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FORM 10-Q
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
-----------------
(Mark One)
[x] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended October 2, 2004
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
Commission file number 1-7023
QUAKER FABRIC CORPORATION
(Exact name of registrant as specified in its charter)
Delaware 04-1933106
(State of incorporation) (I.R.S. Employer Identification No.)
941 Grinnell Street, Fall River, Massachusetts 02721
(Address of principal executive offices)
(508) 678-1951
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes X No
----- -----
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).
Yes X No
----- -----
Indicate the number of shares outstanding of each of the issuer's classes of
common stock as of the latest practicable date.
As of November 10, 2004, 16,823,418 shares of Registrant's Common Stock,
$0.01 par value, were outstanding.
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Table of Contents
QUAKER FABRIC CORPORATON
Quarterly Report on Form 10-Q
Quarter ending October 2, 2004
PART I FINANCIAL INFORMATION
Item 1. Consolidated Balance Sheets 2
Consolidated Statements of Income 3
Consolidated Statements of Comprehensive Income 4
Consolidated Statements of Cash Flows 5
Notes to Consolidated Financial Statements 6
Item 2. Management's Discussion and Analysis of Financial Condition and 12
Results of Operations
Item 3. Quantitative and Qualitative Disclosures about Market Risk 19
Item 4. Controls and Procedures 20
PART II OTHER INFORMATION
Item 6. Exhibits 21
Signatures 22
1
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
QUAKER FABRIC CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Dollars in thousands, except per share amounts)
October 2, January 3,
2004 2004
----------- ----------
ASSETS (Unaudited) (Audited)
Current assets:
Cash and cash equivalents $ 7,351 $ 5,591
Accounts receivable, less reserves of $1,850 and $2,089 at
October 2, 2004 and January 3, 2004, respectively 42,902 44,374
Inventories 47,857 43,987
Prepaid and deferred income taxes 1,158 1,038
Production supplies 1,954 1,727
Prepaid insurance 1,753 2,132
Other current assets 7,003 7,842
-------- --------
Total current assets 109,978 106,691
Property, plant and equipment, net 160,373 162,293
Goodwill 5,432 5,432
Other assets 1,967 1,862
-------- --------
Total assets $277,750 $276,278
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Current portion of debt (Note 8) $ 45,000 $ 5,000
Accounts payable 18,146 14,386
Accrued expenses 12,117 13,137
-------- --------
Total current liabilities 75,263 32,523
Long-term debt (Note 8) -- 40,000
Deferred income taxes 31,521 31,634
Other long-term liabilities 2,858 2,616
Redeemable preferred stock:
Series A convertible, $0.01 par value per share, liquidation preference
$1,000 per share, 50,000 shares authorized, none issued -- --
Stockholders' equity:
Common stock, $0.01 par value per share, 40,000,000 shares authorized;
16,822,418 and 16,795,818 shares issued and outstanding as of
October 2, 2004 and January 3, 2004, respectively 168 168
Additional paid-in capital 89,057 88,870
Unearned compensation (540) (695)
Retained earnings 81,542 83,228
Other accumulated comprehensive loss (2,119) (2,066)
-------- --------
Total stockholders' equity 168,108 169,505
-------- --------
Total liabilities and stockholders' equity $277,750 $276,278
======== ========
The accompanying notes are an integral part of these
consolidated financial statements
2
QUAKER FABRIC CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(Amounts in thousands, except per share amounts)
Three Months Ended Nine Months Ended
------------------ --------------------
Oct. 2, Oct. 4, Oct. 2, Oct. 4,
2004 2003 2004 2003
------- ------- -------- --------
(Unaudited) (Unaudited)
Net sales $63,585 $80,765 $221,101 $244,876
Cost of products sold 51,870 62,922 177,292 193,581
------- ------- -------- --------
Gross profit 11,715 17,843 43,809 51,295
Selling, general and administrative expenses 14,185 13,581 41,591 41,130
------- ------- -------- --------
Operating income (loss) (2,470) 4,262 2,218 10,165
Other expenses:
Interest expense 860 968 2,567 3,028
Other, net (31) (5) (83) 84
------- ------- -------- --------
Income (loss) before provision for income taxes (3,299) 3,299 (266) 7,053
Provision (benefit) for income taxes (1,171) 1,122 (94) 2,398
------- ------- -------- --------
Net income (loss) $(2,128) $ 2,177 $ (172) $ 4,655
======= ======= ======== ========
Earnings (loss) per common share - basic (Note 1) $ (0.13) $ 0.13 $ (0.01) $ 0.28
======= ======= ======== ========
Earnings (loss) per common share - diluted (Note 1) $ (0.13) $ 0.13 $ (0.01) $ 0.28
======= ======= ======== ========
Dividends per common share $ 0.030 $ 0.025 $ 0.090 $ 0.075
======= ======= ======== ========
Weighted average shares outstanding - basic (Note 1) 16,821 16,769 16,817 16,636
======= ======= ======== ========
Weighted average shares outstanding - diluted (Note 1) 16,821 16,986 16,817 16,900
======= ======= ======== ========
The accompanying notes are an integral part of these
consolidated financial statements
3
QUAKER FABRIC CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Amounts in thousands)
Three Months Ended Nine Months Ended
------------------ --------------------
Oct. 2, Oct. 4, Oct. 2, Oct. 4,
2004 2003 2004 2003
------- ------- -------- --------
(Unaudited) (Unaudited)
Net income (loss) $(2,128) $2,177 $(172) $4,655
------- ------ ----- ------
Other comprehensive income (loss)
Foreign currency translation adjustments 216 (131) (30) 51
Unrealized gain (loss) on hedging instruments (15) -- (23) --
------- ------ ----- ------
Other comprehensive income (loss) 201 (131) (53) 51
------- ------ ----- ------
Comprehensive income (loss) $(1,927) $2,046 $(225) $4,706
======= ====== ===== ======
The accompanying notes are an integral part of these
consolidated financial statements
4
QUAKER FABRIC CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in thousands)
Nine Months Ended
--------------------
Oct. 2, Oct. 4,
2004 2003
------- --------
(Unaudited)
Cash flows from operating activities:
Net income (loss) $ (172) $ 4,655
Adjustments to reconcile net
income to net cash provided
by operating activities:
Depreciation and amortization 14,016 14,410
Amortization of unearned compensation 155 154
Deferred income taxes (113) 1,629
Tax benefit related to exercise of common stock options 40 402
Changes in operating assets and liabilities:
Accounts receivable 1,475 (7,135)
Inventories (3,883) 3,400
Prepaid expenses and other assets 726 1,213
Accounts payable and accrued expenses 2,740 3,633
Other long-term liabilities 242 459
------- --------
Net cash provided by operating activities 15,226 22,820
------- --------
Cash flows from investing activities:
Purchase of property, plant and equipment (12,056) (6,623)
------- --------
Cash flows from financing activities:
Change in revolving credit facility -- (16,200)
Proceeds from exercise of common stock options and
issuance of shares under the employee stock purchase plan 147 656
Cash dividends (1,514) (1,255)
------- --------
Net cash used in financing activities (1,367) (16,799)
------- --------
Effect of exchange rates on cash (43) 99
------- --------
Net increase (decrease) in cash 1,760 (503)
Cash and cash equivalents, beginning of period 5,591 1,098
------- --------
Cash and cash equivalents, end of period $ 7,351 $ 595
======= ========
The accompanying notes are an integral part of these
consolidated financial statements
5
QUAKER FABRIC CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Amounts in thousands, except per share amounts)
Note 1 - BASIS OF PRESENTATION
The accompanying unaudited consolidated financial statements reflect all
normal and recurring adjustments that are, in the opinion of management,
necessary to present fairly the financial position, results of operations and
cash flows for the interim periods presented. The unaudited consolidated
financial statements have been prepared pursuant to the instructions to Form
10-Q and Rule 10-01 of regulation S-X of the Securities and Exchange Commission.
In the opinion of management, the accompanying unaudited consolidated financial
statements were prepared following the same policies and procedures used in the
preparation of the audited financial statements and reflect all adjustments
(consisting of normal recurring adjustments) considered necessary to present
fairly the financial position and operations of Quaker Fabric Corporation and
Subsidiaries (the "Company"). Operating results for the nine months ended
October 2, 2004 are not necessarily indicative of the results expected for the
full fiscal year or any future period. These financial statements should be read
in conjunction with the financial statements and notes thereto included in the
Company's Annual Report on Form 10-K for the year ended January 3, 2004.
Earnings Per Common Share
Basic earnings per common share is computed by dividing net income by the
weighted average number of common shares outstanding during the period. For
diluted earnings per share, the denominator also includes dilutive outstanding
stock options determined using the treasury stock method. The following table
reconciles weighted average common shares outstanding to weighted average common
shares outstanding and dilutive potential common shares.
Three Months Ended Nine Months Ended
------------------ -----------------
Oct. 2, Oct. 4, Oct. 2, Oct. 4,
2004 2003 2004 2003
---- ---- ---- ----
(In thousands)
Weighted average common shares outstanding 16,821 16,769 16,817 16,636
Dilutive potential common shares - 217 - 264
------ ------ ------ ------
Weighted average common shares outstanding
and dilutive potential common shares 16,821 16,986 16,817 16,900
====== ====== ====== ======
Antidilutive options 2,258 1,838 1,441 1,838
====== ====== ====== ======
Due to a loss for the three months and nine months ended October 2, 2004,
zero incremental shares are included in the dilutive weighted average shares
outstanding because the effect would be antidilutive.
6
Note 2 - INVENTORIES
Inventories are stated at the lower of cost or market and include
materials, labor and overhead. A standard cost system is used and approximates
cost on a first-in, first-out (FIFO) basis. Cost for financial reporting
purposes is determined using the last-in, first-out (LIFO) method.
Inventories at October 2, 2004 and January 3, 2004 consisted of the
following:
October 2, January 3,
2004 2004
---- ----
Raw materials $21,611 $19,714
Work-in-process 7,751 7,709
Finished goods 17,104 12,484
------- -------
Inventory at FIFO 46,466 39,907
LIFO adjustment 1,391 4,080
------- -------
Inventory at LIFO $47,857 $43,987
======= =======
LIFO inventory values are higher than FIFO costs because current
manufacturing costs are lower than the older historical costs used to value
inventory on a LIFO basis.
Note 3 - SEGMENT REPORTING
The Company operates as a single business segment consisting of sales of
two products, upholstery fabric and specialty yarns. Management evaluates the
Company's financial performance in the aggregate and allocates the Company's
resources without distinguishing between yarn and fabric products.
7
Net sales to unaffiliated customers by major geographical area were as
follows:
Three Months Ended Nine Months Ended
------------------ -----------------
Oct. 2, Oct. 4, Oct. 2, Oct. 4,
2004 2003 2004 2003
---- ---- ---- ----
(In thousands)
United States $56,137 $70,949 $195,610 $216,745
Canada 2,827 3,579 9,712 10,754
Mexico 1,793 1,977 5,820 6,785
Middle East 881 1,426 2,739 2,547
South America 525 561 1,818 1,726
Europe 657 1,012 2,704 2,985
All Other 765 1,261 2,698 3,334
------- ------- -------- --------
$63,585 $80,765 $221,101 $244,876
======= ======= ======== ========
Net sales by product category are as follows:
Three Months Ended Nine Months Ended
------------------ -----------------
Oct. 2, Oct. 4, Oct. 2, Oct. 4,
2004 2003 2004 2003
---- ---- ---- ----
(In thousands)
Fabric $58,643 $78,002 $203,202 $236,337
Yarn 4,520 2,444 16,728 7,631
Other 422 319 1,171 908
------- ------- -------- --------
$63,585 $80,765 $221,101 $244,876
======= ======= ======== ========
Note 4 - ACCOUNTING FOR STOCK BASED COMPENSATION
Accounting for Stock-Based Compensation. The Company follows Accounting
Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees"
("APB No. 25"), in accounting for its employee stock option and employee stock
purchase plans, rather than the fair value method of accounting provided under
Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based
Compensation" ("SFAS No. 123"). Under APB No. 25, the Company accounts for its
employee stock options using the intrinsic value method. Under this method the
Company does not recognize compensation expense on stock options granted to
employees when the exercise price of each option is greater than or equal to the
market price of the underlying stock on the date of the grant.
The following pro forma information presents the Company's net income and
basic and diluted net income per share for the three months and nine months
ended October 2, 2004 and October 4, 2003 as if compensation cost had been
measured under the fair value method of
8
SFAS No. 123, "Accounting for Stock-Based Employee Compensation," for stock
option grants and shares issued under the employee stock option and employee
stock purchase plans, respectively. The Company utilizes the Black-Scholes
option pricing model to estimate the fair value of options.
Three Months Ended Nine Months Ended
------------------ -----------------
Oct. 2, Oct. 4, Oct. 2, Oct. 4,
2004 2003 2004 2003
---- ---- ---- ----
(In thousands) (In thousands)
---------------- -----------------
(Unaudited) (Unaudited)
Net income (loss), as reported $(2,128) $2,177 $(172) $4,655
Add: Stock-based employee compensation
expense included in net income, net of
related tax effects 33 37 100 102
Less: Stock-based employee compensation
expense determined under Black-Scholes
option pricing model, net of related tax effects (294) (265) (896) (793)
------- ------ ----- ------
Pro forma net income (loss): $(2,389) $1,949 $(968) $3,964
======= ====== ===== ======
Earnings (loss) per common share - basic
As reported $(0.13) $0.13 $(0.01) $0.28
Pro forma $(0.14) $0.12 $(0.06) $0.24
Earnings (loss) per common share - diluted
As reported $(0.13) $0.13 $(0.01) $0.28
Pro forma $(0.14) $0.11 $(0.06) $0.23
Note 5 - COMMITMENTS AND CONTINGENCIES
(a) Income Taxes. The Company is currently challenging tax assessments
from the Internal Revenue Service for the years 1997-1999 and from the
Massachusetts Department of Revenue for the years 1993-1998. In
addition, during the third quarter of 2003, the Company filed amended
tax returns for these and subsequent years to claim approximately
$3,500 of federal and state research and development credits. Audits
of these amended returns commenced during October 2003. There is
significant uncertainty surrounding the amount and timing of the
benefit, if any, that will be ultimately realized. The Company
believes that it has a supportable basis for claiming these credits,
but the amounts are subject to ongoing audits by federal and state
authorities. Accordingly, the Company has not reflected the potential
benefits of these credits in its financial statements for these or
subsequent years. No benefit will be recognized in the financial
statements until these gain contingencies are resolved through the
eventual disposition with the respective tax authorities.
(b) Litigation. In the ordinary course of business, the Company is party
to various types of litigation. The Company believes it has
meritorious defenses to all claims and in its opinion, all litigation
currently pending or threatened will not have a material effect on the
Company's financial position, results of operations or liquidity.
9
(c) Environmental Cleanup Matters. The Company accrues for estimated costs
associated with known environmental matters when such costs are
probable and can be reasonably estimated. The actual costs to be
incurred for environmental remediation may vary from estimates, given
the inherent uncertainties in evaluating and estimating environmental
liabilities, including the possible effects of changing laws and
regulations, the stage of the remediation process and the magnitude of
contamination found as the remediation progresses. During 2003, the
Company entered into agreements with the Massachusetts Department of
Environmental Protection to install air pollution control equipment at
one of its manufacturing plants in Fall River, Massachusetts.
Management anticipates that the costs associated with the acquisition
and installation of the equipment will total approximately $900 over a
three-year period, which began in 2003. These costs will be
capitalized and depreciated over the estimated useful life of the
equipment involved. Management believes the ultimate disposition of
known environmental matters will not have a material adverse effect on
the liquidity, capital resources, business or consolidated financial
position of the Company.
Note 6 - INCOME TAXES
The Company determines its periodic income tax expense based upon the
current period income and the estimated annual effective tax rate for the
Company. The rate is revised, if necessary, as of the end of each successive
interim period during the fiscal year to the Company's best current estimate of
its annual effective tax rate.
Note 7 - NEW FACILITY ACQUISITION
On July 2, 2004, the Company entered into a purchase and sale agreement
(the "P&S") to acquire for $21.0 million a 600,000 square foot, single story
industrial building located on 33.6 acres of land in Fall River, Massachusetts.
On September 30, 2004 the Company provided the seller with official notice of
its decision to terminate the P&S, resulting in a charge to Quaker's third
quarter pre-tax earnings of approximately $175,000, and is now engaged in active
negotiations with the seller with respect to a proposed leasing arangement
involving 540,000 square feet of manufacturing and warehousing space in the
building, representing all of the space at this site except for the 60,000
square feet of office space.
Note 8 - LONG-TERM DEBT
The long term portion of the amounts outstanding under the Note Agreements
(as hereinafter defined) has been classified as "current" on the Balance Sheet
as of October 2, 2004 in accordance with Emerging Issues Task Force Issue 86-30,
"Classification of Obligations When a Violation is Waived by the Creditor." The
Company is in discussions with its lenders regarding proposed amendments to the
Note Agreements and the Credit Agreement (as hereinafter defined) seeking to
reduce the financial covenant maintenance and incurrence requirements under
those agreements going forward to levels that the Company believes will be
achievable under anticipated conditions in the industry. Any such further
amendments to the Note Agreements or the Credit Agreement may also include other
changes to the terms of those agreements which may be unfavorable to the
Company. There can be no assurance that the Company will reach agreement with
its lenders to amend the Note Agreements or the Credit Agreement on terms
acceptable to the Company, or at all. In addtion, absent appropriate
10
amendments to the Note Agreements and Credit Agreement, the Company may be
required to seek alternate financing sources, the terms of which financing, if
obtainable, may be disadvantageous to the Company. Based upon the anticipated
performance of the Company for the foreseeable future, and absent an appropriate
waiver from the lenders, the failure to obtain such amendments would likely
result in a default under the Note Agreements and the inability to borrow under
the Credit Agreement as early as the end of fiscal 2004.
Note 9 - NEW ACCOUNTING PRONOUNCEMENTS
Consolidation of Variable Interest Entities
In January 2003, FASB issued Interpretation No. 46 (FIN 46), "Consolidation
of Variable Interest Entities," which clarifies the application of Accounting
Research Bulletin (ARB) No. 51, "Consolidated Financial Statements," relating to
consolidation of certain entities. First, FIN 46 will require identification of
the Company's participation in variable interest entities (VIE), which are
defined as entities with a level of invested equity that is not sufficient to
fund future activities to permit them to operate on a stand alone basis, or
whose equity holders lack certain characteristics of a controlling financial
interest. Then, for entities identified as VIE, FIN 46 sets forth a model to
evaluate potential consolidation based on an assessment of which party to the
VIE, if any, bears a majority of the exposure to its expected losses, or stands
to gain from a majority of its expected returns. In December 2003, the FASB
issued a revised FIN 46 ("FIN 46R") to defer the effective date and provide
further clarification on the interpretation. FIN 46R is effective for public
companies in the first fiscal period after December 15, 2003. The Company does
not have any interests that would qualify as a VIE and, therefore, the adoption
of FIN 46 does not have an effect on the Company's results of operations and
financial condition.
Accounting for Certain Financial Instruments with Characteristics of Both
Liabilities and Equity
In May 2003, the FASB issued SFAS 150 (SFAS 150), "Accounting For Certain
Financial Instruments with Characteristics of Both Liabilities and Equity",
which establishes standards for how an issuer of financial instruments
classifies and measures certain financial instruments with characteristics of
both liabilities and equity. It requires that an issuer classify a financial
instrument that is within its scope as a liability (or an asset in some
circumstances) if, at inception, the monetary value of the obligation is based
solely or predominantly on a fixed monetary amount known at inception,
variations in something other than the fair value of the issuer's equity shares
or variations inversely related to changes in the fair value of the issuer's
equity shares. In November 2003, the FASB deferred the effective date for
applying the provisions of SFAS 150 for mandatorily redeemable financial
instruments that have a fixed redemption period to be effective for fiscal
periods beginning after December 15, 2003. For all other mandatorily redeemable
financial instruments, the disclosure provisions of SFAS 150 have been deferred
for an indefinite period. The adoption of this standard did not have any impact
on the Company's financial position or results of operations.
11
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The Company's fiscal year is a 52 or 53 week period ending on the Saturday
closest to January 1. "Fiscal 2003" was a 52 week period ended January 3, 2004
and "Fiscal 2004" will be a 52 week period ending January 1, 2005. The first
nine months of Fiscal 2003 and Fiscal 2004 ended October 4, 2003 and October 2,
2004, respectively.
Critical Accounting Policies
The Company considered the disclosure requirements of Financial
Reporting Release No. 60 regarding critical accounting policies and Financial
Reporting Release No. 61 regarding liquidity and capital resources, certain
trading activities and related party/certain other disclosures, and concluded
that, except as disclosed in this filing and in the Form 8-K filing made by the
Company on October 12, 2004, there were no material changes in these areas
during the first nine months of 2004 that would warrant further disclosure
beyond those matters previously disclosed in the Company's Annual Report on Form
10-K for the year ended January 3, 2004.
General
Quaker is a leading designer, manufacturer and worldwide marketer of a
broad range of woven upholstery fabrics, which it sells at various price points
primarily to manufacturers of residential furniture. The Company is also a
leading developer and manufacturer of specialty yarns. Approximately 12.5% of
the Company's revenues during the first nine months of 2004 were attributable to
fabrics sold outside the United States and approximately 65.0% of Quaker's
fabrics are manufactured to customer order.
Competition in the industry is intense, from both domestic fabric mills and
fabric mills located outside the U.S. manufacturing products for sale into the
U.S. market. Management believes that competition in the U.S. domestic market
may intensify following the January 1, 2005 expiration of the quotas imposed
under the Uruguay Round Agreement on Textiles and Clothing on textile and
apparel products coming into the U.S. The Company's fabric products compete with
other furniture coverings, including leather, suede, prints, tufts, flocks and
velvets, for consumer acceptance. Consumer tastes in upholstered furniture
coverings are somewhat cyclical and do change over time, with various coverings
gaining or losing share depending on changes in home furnishing trends. For
example, leather and suede furniture has enjoyed growing popularity over the
past few years, primarily at the expense of woven fabrics, such as the Jacquards
and other woven fabrics Quaker manufactures. As a result, overall domestic
demand for furniture covered with woven upholstery products is currently
somewhat weaker than demand for other types of furniture, including furniture
covered with leather and suede products. In addition, Company sales into some
foreign markets have been hurt by market-specific geopolitical and macroeconomic
factors reducing aggregate demand in these locations.
Competitive factors in the industry include product design, product
pricing, customer service and quality. Competition from lower cost imported
products has increased, particularly those products coming into the United
States from China and other parts of Asia. Management considers such factors as
incoming customer order rates, size of production backlog, manufacturing
efficiencies, product mix and price points in evaluating the Company's financial
12
condition and operating performance. Incoming fabric orders during the first
nine months of 2004 were down approximately 17.3% compared to the first nine
months of 2003. The total backlog of fabric and yarn products at the end of the
first nine months of 2004 was down 35.2% compared to that of a year ago.
Management will continue to aggressively pursue its core strategy of building
profitable volume by providing the market with the best products and service,
while at the same time reducing the Company's cost structure and production
rates to levels consistent with demand. To that end, during the third quarter of
2004, the Company completed a reduction in force affecting both its production
and administrative areas and implemented other cost cutting measures intended to
reduce Quaker's annual operating costs by approximately $4.0 million, in the
aggregate. Further company-wide staffing reductions and cost-cutting programs,
intended to reduce the Company's annual operating costs by an additional
$7.0 million, are currently underway and management anticipates that these
additional measures will be completed by the end of the fourth quarter of
this year.
It is also important to note that unusually high energy prices have a
negative effect on the Company's financial performance for two reasons. The
Company uses significant amounts of electricity to power its manufacturing
equipment and it is anticipated that today's higher energy prices will result in
a significant increase in the Company's utility costs following the expiration,
during the fourth quarter of this year, of the three-year power supply agreement
the Company originally put in place in the fourth quarter of 2001. In addition,
higher energy prices push up the cost of the petroleum-based raw materials that
go into the yarns and fabrics Quaker produces, putting additional pressure on
the Company's margin performance.
Results of Operations - Quarterly Comparison
Net sales for the third quarter of 2004 decreased $17.2 million or 21.3%,
to $63.6 million from $80.8 million for the third quarter of 2003. Net fabric
sales within the United States decreased 24.7%, to $51.6 million in the third
quarter of 2004 from $68.5 million in the third quarter of 2003, primarily due
to increased competition from leather and lower priced imported suede products.
In addition, overall domestic furniture demand appears to be lagging the U.S.
economic recovery as a whole, with the upholstered furniture category trailing
aggregate demand for furniture. The overall weighted average sales price per
yard increased 1.9%, to $5.81 for the third quarter of 2004 from $5.70 for the
third quarter of 2003 due to a slight shift in product mix to middle to
better-end fabrics and an increase of 3.4% in the average price point of middle
to better-end fabrics. Foreign and Export sales decreased 24.1%, to $7.5 million
in the third quarter of 2004 from $9.9 million in the third quarter of 2003. Net
yarn sales increased 87.5%, to $4.5 million in the third quarter of 2004 from
$2.4 million in the same period of 2003. This improvement in the yarn sales
segment is due to the penetration of new markets, particularly the craft yarn
category.
The Company's dollar value of incoming orders during the third quarter of
2004 decreased approximately 30.0% compared to the third quarter of 2003. The
dollar value of the backlog decreased by approximately 35.2%, to $19.6 million
at the end of the third quarter of 2004 as compared to $30.2 million at the end
of the same period in 2003, with the dollar value of the fabric backlog down
36.0% and the dollar value of the yarn backlog down 15.1%.
The gross profit margin for the third quarter of 2004 decreased to 18.4%
from 22.1% in the third quarter of 2003. The decrease in the gross margin
percentage resulted primarily from higher raw material costs and lower weekly
production and shipping rates.
Selling, general and administrative expenses increased to $14.2 million in
the third quarter of 2004 from $13.6 million in the third quarter of 2003.
Higher costs were incurred in the
13
third quarter of 2004 as compared to the third quarter of 2003 in several
semi-variable expense categories, such as expenditures for professional fees and
certain wage and fringe benefit expenses. Sarbanes-Oxley Act compliance-related
expenses, expenses associated with the termination of an agreement to purchase
an industrial building in Fall River, Massachusetts (see Note 7) and severance
costs arising out of the reduction in force completed during the third quarter
were the reasons for increases in these categories. Selling, general and
administrative expenses as a percentage of net sales increased to 22.3% in the
third quarter of 2004 from 16.8% in the third quarter of 2003. This increase as
a percentage of net sales was due to lower net sales in combination with the
above mentioned higher expenses in the third quarter of 2004 compared to the
same period in 2003.
Interest expense was $0.9 million for the third quarter of 2004 and $1.0
million for the third quarter of 2003. Lower levels of both variable and fixed
rate debt in the third quarter of 2004 resulted in the decline in interest
expense.
The Company provides for income taxes on an interim basis, using an
estimated annual effective income tax rate. The Company's estimated tax rate was
35.4% for 2003 and 36.5% for the first quarter of 2004. During the second
quarter of 2004, the Company adjusted the estimated annual effective tax rate
for 2004 downward to 35.5%. This reduction in the tax rate is due to lower
levels of projected income for 2004 reducing the effective statutory federal
income tax rate from 35% to approximately 34% and an increase in the estimated
benefit to the tax rate associated with the Extraterritorial Income Exclusion.
The effective income tax rate is lower than the combined federal and state
statutory rates, due primarily to certain tax benefits related to
extraterritorial income at the federal level and investment tax credits at the
state level.
The Company is currently challenging tax assessments from the Internal
Revenue Service for the years 1997-1999 and from the Massachusetts Department of
Revenue for the years 1993-1998. In addition, during the third quarter of Fiscal
2003 the Company filed amended tax returns for these and subsequent years to
claim approximately $3.5 million of federal and state research and development
credits. Audits of these amended returns commenced during October 2003. There is
significant uncertainty surrounding the amount and timing of the benefit, if
any, that will be ultimately realized. The Company believes that it has a
supportable basis for claiming these credits, but the amounts are subject to
ongoing audits by federal and state authorities. Accordingly, the Company has
not reflected the potential benefits of these credits in its financial
statements for these or subsequent years. No benefit will be recognized in the
financial statements until these gain contingencies are resolved through the
eventual disposition with the respective tax authorities.
The Company incurred a net loss in the third quarter of 2004 of ($2.1)
million or ($0.13) per common share-diluted, compared to net income of $2.2
million or $0.13 per common share-diluted for the third quarter of 2003.
Results of Operations - Nine-month Comparison
Net sales for the first nine months of 2004 decreased $23.8 million or
9.7%, to $221.1 million from $244.9 million for the first nine months of 2003.
Net fabric sales within the United States decreased 14.4%, to $178.9 million in
the first nine months of 2004 from $209.1 million in the first nine months of
2003, primarily due to increased competition from leather and lower priced
imported suede products. In addition, overall domestic furniture demand appears
to be lagging the U.S. economic recovery as a whole, with the upholstered
furniture category trailing aggregate demand for furniture. The overall weighted
average sales price per yard increased
14
2.0%, to $5.73 for the first nine months of 2004 from $5.62 for the first nine
months of 2003 due to a slight shift in product mix to middle to better-end
fabrics and an increase of 2.6% in the average price point of middle to
better-end fabrics. Foreign and Export sales decreased 9.1%, to $25.8 million in
the first nine months of 2004 from $28.4 million in the first nine months of
2003. Net yarn sales increased 119.7%, to $16.7 million in the first nine months
of 2004 from $7.6 million in the same period of 2003. This improvement in the
yarn sales segment is due to the penetration of new markets, particularly the
craft yarn category.
The Company's dollar value of incoming orders during the first nine months
of 2004 decreased approximately 17.3% compared to the first nine months of 2003.
The dollar value of the backlog decreased by approximately 35.2%, to $19.6
million at the end of the first nine months of 2004 as compared to $30.2 million
at the end of the same period in 2003, with the dollar value of the fabric
backlog down 36.0% and the dollar value of the yarn backlog down 15.1%.
The gross profit margin for the first nine months of 2004 decreased to
19.8%, from 20.9% in the same period of 2003. The decrease in the margin
percentage resulted primarily from higher raw material costs and lower weekly
production and shipping rates.
Selling, general and administrative expenses increased to $41.6 million in
the first nine months of 2004 from $41.1 million in the first nine months of
2003. Higher costs were incurred in the first nine months of 2004 as compared to
the first nine months of 2003 in several semi-variable expense categories, such
as expenditures for professional fees and certain wage and fringe benefit
expenses. Sarbanes-Oxley Act compliance-related expenses, expenses associated
with the termination of an agreement to purchase an industrial building in Fall
River, Massachusetts (see Note 7) and severance costs arising out of the
reduction in force completed during the third quarter were the reasons for
increases in these categories. Selling, general and administrative expenses as a
percentage of net sales increased to 18.8% in the first nine months of 2004 from
16.8% in the first nine months of 2003. This increase as a percentage of net
sales was due to lower net sales in the first nine months of 2004 compared to
the same period in 2003.
Interest expense was $2.6 million for the first nine months of 2004 and
$3.0 million for the first nine months of 2003. Lower levels of both variable
and fixed rate debt in the first nine months of 2004 resulted in the decline in
interest expense.
The Company provides for income taxes on an interim basis, using an
estimated annual effective income tax rate. The Company's estimated tax rate was
35.4% for 2003 and 36.5% for the first quarter of 2004. During the second
quarter of 2004, the Company adjusted the estimated annual effective tax rate
for 2004 downward to 35.5%. This reduction in the tax rate is due to lower
levels of projected income for 2004 reducing the effective statutory federal
income tax rate from 35% to approximately 34% and an increase in the estimated
benefit to the tax rate associated with the Extraterritorial Income Exclusion.
The effective income tax rate is lower than the combined federal and state
statutory rates, due primarily to certain tax benefits related to
extraterritorial income at the federal level and investment tax credits at the
state level.
The Company is currently challenging tax assessments from the Internal
Revenue Service for the years 1997-1999 and from the Massachusetts Department of
Revenue for the years 1993-1998. In addition, during the third quarter of Fiscal
2003 the Company filed amended tax returns for these and subsequent years to
claim approximately $3.5 million of federal and state research and development
credits. Audits of these amended returns commenced during October 2003. There is
significant uncertainty surrounding the amount and timing of the benefit, if
any, that will be ultimately realized. The Company believes that it has a
supportable basis for claiming
15
these credits, but the amounts are subject to ongoing audits by federal and
state authorities. Accordingly, the Company has not reflected the potential
benefits of these credits in its financial statements for these or subsequent
years. No benefit will be recognized in the financial statements until these
gain contingencies are resolved through the eventual disposition with the
respective tax authorities.
Net income for the first nine months of 2004 decreased to ($0.2) million or
($0.01) per common share-diluted, from $4.7 million or $0.28 per common
share-diluted for the first nine months of 2003.
Liquidity and Capital Resources
The Company historically has financed its operations and capital
requirements through a combination of internally generated funds, borrowings
under the Credit Agreement (as hereinafter defined), and debt and equity
offerings. The Company's capital requirements have arisen principally in
connection with (i) the purchase of equipment to expand production capacity,
introduce new technologies to broaden and differentiate the Company's products,
and improve the Company's quality and productivity performance, (ii) increases
in the Company's working capital needs related to its sales growth, and (iii)
investments in the Company's information technology systems.
The primary source of the Company's liquidity and capital resources in
recent years has been operating cash flow. The Company's net cash provided by
operating activities was $15.2 million and $22.8 million in the first nine
months of 2004 and 2003, respectively. Cash provided by operating activities
decreased during 2004 due principally to a reduction in net income of $4.8
million and a reduction in the deferred tax provision. Historically, the Company
has supplemented its operating cash flow with borrowings under the Credit
Agreement. Net debt repayments were $0.0 million in the first nine months of
2004 and $16.2 million in the first nine months of 2003.
Capital expenditures in the first nine months of 2004 and 2003 were $12.1
million and $6.6 million, respectively. Capital expenditures during the first
nine months of 2004 were funded by operating cash flow. Management anticipates
that capital expenditures for new projects will total approximately $15.7
million in 2004, consisting of approximately $11.5 million for various
manufacturing equipment, $2.1 million for IT projects, and $2.1 million for
various other capital projects. Management believes that cash on hand, operating
income and borrowings under the Credit Agreement (as hereinafter defined), will
provide sufficient funding for the Company's capital expenditures and working
capital needs for the foreseeable future, subject to the favorable resolution of
discussions with its lenders described below.
On July 2, 2004, the Company entered into a purchase and sale agreement
(the "P&S") to acquire for $21.0 million a 600,000 square foot, single story
industrial building located on 33.6 acres of land in Fall River, Massachusetts.
On September 30, 2004 the Company provided the seller with official notice of
its decision to terminate the P&S, resulting in a charge to Quaker's third
quarter pre-tax earnings of approximately $175,000, and is now engaged in active
negotiations with the seller with respect to a proposed leasing arangement
involving 540,000 square feet of manufacturing and warehousing space in the
building, representing all of the space at this site except for the 60,000
square feet of office space.
The Company issued $45.0 million of Senior Notes due October 2005 and 2007
(the Senior Notes) during 1997 under a Note Agreement (the "Senior Note
Agreement"). The Senior Notes are unsecured and bear interest at a fixed rate of
7.09% on $15.0 million and 7.18%
16
on $30.0 million. The Senior Notes may be prepaid in whole or in part prior to
maturity, at the Company's option, subject to a yield maintenance premium, as
defined. Annual principal payments began on October 10, 2003 with a final
payment due October 10, 2007. Annual principal payment amounts are three
payments of $5.0 million beginning in October 2003 (of which only the October
2005 payment is unpaid as of November 10, 2004), followed by two payments of
$15.0 million beginning in 2006.
On February 14, 2002, the Company issued $5.0 million of 7.56% Series A
Notes due February 2009 (the "Series A Notes") under a Note Purchase Agreement
(the "Series A Note Agreement"). The Series A Notes are unsecured and bear
interest at a fixed rate of 7.56%, payable semiannually. The Series A Notes may
be prepaid in whole or in part prior to maturity, at the Company's option,
subject to a yield maintenance premium, as defined. In addition and also on
February 14, 2002, the Company entered into a $45.0 million non-committed Shelf
Note Agreement (the "Shelf Agreement," and together with the Senior Note
Agreement and the Series A Note Agreement, the "Note Agreements") with an
insurance company pursuant to which, if the conditions to borrowing, including
the consent of the insurance company, were met, the Company may issue additional
senior notes prior to February 14, 2005 with maturity dates of up to ten years.
The Company also has a $60.0 million Credit Agreement with a bank which
expires January 31, 2007 (the "Credit Agreement"). As of October 2, 2004, the
Company had no loans outstanding under the Credit Agreement, approximately
$800,000 of letters of credit, and unused availability of $59.2 million. See
Note 5 of Notes to Consolidated Financial Statements included in the Company's
2003 Annual Report on Form 10-K.
The Company is required to comply with a number of affirmative and negative
convenants under the Credit Agreement and the Note Agreements, including, but
not limited to, maintenance of certain financial tests and ratios (including
interest coverage ratios, net worth related ratios, and net worth requirements);
limitations on certain business activities of the Company; restrictions on the
Company's ability to declare and pay dividends, incur additional indebtedness,
create certain liens, incur capital lease obligations, make certain investments,
engage in certain transactions with stockholders and affiliates, and purchase,
merge, or consolidate with or into any other corporation. On October 12, 2004,
Quaker Fabric Corporation of Fall River ("Quaker"), a wholly-owned subsidiary of
the Company, and the Company, as guarantor, entered into amendments effective as
of October 1, 2004 to the Note Agreements with the lenders. The amendments
provide for a reduction in the Fixed Charge Coverage Ratio (as defined in the
Note Agreements) required to be maintained by Quaker from 1.75 to 1.00, to 1.50
to 1.00 for the twelve (12) month period ended on October 2, 2004 (the last day
of the third fiscal quarter of 2004). In August 2004, the Company entered into a
similar amendment to the Credit Agreement. The amendments to the Note Agreements
also provide that (a) neither Quaker nor any of its subsidiaries will create or
permit to exist any Lien (as defined in the Note Agreements) securing
obligations under Quaker's Credit Agreement and (b) prior to January 1, 2005,
the Company will not declare or pay any dividends on or make any distributions
with respect, or purchase, redeem or retire, any of its capital stock. As a
result of the amendments to the Note Agreements and the Credit Agreement, Quaker
and the Company were in compliance with their affirmative and negative covenants
as of October 2, 2004.
The Company is in discussions with its lenders regarding proposed
amendments to the Note Agreements and the Credit Agreement seeking to reduce the
financial covenant maintenance and incurrence requirements under those
agreements going forward to levels that the Company believes will be achievable
by them under anticipated conditions in the industry. Any such further
amendments to the Note Agreements or the Credit Agreement may
17
also include other changes to the terms of those agreements which may be
unfavorable to the Company. There can be no assurance that the Company will
reach agreement with its lenders to amend the Note Agreements or the Credit
Agreement on terms acceptable to the Company, or at all. The Company may be
required to seek alternate financing sources, the terms of which financing, if
obtainable, may be disadvantageous to the Company. Based upon the anticipated
performance of the Company for the foreseeable future, and absent an appropriate
waiver from the lenders, the failure to obtain such amendments would likely
result in a default under the Note Agreements and the inability to borrow under
the Credit Agreement as early as the end of fiscal 2004.
No dividends were paid on the Company's common stock prior to Fiscal 2003.
During the first quarter of 2003, the Board of Directors adoped a new dividend
policy. This policy provides for future dividends to be declared at the
discretion of the Board of Directors, based on the Board's quarterly evaluation
of the Company's results of operations, cash requirements, financial conditions
and other factors deemed relevant by the Board. In the first nine months of 2004
and 2003, the Company paid cash dividends of $1.5 million or $0.09 per common
share and $1.3 million or $0.075 per common share, respectively. As noted above,
the Company has agreed with its lenders not to declare or pay any dividends
prior to January 1, 2005. It is anticipated that any amendments to the Note
Agreements or the Credit Agreement, or any agreements for alternate financing,
may prohibit the declaration or payment of dividends.
Inflation
The Company does not believe that inflation has had a significant impact on
the Company's results of operations for the periods presented. Historically, the
Company believes it has been able to minimize the effects of inflation by
improving its manufacturing and purchasing efficiency, by increasing employee
productivity, and by reflecting the effects of inflation in the selling prices
of the new products it introduces each year.
Cautionary Statement Regarding Forward-Looking Information
Statements contained in this report, as well as oral statements made by the
Company that are prefaced by the words "may," "will," "expect," "anticipate,"
"continue," "estimate," "project," "intend," "designed" and similar expressions,
are intended to identify forward-looking statements regarding events, conditions
and financial trends that may affect the Company's future plans of operations,
business strategy, results of operations and financial position. These
statements are based on the Company's current expectations and estimates as to
prospective events and circumstances about which the Company can give no firm
assurance. Further, any forward-looking statement speaks only as of the date on
which such statement is made, and the Company undertakes no obligation to update
any forward-looking statement to reflect events or circumstances after the date
on which such statement is made. As it is not possible to predict every new
factor that may emerge, forward-looking statements should not be relied upon as
a prediction of the Company's actual future financial condition or results.
These forward-looking statements, like any forward-looking statements, involve
risks and uncertainties that could cause actual results to differ materially
from those projected or anticipated. Such risks and uncertainties include
product demand and market acceptance of the Company's products, regulatory
uncertainties, the Company's ability to comply in a timely manner with the rules
and regulations set forth in the Sarbanes-Oxley Act, the effect of economic
conditions, the impact of competitive products and pricing, foreign currency
exchange rates, changes in customer ordering patterns,
18
and the effect of uncertainties in markets outside the U.S. (including Mexico
and South America) in which the Company operates.
Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Derivative Financial Instruments, Other Financial Instruments, and Derivative
Commodity Instruments
Quantitative and Qualitative Disclosures About Market Risk
The Company's exposures relative to market risk are due to foreign exchange
risk and interest rate risk.
Foreign Currency Risk
Approximately 2.6% of the Company's revenues are generated outside the U.S.
from sales which are not denominated in U.S. dollars. Foreign currency risk
arises because the Company engages in business in certain foreign countries in
local currency. Accordingly, in the absence of hedging activities, whenever the
U.S. dollar strengthens relative to the other major currencies, there is an
adverse affect on the Company's results of operations, and alternatively,
whenever the U.S. dollar weakens relative to the other major currencies, there
is a positive affect on the Company's results of operations.
It is the Company's policy to minimize, for a period of time, the
unforeseen impact on its results of operations of fluctuations in foreign
exchange rates by using derivative financial instruments to hedge the fair value
of foreign currency denominated intercompany payables. The Company's primary
foreign currency exposures in relation to the U.S. dollar are the Mexican peso
and the Brazilian real.
At October 2, 2004, the Company had the following derivative financial
instruments to hedge the anticipated cash flows from the repayment of foreign
currency denominated intercompany payables outstanding:
Notional Weighted Notional
Amount in Average Amount in Fair Value
Type of Local Contract U.S. Gain
Instrument Currency Currency Rate Dollars (Losses) Maturity
---------- -------- -------- ---- ------- -------- --------
Forward Contracts Mexican Peso 16.0 million 11.57 $1.4 million $ (6,000) Jan. 2005
Capped Forward Options Mexican Peso 44.0 million 11.52 $3.8 million $ 59,000 Dec. 2005
Forward Contracts Brazilian Real 0.6 million 3.13 $0.2 million $(14,000) Feb. 2005
The Capped Forward Options are agreements to sell Mexican pesos at the
fixed rate of 11.52, as long as the spot rate at the maturity of each contract
is 12.70 or less.
19
The Company occasionally purchases manufacturing equipment at prices which
are denominated in foreign currencies. The Company hedges these purchases by
purchasing forward contracts at the time the purchase commitment is made. As of
October 2, 2004, the Company had entered into forward contracts to purchase 1.2
million Euros (USD $1.4 million) at an average rate of 1.24. The fair value of
these contracts was $23,000 as of October 2, 2004.
Interest Rate Risk
All of the Company's outstanding long-term debt is at fixed rates.
Accordingly, a change in prevailing interest rates has an insignificant effect
on the Company's interest expense. The fair value of the Company's long-term
debt, however, would change in response to interest rate movements due to its
fixed rate nature.
The Company has evaluated the impact on all long-term maturities of
changing the interest rate 10% from the rate levels that existed at October 2,
2004 and has determined that such a rate change would not have a material impact
on the Company.
Item 4. CONTROLS AND PROCEDURES
The Company's management, under the supervision and with the participation
of the Chief Executive Officer and Chief Financial Officer, has evaluated the
effectiveness of the Company's disclosure controls and procedures (as such term
is defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as
amended (the "Exchange Act")) as of the end of the period covered by this
report. Based on such evaluation, management has concluded that, as of the end
of the period covered by this report, the Company's disclosure controls and
procedures are effective in alerting them on a timely basis to material
information relating to the Company (including its consolidated subsidiaries)
required to be included in the Company's periodic filings under the Exchange
Act. In addition, management has evaluated and concluded that during the most
recent fiscal quarter covered by this report, there has not been any change in
the Company's internal control over financial reporting that has materially
affected, or is reasonably likely to materially affect, the Company's internal
control over financial reporting.
20
QUAKER FABRIC CORPORATION AND SUBSIDIARIES
PART II - OTHER INFORMATION
Item 6. Exhibits
(A) Exhibits
31.1 Certification by the Chief Executive Officer pursuant
to section 302 of the Sarbanes-Oxley Act of 2002.
31.2 Certification by the Chief Financial Officer pursuant
to section 302 of the Sarbanes-Oxley Act of 2002.
32.1 Certification by the Chief Executive Officer pursuant
to section 906 of the Sarbanes-Oxley Act of 2002.
32.2 Certification by the Chief Financial Officer pursuant
to section 906 of the Sarbanes-Oxley Act of 2002.
21
QUAKER FABRIC CORPORATION AND SUBSIDIARIES
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.
QUAKER FABRIC CORPORATION
Date: November 12, 2004 By: /s/ Paul J. Kelly
---------------------- ---------------------
Paul J. Kelly
Vice President - Finance
and Treasurer (Principal Financial Officer)
22