accounting for Contingencies, the Company maintains allowances for doubtful accounts for estimated losses resulting from customers’ non-payment of trade accounts receivable owed to the Company. These trade receivables arise in the ordinary course of business from sales of raw material, finished product or services to the Company’s customers. The estimate of allowance for doubtful accounts is based upon the Company’s bad debt experience, prevailing market conditions, aging of trade accounts receivable, and interest rates, among other factors. If the financial condition of the Company’s customers deteriorates, resulting in the customer’s inability to pay the Company’s receivable as it comes due, additional allowance for doubtful accounts may be required. Accounts receivable was approximately $23.5 million and $26.7 million, and the allowance for doubtful accounts was approximately $0.5 million and $0.8 million, at April 2, 2005 and January 1, 2005, respectively.
Inventories
The Company’s inventories are valued at the lower of cost or market. Finished product manufacturing cost is calculated using the first-in, first-out (FIFO) method, based upon the Company’s raw material costs, collection and factory production operating expenses, and depreciation expense on collection and factory assets. Market values of inventory are estimated at each plant location, based upon either the backlog of unfilled sales orders at the balance sheet date, or for unsold inventory, upon regional finished product prices quoted in the Jacobsen index at the balance sheet date. Estimates of market value, based upon the backlog of unfilled sales orders or upon the Jacobsen index, assume that the inventory held by the Company at the balance sheet date will be sold at the estimated market finished product sales price, subsequent to the balance sheet date. Actual sales prices received on future sales of inventory held at the end of a period may vary from either the backlog unfilled sales order price or the Jacobsen index quotation at the balance sheet date. Such variances could cause actual sales prices realized on future sales of inventory to be different than the estimate of market value of inventory at the end of the period. Inventories were approximately $7.6 million and $6.0 million at April 2, 2005 and January 1, 2005, respectively.
Page 25
Long-Lived Assets Depreciation and Amortization Expense and Valuation
The Company’s property, plant and equipment are recorded at cost when acquired. Depreciation expense is computed on property, plant and equipment based upon a straight line method over the estimated useful life of the assets, which is based upon a standard classification of the asset group. Buildings and improvements are depreciated over a useful life of 15 to 30 years, machinery and equipment are depreciated over a useful life of 3 to 10 years, and vehicles are depreciated over a life of 2 to 6 years. These useful life estimates have been developed based upon the Company’s historical experience of asset life utility, and whether the asset is new or used when placed in service. The actual life and utility of the asset may vary from this estimated life. Useful lives of the assets may be modified from time to time when the future utility or life of the asset is deemed to change from that originally estimated when the asset was placed in service. Depreciation expense was approximately $2.8 million and $2.8 million, at April 2, 2005 and April 3, 2004, respectively.
The Company’s intangible assets, including routes, raw material supply agreements and non-compete agreements are recorded at fair value when acquired. Amortization expense is computed on these intangible assets based upon a straight line method over the estimated useful life of the assets, which is based upon a standard classification of the asset group. Collection routes are amortized over a useful life of 8 to 15 years; raw material supply agreements and non-compete agreements are amortized over a useful life of 3 to 10 years. The actual economic life and utility of the asset may vary from this estimated life. Useful lives of the assets may be modified from time to time when the future utility or life of the asset is deemed to change from that originally estimated when the asset was placed in service. Amortization expense was approximately $1.0 million and $1.0 million at April 2, 2005 and April 3, 2004, respectively.
The Company reviews the carrying value of long lived assets on a regular basis, including at the end of each fiscal year, for indications of impairment. Impairment is indicated whenever the carrying value of the asset is not recoverable or exceeds estimated fair value. For purposes of calculating impairment on long lived operating assets, the Company has defined its reporting units to be each of the Company’s plant locations. The Company estimates fair value of its long lived assets at each plant based upon future undiscounted net cash flows from use of those assets. In calculating such estimates, actual historical operating results and anticipated future economic factors, such as future business volume, future finished product prices, and future operating costs and expense are evaluated and estimated as a component of the calculation of future undiscounted cash flows for each operating plant location. The estimates of fair value of the reporting units and of future undiscounted net cash flows from operation of these assets could change if actual volumes, prices, costs or expenses vary from these estimates. A future reduction of earnings in the Company’s plants could result in an impairment charge because the estimate of fair value would be negatively impacted by a reduction of earnings.
The Company reviews the carrying value of assets held for sale on a regular basis for indications of impairment. Impairment is indicated whenever the carrying value of the asset exceeds estimated fair value. For purposes of calculating impairment on assets held for sale, the Company utilizes estimated sales value of the assets as an estimate of fair value. The estimates of fair value of the assets held for sale could change if the actual sales value realized, or realizable, varies from the estimated sale value.
The net book value of property, plant and equipment was approximately $75.7 million and $75.4 million at April 2, 2005 and January 1, 2005, respectively. The net book value of intangible assets, including deferred loan cost, was approximately $18.4 million and $19.6 million at April 2, 2005 and January 1, 2005, respectively.
Page 26
Goodwill Valuation
The Company reviews the carrying value of goodwill on a regular basis, including at the end of each fiscal year, for indications of impairment at each plant location which has recorded goodwill as an asset. Impairment is indicated whenever the carrying value of plant assets exceeds the estimated fair value of plant assets. For purposes of evaluating impairment of goodwill, the Company estimates fair value of plant assets at each plant, based upon future discounted net cash flows from use of those assets. In calculating such estimates, actual historical operating results and anticipated future economic factors, such as future business volume, future finished product prices, and future operating costs and expenses are evaluated and estimated as a component of the calculation of future discounted cash flows for each operating plant location with recorded goodwill. The estimates of fair value of assets at these plant locations and of future discounted net cash flows from operation of these assets could change if actual volumes, prices, costs or expenses vary from these estimates. A future reduction of earnings in the plants with recorded goodwill could result in an impairment charge because the estimate of fair value would be negatively impacted by a reduction of earnings at those plants. Goodwill was approximately $4.4 million at both April 2, 2005 and January 1, 2005.
Accrued Medical Claims Liability
The Company provides a self-insured group health plan to its employees, which provides medical benefits to participating employees. The Company has an employer’s stop loss insurance policy to cover individual claims in excess of $175,000 per employee per year. The amount charged to medical insurance expense includes claims paid during the year and includes estimates of liabilities for outstanding medical claims under the plan at the balance sheet date, based upon historical claims expense and historical claims submission information, and also includes an accrual for estimated severe illness claims, which is based upon the stop loss limit per employee and the number of employees filing those claims. If actual future medical claims by employees varies significantly from historical spending or if the actual timeliness of submission of those claims by medical care providers changes, the actual medical claims may vary from the estimated liability. The actual cost of providing medical care to severely ill employees and dependents may vary from estimates if the patient either recovers or dies. Accrued medical claims liability included in accrued expenses was approximately $2.4 million and $2.3 million at April 2, 2005 and January 1, 2005, respectively.
Self Insurance, Environmental, and Legal Reserves
The Company purchases its workers compensation, auto and general liability insurance on a retrospective basis. The Company estimates and accrues its expected ultimate costs related to claims occurring during each fiscal year and carries this accrual as a reserve until such claims are paid by the Company. Estimates of self insurance liability are based upon the report of a third party actuarial report, which the Company relies upon in calculating its estimates. The Company has also accrued loss reserves related to environmental and litigation matters, based upon estimated undiscounted future costs. In developing estimates of loss, the Company utilizes its staff, outside consultants, and outside counsel as sources of information and judgment as to the expected undiscounted future costs of the claims. With respect to the Company’s self insurance, environmental and litigation reserves, estimates of reserve liability could change if future events are different than those included in the estimates of the actuary, consultants or management of the Company. The reserve for insurance, environmental, and litigation contingencies included in accrued expenses and other non-current liabilities were approximately $15.5 million and $13.9 million at April 2, 2005 and January 1, 2005, respectively.
Page 27
Pension Liability
The Company provides retirement benefits to employees under separate final-pay noncontributory pension plans for salaried and hourly employees (excluding those employees covered by a union-sponsored plan), who meet service and age requirements. Benefits are based principally on length of service and earnings patterns during the five years preceding retirement. Pension expense and pension liability recorded by the Company is based upon an annual actuarial estimate provided by a third party administrator. Factors included in estimates of current year pension expense and pension liability at the balance sheet date include estimated future service period of employees, estimated future pay of employees, estimated future retirement ages of employees, and the projected time period of pension benefit payments. Two of the most significant assumptions used to calculate future pension obligations are the discount rate applied to pension liability and the expected rate of return on pension plan assets. These assumptions and estimates are subject to the risk of change over time, and each factor has inherent uncertainties which neither the actuary nor the Company is able to control, or to predict with certainty.
The discount rate applied to the Company’s pension liability is the interest rate used to calculate the present value of the pension benefit obligation. The discount rate is based on the yield of long-term corporate fixed income securities at the measurement date of October 1 in the year of calculation. The weighted average discount rate was 6.0% and 6.5% at October 1 in Fiscal 2004 and Fiscal 2003, respectively.
The expected rate of return on the Company’s pension plan assets is the interest rate used to calculate future returns on investment of the plan assets. The expected return on plan assets is a long-term assumption whose accuracy can only be assessed over a long period of time. The weighted average expected return on pension plan assets was 8.75% for both Fiscal 2004 and Fiscal 2003.
The Company has recorded a minimum pension liability of approximately $13.6 million and $9.0 million at January 1, 2005 and January 3, 2004, respectively. The Company’s net pension cost was approximately $0.8 million, and $0.7 million at April 2, 2005 and April 3, 2004, respectively.
Income Taxes
In calculating net income, the Company includes estimates in the calculation of tax expense, the resulting tax liability, and in future utilization of deferred tax assets which arise from temporary timing differences between financial statement presentation and tax recognition of revenue and expense. The Company’s deferred tax assets include net operating loss carry-forward which is limited to approximately $0.7 million per year in future utilization due to the change in majority control, resulting from the May 2002 recapitalization of the Company. As a result of these matters, the estimate of future utilization of deferred tax assets relies upon the forecast of future reversal of the Company’s deferred tax liabilities, which provide some evidence of the ability of the Company to utilize deferred tax assets in future years. Valuation allowances for deferred tax assets are recorded when it is more likely than not that deferred tax assets will expire before they are utilized and the tax benefit is realized. Based upon the Company’s evaluation of these matters, a significant portion of the Company’s net operating loss carry-forwards will expire unused. The valuation allowance established to provide a reserve against these deferred tax assets was approximately $20.3 million and $20.3 million at April 2, 2005 and January 1, 2005, respectively.
Stock Option Expense
The Company currently discloses the pro forma effects on net income of expense of stock options issued, and the Company will begin recording compensation expense related to stock options granted, beginning in the first quarter of Fiscal 2006, in accordance with implementation requirements for recently issued SFAS 123 R. The calculation of expense of stock options issued utilizes the Black-Scholes mathematical model which estimates the fair value of the option award to the holder and the compensation expense to the Company, based upon estimates of volatility, risk-free rates of return at the date of issue, and projected vesting of the option grants. If actual share price volatility or vesting differs from the projection, the actual expense recorded may vary. The Company’s pro forma expense related to stock options granted was approximately $0.1 million and $0.1 million at April 2, 2005 and April 3, 2004, respectively.
Page 28
NEW ACCOUNTING PRONOUNCEMENTS
No new accounting pronouncements were issued which were applicable to the Company during the first quarter of Fiscal 2005.
FORWARD LOOKING STATEMENTS
This Quarterly Report on Form 10-Q includes “forward-looking” statements that involve risks and uncertainties. The words “believe,” “anticipate,” “expect,” “estimate,” “intend,” and similar expressions identify forward-looking statements. All statements other than statements of historical facts included in the Quarterly Report on Form 10-Q, including, without limitation, the statements under the section entitled “Business,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Legal Proceedings” and located elsewhere herein regarding industry prospects and the Company’s financial position are forward-looking statements. Actual results could differ materially from those discussed in the forward-looking statements as a result of certain factors. Although the Company believes that the expectations reflected in such forward-looking statements are reasonable, it can give no assurance that such expectations will prove to be correct.
In addition to those factors discussed in this report and under the heading “Risk Factors” in Item 7A of Part I of the Company’s annual report on Form 10-K for the year ended January 1, 2005, and in the Company’s other public filings with the SEC, important factors that could cause actual results to differ materially from the Company’s expectations include: the Company’s continued ability to obtain sources of supply for its rendering operations; general economic conditions in the American, European and Asian markets; prices in the competing commodity markets which are volatile and are beyond the Company’s control; and BSE and its impact on finished product prices, export markets, energy prices and government regulation are still evolving and are beyond the Company’s control. Among other things, future profitability may be affected by the Company’s ability to grow its business which faces competition from companies which may have substantially greater resources than the Company.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS
Market risks affecting the Company are exposures to changes in interest rates on debt and the price of natural gas used in the Company’s plants. The Company has used interest rate and natural gas swaps to manage these related risks. The Company is not currently party to any interest rate swap agreements. The Company uses natural gas forward purchase agreements with its suppliers to manage the price risk of natural gas used in its facilities.
As of April 2, 2005, the Company had forward purchase agreements in place for purchases of approximately $0.5 million of natural gas.
Page 29
ITEM 4. CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures. As required by Exchange Act Rule 13a-15(b), the Company’s management, including the Chief Executive Officer and Chief Financial Officer, conducted an evaluation as of the end of the period covered by this report of the effectiveness of the design and operation of the Company’s disclosure controls and procedures. As defined in Exchange Act Rule 13a-15(e) and 15d-15(e) under the Exchange Act, disclosure controls and procedures are controls and other procedures of the Company that are designed to ensure information required to be disclosed by the Company in the reports it files or submits under the Exchange Act is recorded, processed, summarized and reported within time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by the Company in the reports it files or submits under the Exchange Act is accumulated and communicated to Company management, including the Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.
Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective as of the end of the period covered by this report.
Changes in Internal Control Over Financial Reporting. As required by Exchange Act Rule 13a-15(d), the Company’s management, including the Chief Executive Officer and Chief Financial Officer, also conducted an evaluation of the Company’s internal control over financial reporting to determine whether any change occurred during the quarter covered by this report that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting. Based on that evaluation, there have been no significant changes in the Company’s internal controls or in other factors that could significantly affect the internal controls subsequent to the date of their evaluation in connection with the preparation of this quarterly report on Form 10-Q.
Page 30
DARLING INTERNATIONAL INC. AND SUBSIDIARIES
FORM 10-Q FOR THE THREE
MONTHS ENDED APRIL 2, 2005
PART II: Other Information
| Item 6. | EXHIBITS AND REPORTS ON FORM 8-K. |
| (a) | Exhibits | |
| 31.1 | Certification pursuant to Rule 13a-14(a) or Rule 15d-14(a) of the
Securities Exchange Act of 1934, of Randall C. Stuewe, the Chief Executive
Officer of the Company. |
|
| 31.2 | Certification pursuant to Rule 13a-14(a) or Rule 15d-14(a) of the
Securities Exchange Act of 1934, of John O. Muse, the Chief Financial Officer of
the Company. |
|
| 32.1 | Certification pursuant to 18 U.S.C. Section 1350, as adopted
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, of Randall C. Stuewe,
the Chief Executive Officer of the Company, and of John O. Muse, the Chief Financial Officer of the Company. |
| (b) | Reports on Form 8-K Current report on Form 8-K (Items 7 and 9) filed on January 25, 2005. Current report on Form 8-K (Items 2 and 9) filed on March 16, 2005. Current report on Form 8-K (Items 2 and 9) filed on March 17, 2005. |
Page 31
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
| DARLING INTERNATIONAL INC. | ||
| Date: May 12, 2005 | By: /s/ Randall C. Stuewe
Randall C. Stuewe Chairman and Chief Executive Officer | |
| Date: May 12, 2005 |
By: /s/ John O. Muse John O. Muse Executive Vice President Administration and Finance (Principal Financial Officer) |
Page 32