SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-Q

 

 

Vertis, Inc.

(Exact Names of Registrants as Specified in Their Charters)

 

 

 

Indicate by check mark whether the Registrants (1) have 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 Registrants were required to file such reports), and (2) have been subject to such filing requirements for the past 90 days

Yes ý No o

 

Indicated by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act)

Yes o No ý

 

As of October 31, 2003 there were 1,000 shares of the registrant’s common stock outstanding.

 

 

INDEX

 

Part I  - Financial Information
Item 1. Financial Statements
	Condensed Consolidated Balance Sheets of Vertis, Inc. and Subsidiaries at September 30, 2003 and December 31, 2002
	Condensed Consolidated Statements of Operations of Vertis, Inc. and Subsidiaries for the Three Months Ended September 30, 2003 and 2002
	Condensed Consolidated Statements of Operations of Vertis, Inc. and Subsidiaries for the Nine Months Ended September 30, 2003 and 2002
	Condensed Consolidated Statements of Cash Flows of Vertis, Inc. and Subsidiaries for the Nine Months Ended September 30, 2003 and 2002
	Notes to Condensed Consolidated Financial Statements of Vertis, Inc. and Subsidiaries
Item 2.
	Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.
	Quantitative and Qualitative Disclosures about Market Risk
Item 4.
	Controls and Procedures
Part II  - Other Information
Item 1.
	Legal Proceedings
Item 5.
	Other Information
Item 6.
	Exhibits and Reports on Form 8-K
Signatures

 

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Part I - FINANCIAL INFORMATION

 

Item 1:  Financial Statements

 

Vertis, Inc. and Subsidiaries

Condensed Consolidated Balance Sheets

 

In thousands, except share amounts

 

		September 30, 2003			December 31, 2002
		(Unaudited)
ASSETS
Current Assets:
Cash and cash equivalents		$	8,427		$	5,735
Accounts receivable, net		179,831			131,525
Inventories		43,653			37,189
Maintenance parts		19,776			18,861
Deferred income taxes					7,806
Prepaid expenses and other current assets		11,797			15,890
Total current assets		263,484			217,006
Property, plant and equipment, net		407,532			445,493
Goodwill		351,238			342,304
Investments		73,587			72,411
Deferred financing costs, net		32,064			37,113
Other assets, net		19,187			20,671
Total Assets		$	1,147,092		$	1,134,998
LIABILITIES AND STOCKHOLDER’S DEFICIT
Current Liabilities:
Accounts payable		$	195,011		$	133,177
Compensation and benefits payable		32,666			37,834
Accrued interest		35,107			16,588
Accrued income taxes		6,953			5,951
Current portion of long-term debt		611			5,384
Other current liabilities		28,100			36,587
Total current liabilities		298,448			235,521
Due to parent		7,506			7,822
Long-term debt, net of current portion		1,089,958			1,087,684
Deferred income taxes		65,837			26,073
Other long-term liabilities		31,775			27,890
Total liabilities		1,493,524			1,384,990
Stockholder’s deficit:
Common stock - authorized 3,000 shares; $0.01 par value; issued and outstanding 1,000 shares
Contributed capital		408,963			408,965
Accumulated deficit		(748,370		)	(646,579		)
Accumulated other comprehensive loss		(7,025		)	(12,378		)
Total stockholder’s deficit		(346,432		)	(249,992		)
Total Liabilities and Stockholder’s Deficit		$	1,147,092		$	1,134,998

 

See Notes to Condensed Consolidated Financial Statements.

 

2

 

Vertis, Inc. and Subsidiaries

Condensed Consolidated Statements of Operations

 

In thousands

 

Three Months Ended September 30,		2003			2002
		(Unaudited)
Net sales		$	390,943		$	409,583
Operating expenses:
Costs of production		305,977			311,613
Selling, general and administrative		46,071			46,891
Restructuring charges		6,762			2,770
Depreciation and amortization of intangibles		20,705			22,817
		379,515			384,091
Operating income		11,428			25,492
Other expenses (income):
Interest expense, net		33,508			31,598
Other, net		740			1,891
		34,248			33,489
Loss before income taxes		(22,820		)	(7,997		)
Income tax expense (benefit)		1,206			(2,733		)
Net loss		$	(24,026	)	$	(5,264	)

 

See Notes to Condensed Consolidated Financial Statements.

 

3

 

Vertis, Inc. and Subsidiaries

Condensed Consolidated Statements of Operations

 

In thousands

 

Nine Months Ended September 30,		2003			2002 As Restated
		(Unaudited)
Net sales		$	1,139,506		$	1,220,355
Operating expenses:
Costs of production		889,298			922,306
Selling, general and administrative		136,299			138,429
Restructuring charges		6,762			5,816
Depreciation and amortization of intangibles		63,169			67,273
		1,095,528			1,133,824
Operating income		43,978			86,531
Other expenses (income):
Interest expense, net		104,305			100,365
Other, net		(6,646		)	2,981
		97,659			103,346
Loss before income taxes		(53,681		)	(16,815		)
Income tax expense		48,101			482
Loss before cumulative effect of accounting change		(101,782		)	(17,297		)
Cumulative effect of accounting change					108,365
Net loss		$	(101,782	)	$	(125,662	)

 

See Notes to Condensed Consolidated Financial Statements.

 

4

 

Vertis, Inc. and Subsidiaries

Condensed Consolidated Statements of Cash Flows

 

In thousands

 

Nine Months Ended September 30,		2003			2002 As Restated
		(Unaudited)
Cash Flows from Operating Activities:
Net loss		$	(101,782	)	$	(125,662	)
Adjustments to reconcile net loss to net cash provided by operating activities:
Depreciation and amortization		63,169			67,273
Amortization of deferred financing costs		6,156			7,747
Write-off of deferred financing fees		10,958			8,239
Restructuring charges		6,762			5,816
Cumulative effect of accounting change					108,365
Deferred income taxes		50,028			(4,421		)
Other		4,650			4,464
Changes in operating assets and liabilities (excluding effect of acquisition)
Decrease in accounts receivable		16,054			36,072
Increase in inventories		(6,462		)	(135		)
Decrease (increase) in prepaid expenses and other assets		4,528			(3,653		)
Decrease in accounts payable and other liabilities		(8,073		)	(52,972		)
Net cash provided by operating activities		45,988			51,133
Cash Flows from Investing Activities:
Capital expenditures		(25,222		)	(22,673		)
Software development costs capitalized		(2,215		)	(1,916		)
Proceeds from sale of property, plant and equipment		610			1,459
Acquisition of business, net of cash acquired		(133		)
Net cash used in investing activities		(26,960		)	(23,130		)
Cash Flows from Financing Activities:
Issuance of long-term debt		340,714			247,500
Net repayments under revolving credit facilities		(38,194		)	(27,487		)
Repayments of long-term debt		(309,987		)	(251,217		)
Deferred financing costs		(12,091		)	(8,883		)
Increase in outstanding checks drawn on controlled disbursement accounts		2,792			7,512
Other financing activities		(326		)	(679		)
Net cash used in financing activities		(17,092		)	(33,254		)
Effect of exchange rate changes on cash		756			369
Net increase (decrease) in cash and cash equivalents		2,692			(4,882		)
Cash and cash equivalents at beginning of year		5,735			17,533
Cash and cash equivalents at end of period		$	8,427		$	12,651
Supplemental Cash Flow Information:
Interest paid		$	66,745		$	80,807
Income taxes paid		$	1,642		$	1,208
Detachable warrants issued					$	15,766

 

See Notes to Condensed Consolidated Financial Statements.

 

5

 

VERTIS, INC. AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

1.              GENERAL

 

The accompanying condensed consolidated financial statements of Vertis, Inc. and Subsidiaries (collectively, “Vertis” or the “Company”) have been prepared in accordance with accounting principles generally accepted in the United States of America (“generally accepted accounting principles”) and are unaudited.  The financial statements include all normal and recurring adjustments that management of the Company considers necessary for the fair presentation of its financial position and operating results. The Company prepared the condensed consolidated financial statements following the requirements of the Securities and Exchange Commission for interim reporting. As permitted under those rules, the Company condensed or omitted certain footnotes or other financial information that are normally required by the generally accepted accounting principles for annual financial statements. As these are condensed financial statements, one should also read the consolidated financial statements and notes in the Company’s annual report on Form 10-K for the year ended December 31, 2002.

 

Revenues, expenses, assets and liabilities can vary during each quarter of the year. Therefore, the results and trends in these interim financial statements may not be the same as those for the full year.

 

Certain amounts for prior periods have been reclassified to conform to the current period presentation.

 

The difference between net loss and total comprehensive loss of $5.4 million for the nine months ended September 30, 2003 is made up of adjustments for foreign currency translation and the interest rate swap.  For the nine months ended September 30, 2002, the difference, which amounted to $3.2 million, is comprised of foreign currency translation and the fair value of interest rate swap adjustments (see Note 9).

 

2.              RESTRUCTURING CHARGES

 

The Company began a new restructuring plan in the third quarter of 2003, which is expected to be complete by 2004.  This plan includes the closure of facilities, some of which are associated with the consolidation of operations; reductions in work force of approximately 174 employees; and the abandonment of assets associated with vacating these premises.  In the third quarter of 2003, the Advertising Technology Services segment recorded $1.3 million in severance costs due to headcount reductions of 73 employees and $5.3 million in facility closure costs related to the closure of three facilities.  Additionally, the Retail and Newspaper Services segment and the Direct Marketing Services segment each recorded $0.1 million in severance costs due to headcount reductions of 36 and 9 employees, respectively.

 

The Company expects the costs associated with the restructuring plan at the Advertising Technology Services segment to be an estimated $9.6 million (net of estimated sublease income of $7.5 million) of which approximately $4.1 million are non-

 

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cash costs.  This plan is expected to be complete in 2003.  The costs associated with the restructuring effort at the Direct Marketing Services segment, which should be complete in 2003, are expected to be approximately $0.2 million.  The Company expects the restructuring plan at its Retail and Newspaper Services segment to cost approximately $0.5 million and to be complete in 2004.

 

In the nine months ended September 30, 2002, Vertis Europe combined two facilities and recorded $1.9 million in restructuring charges comprised mainly of facility closure costs and severance costs.  The Advertising Technology Services segment recorded $2.7 million in severance costs related to the termination of approximately 250 employees, and $1.1 million in facility closure costs, both in an effort to streamline operations.  Additionally, the Direct Marketing Services segment recorded $0.8 million in severance costs related to the termination of 133 employees, and the Retail and Newspaper Services segment recorded $0.6 million in severance costs.  Offsetting these charges is a $1.3 million adjustment to the estimate of 2001 restructuring costs made in 2002.  During the remainder of 2002, the Company recorded an additional $13.3 million in restructuring costs, for a total 2002 restructuring charge of $19.1 million, related to the closure of five facilities and the termination of approximately 50 employees in the Advertising Technology Services segment and the consolidation of production capabilities within the Direct Marketing Services segment.  The restructuring plan begun in 2000, which encompasses these 2002 programs, was completed at December 31, 2002.

 

The Company expects to pay approximately $4.0 million of the accrued restructuring costs during the next twelve months, and the remainder, approximately $7.4 million, by 2011.

 

The significant components of restructuring charges were as follows:

 

(In thousands)		Severance and Related Costs			Asset Write Off and Disposal Costs			Facility Closing Costs			Other Costs			Total
Accrued balance at December 31, 2002		$	1,704		$	2,019		$	7,084		$	873		$	11,680
Restructuring charges in the nine months ended September 2003		1,479						5,283						6,762
Restructuring payments in the nine months ended September 2003		(2,178		)	(1,924		)	(2,868		)	(119		)	(7,089		)
Accrued balance at September 30, 2003		$	1,005		$	95		$	9,499		$	754		$	11,353

 

 

3.            GOODWILL AND OTHER INTANGIBLES

 

On January 1, 2002, the Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 142 (“SFAS 142”), “Goodwill and Other Intangibles.”  Under this statement, goodwill and intangible assets with indefinite lives are no longer amortized. The Company stopped amortizing its existing goodwill as of January 1, 2002.  Additionally, under the transitional provisions of SFAS 142, the Company’s goodwill was tested for impairment as of January 1, 2002.  Each of the Company’s reporting units was tested for impairment by comparing the fair value of the reporting unit with the carrying value of that

 

7

 

unit.  Fair value was determined based on a valuation study performed by an independent third party using the discounted cash flow method and the guideline company method.  As a result of the Company’s impairment test completed in the third quarter of 2002, the Company recorded an impairment loss of $86.6 million at the Vertis Advertising Technology Services segment and $21.8 million at the Vertis Europe segment to reduce the carrying value of goodwill to its implied fair value.  Impairment in both cases was due to a combination of factors including operating performance and acquisition price.  In accordance with SFAS 142, the impairment charge was reflected as a cumulative effect of accounting change in the accompanying 2002 condensed consolidated statements of operations and cash flows.  The amount of the impairment charge includes the effect of taxes of $6.8 million, which had not been initially recorded in the Company’s September 30, 2002 financial statements.  As a result, the operating results and cash flows for the nine months ended September 30, 2002 have been restated, net of tax.

 

Goodwill is now reviewed for impairment on an annual basis, or more frequently if events or circumstances indicate that the carrying value may not be recoverable.  The Company has completed its annual goodwill impairment test for 2003, which did not indicate any goodwill impairment.

 

4.            ACQUISITION

 

On June 10, 2003, the Company acquired the sales, marketing and media planning assets of The Newspaper Network, Inc. (collectively, “TNN”) by assuming the working capital deficit of approximately $4.3 million representative of the portion of the business that was purchased.  The Newspaper Network, Inc. is a national sales and marketing company that provides a wide variety of print advertising services specializing in the planning, pricing and placement of newspaper advertising throughout the United States.  The addition of TNN will provide additional media expertise that will better equip the Company to serve large, national clients in key industry markets.

 

Goodwill arising in connection with this acquisition was approximately $4.3 million, calculated as the excess of the liabilities assumed over the fair value of the net assets acquired.  The financial results of TNN are included in the Company’s consolidated financial statements from the date of acquisition.  Amounts and allocations of costs recorded may require adjustment based upon information that is not currently available but will come to the attention of the Company.

 

The following unaudited pro forma information reflects the Company’s results adjusted to include TNN as though the acquisition had occurred at the beginning of 2002.

 

		Nine months ended September 30,
(In thousands)		2003			2002
Net sales		$	1,144,663		$	1,232,046
Net loss		(101,995		)	(125,790		)

 

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5.            ACCOUNTS RECEIVABLE

 

In 1996, the Company entered into a six-year agreement to sell substantially all trade accounts receivable generated by subsidiaries in the U.S. (as amended, the “1996 Facility”) through the issuance of $130.0 million of variable rate trade receivable backed certificates.  In April 2002, the revolving period for these certificates was extended and the certificates were refinanced.  In December 2002, the 1996 Facility expired and the Company entered into a new three-year agreement terminating in December 2005 (the “A/R Facility”) through the issuance of $130.0 million variable rate trade receivable backed notes.  The proceeds from the A/R Facility were used to retire the certificates issued under the 1996 Facility.

 

The A/R Facility allows for a maximum of $130.0 million of trade accounts receivable to be sold at any time based on the level of eligible receivables.  Under the 1996 Facility and the A/R Facility, the Company sells its trade accounts receivable through a bankruptcy-remote wholly-owned subsidiary.  However, the Company maintains an interest in the receivables and has been contracted to service the accounts receivable.  The Company received cash proceeds for servicing of $2.4 million for both the nine months ended September 30, 2003 and 2002, respectively.  These proceeds are fully offset by servicing costs.

 

At September 30, 2003 and December 31, 2002, accounts receivable of $113.5 million and $125.9 million, respectively, had been sold under the facilities and, as such, are reflected as reductions of accounts receivable.  At September 30, 2003 and December 31, 2002, the Company retained an interest in the pool of receivables in the form of overcollateralization and cash reserve accounts of $50.1 million and $46.3 million, respectively, which is included in Accounts receivable, net on the balance sheet at allocated cost, which approximates fair value.  The proceeds from collections reinvested in securitizations amounted to $1,048.9 million and $1,115.2 million in the nine months ended September 30, 2003 and 2002, respectively.

 

Fees for the program under the facilities vary based on the amount of interests sold and the London Inter Bank Offered Rate (“LIBOR”) plus an average margin of 90 basis points in 2003 and 37 basis points in 2002.  The loss on sale, which approximated the fees, totaled $2.0 million and $2.1 million for the nine months ended September 30, 2003 and 2002, respectively, and is included in Other, net.

 

6.            INVENTORY

 

Inventories are summarized as follows:

 

(In thousands)		September 30, 2003			December 31, 2002
Paper		$	27,009		$	20,412
Work in process		7,122			6,438
Ink and chemicals		3,697			4,075
Other		5,825			6,264
		$	43,653		$	37,189

 

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7.            SEGMENT INFORMATION

 

The Company operates in four business segments. Each segment offers different products or services requiring different production and marketing strategies. The four segments are:

 

•                  Retail and Newspaper Services - includes advertising inserts and circulation-building newspaper products such as Sunday comics, TV listing guides, Sunday magazine sections and special supplements.

 

•                  Direct Marketing Services - includes highly customized one-to-one marketing programs and direct marketing services such as automated digital fulfillment services, direct mail production including varying levels of personalization, mailing management services, and effectiveness measurement.

 

•                  Advertising Technology Services - includes outsourced digital premedia and image content management, response management services and newspaper ad development.

 

•                  Vertis Europe - includes direct marketing and advertising technology products and services provided in Europe, principally the United Kingdom.

 

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The following is unaudited information regarding the Company’s segments:

 

				Three months ended September 30,						Nine months ended September 30,
(In thousands)				2003			2002			2003			2002
Net Sales		Retail and Newspaper Services		$	246,805		$	258,922		$	719,974		$	763,266
		Direct Marketing Services		70,469			72,576			203,591			224,744
		Advertising Technology Services		46,492			48,641			128,936			149,705
		Vertis Europe		31,159			35,286			101,303			99,747
		Elimination of intersegment sales		(3,982		)	(5,842		)	(14,298		)	(17,107		)
		Consolidated Net Sales		$	390,943		$	409,583		$	1,139,506		$	1,220,355
EBITDA		Retail and Newspaper Services		$	30,414		$	37,979		$	89,404		$	118,044
		Direct Marketing Services		7,783			8,843			22,045			30,573
		Advertising Technology Services		(5,647		)	595			(7,401		)	(86,765		)
		Vertis Europe		1,245			3,075			6,396			(12,223		)
		General Corporate		(2,402		)	(4,074		)	3,349			(7,171		)
		Consolidated EBITDA		31,393			46,418			113,793			42,458
		Depreciation and amortization of intangibles		20,705			22,817			63,169			67,273
		Interest expense, net		33,508			31,598			104,305			100,365
		Income tax expense (benefit)		1,206			(2,733		)	48,101			482
		Consolidated Net Loss		$	(24,026	)	$	(5,264	)	$	(101,782	)	$	(125,662	)
Depreciation and Amortization of Intangibles		Retail and Newspaper Services		$	10,455		$	11,053		$	31,937		$	32,752
		Direct Marketing Services		4,624			5,261			14,061			14,874
		Advertising Technology Services		3,873			4,654			11,776			14,272
		Vertis Europe		1,753			1,849			5,395			5,375
		Consolidated Depreciation and Amortization of Intangibles		$	20,705		$	22,817		$	63,169		$	67,273

 

EBITDA represents net income (loss), plus:

 

•                  interest expense (net of interest income),

 

•                  income tax expense (benefit), and

 

•                  depreciation and amortization of intangibles.

 

8.            NEW ACCOUNTING PRONOUNCEMENTS

 

In June 2002, the Financial Accounting Standards Board (“FASB”) issued Statement No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.”  This statement requires recording costs associated with exit or disposal activities at their fair value when a liability has been incurred.  Under previous guidance, various exit costs were accrued upon management’s commitment to an exit plan, which is generally before an actual liability has been incurred.  In the first quarter of 2003, the Company adopted the provisions of this statement, which were incorporated in the condensed consolidated financial statements.

 

In November 2002, the FASB issued Interpretation No. 45, “Guarantors Accounting and Disclosure Requirements for Guarantees.”  The disclosure requirements are effective for financial statements issued after December 15, 2002, and the recognition/measurement requirements are effective on a prospective basis for guarantees

 

11

 

issued or modified after December 31, 2002.  In the first quarter of 2003, the Company adopted the provisions of this interpretation, which did not have an impact on the condensed consolidated financial statements.

 

In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure.”  This statement amends SFAS No. 123 to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation.  In addition, this statement amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based compensation and the effect of the method used on reporting results.  The disclosure provisions of this standard are effective for fiscal years ended after December 15, 2002 and have been incorporated into these condensed consolidated financial statements and accompanying notes (see Note 10).

 

In January 2003, the FASB issued Interpretation No. 46, “Consolidation of Variable Interest Entities” to provide new guidance with respect to the consolidation of all previously unconsolidated entities, including special-purpose entities. This interpretation applies to variable interest entities created after January 31, 2003 and to entities in which an enterprise obtains an interest after that date.  For entities created prior to January 31, 2003, this interpretation is to be adopted on December 31, 2003.  We believe the adoption of this interpretation will not have a material impact on the Company’s condensed consolidated financial position or results of operations.

 

In April 2003, the FASB issued Statement No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.”  This statement amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.”  In general, this statement is effective for contracts entered into or modified after June 30, 2003, and for hedging relationships designated after June 30, 2003.  We believe the adoption of this statement did not have a material impact on the Company’s condensed consolidated financial position.

 

In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.”  This statement establishes standards for how an issuer classifies and measures in its statement of financial position certain financial instruments that embody certain mandatory redeemable obligations for the issuer that are required to be classified as liabilities.  This statement is generally effective for financial instruments entered into or modified after May 31, 2003, and otherwise shall be effective at the beginning of the first interim period beginning after June 15, 2003.  We believe the provisions of the statement do not have a significant impact on the Company’s condensed consolidated financial position.

 

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9.            LONG TERM DEBT

 

Long-term debt consisted of the following:

 

(In thousands)		September 30, 2003			December 31, 2002
Revolving credit facility		$	119,626		$	155,161
Term loan A					124,981
Term loan B					184,219
9 3/4% senior secured second lien notes		341,245
10 7/8% senior notes		347,952			347,685
13 1/2% senior subordinated credit facility		70,421			279,579
13 1/2% senior subordinated notes		210,665
Other notes		660			1,443
		1,090,569			1,093,068
Current portion		(611		)	(5,384		)
		$	1,089,958		$	1,087,684

 

The credit facility (the “Credit Facility”) consisted of three components:

 

•                  A revolving credit facility which allows borrowings of up to $250.0 million, including borrowings in British pounds sterling of up to the equivalent of $160.0 million.  The revolving credit facility matures December 7, 2005 with no repayment of principal until maturity.  Interest is payable either (a) at the Prime rate plus a margin of 2.50% or (b) at the LIBOR rate plus a margin of 3.50%.  These margins may decline over time in accordance with covenants in the Credit Facility;

 

•                  Term Loan A, which required periodic principal payments through December 7, 2005, as well as mandatory repayments in the event of specified asset sales and certain other events; and

 

•                  Term Loan B, which required periodic principal payments through December 7, 2008, as well as repayments at the lenders’ option in the event of specified asset sales.

 

On May 7, 2003, the Company, in the course of its internal financial review, became aware of a required payment due March 31, 2003, under the Credit Facility to the holders of the Term A and B loans in the amount of $40.9 million.  This past due payment was discovered during a review of the definition of “excess cash flow”, as defined in the Credit Facility agreement, resulting in a revision of the previously calculated “excess cash flow” out of which a prepayment was required to be made.  The only period where this re-calculation resulted in a required prepayment was for the year ended December 31, 2002, which was due on March 31, 2003.  On May 8, 2003, the Company received the required waivers for this technical default and made the payment with borrowings from the revolving credit facilities.  The remainder of the Term A and B loans, $267.9 million, was retired in June 2003 in connection with the issuance of the 9 3/4% notes, as discussed below, and the provision under the Credit Facility requiring prepayment of our “excess cash flow” was eliminated.  Following the payment of the

 

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Term A and B loans in their entirety, the Credit Facility consists solely of the revolving credit facility.

 

In June 2003, the Company issued $350.0 million of senior secured second lien notes with an interest rate of 9 3/4% and maturity date of April 1, 2009 (the “9 3/4% notes”).  The notes pay interest semi-annually on April 1 and October 1 of each year.  After deducting the initial purchasers discount and transaction expenses, the net proceeds received by the Company were $330.3 million.  The Company used these net proceeds to pay off $267.9 million remaining on the Term A and B loans and $62.4 million of the revolving credit facility.

 

In 2002, the Company issued $350.0 million of senior unsecured notes with an interest rate of 10 7/8% and maturity date of June 15, 2009 (the “10 7/8% notes”).  The notes pay interest semi-annually on June 15 and December 15 of each year.  After deducting the initial purchasers discount and transaction expenses, the net proceeds received by the Company were $338.0 million.  The Company used these net proceeds to repay $181.5 million of the Term A and B loans and $156.5 million of the senior subordinated credit facility.

 

The senior subordinated credit facility, which had been originally issued in 1999 as a bridge facility, was converted into a term loan in December 2000, expiring on December 7, 2009.  The interest rate of the term notes representing this term loan is 13 1/2%.  In connection with the issuance of the 10 7/8% notes in 2002, $156.5 million was repaid under the senior subordinated credit facility.  Pursuant to the senior subordinated credit facility, the Company issued $210.7 million 13 1/2% senior subordinated notes due December 7, 2009 (the “Exchange Notes”) in the nine-month period ended September 30, 2003 in exchange for the term notes held by the holders requesting the exchange.  The remaining $82.8 million of outstanding term notes, excluding the discount, can be exchanged at the election of the holder in accordance with the senior subordinated credit facility.  The Exchange Notes pay interest semi-annually on June 1 and December 1 of each year.

 

The Credit Facility, the senior subordinated credit facility, the 10 7/8% notes, the 9 3/4% notes and the Exchange Notes contain customary covenants including restrictions on capital expenditures, dividends, and investments.  In particular, these debt instruments all contain customary high-yield debt covenants imposing limitations on the payment of dividends or other distributions on or in respect of the Company or the capital stock of its restricted subsidiaries.  Substantially all of the Company’s assets are pledged as collateral for the outstanding debt under the Credit Facility.  All of the Company’s debt has customary provisions requiring prepayment in the event of a change in control and from the proceeds of asset sales, as well as cross-default provisions.  In addition, the Credit Facility agreement has provisions requiring prepayment from the proceeds of issuances of debt and equity securities, and financial covenants that require us to maintain specified financial ratios as follows.  The consolidated net interest coverage ratio is the ratio of EBITDA to net interest expense, which is required to be, at a minimum, 1.50 to 1.00.  At September 30, 2003, the Company’s net interest coverage ratio is calculated as 1.72 to 1.00.  The leverage ratio is the ratio of consolidated debt to EBITDA, which must not exceed 6.50 to 1.00.  At September 30, 2003, the Company’s leverage ratio is calculated as 6.09 to 1.00.  The senior secured leverage ratio is the ratio of senior secured debt to

 

14

 

EBITDA, which must not exceed 2.00 to 1.00.   The Company’s senior secured leverage ratio, as calculated at September 30, 2003, is 1.20 to 1.00.  The amounts of EBITDA and net interest expense used in the preceding ratio calculations are not equivalent to the amounts included in these financial statements, but rather are amounts calculated as set forth in the Credit Facility.  If the Company is unable to maintain these financial ratios, the bank lenders could require the Company to repay any amounts owing under the Credit Facility.  At September 30, 2003, the Company is in compliance with its debt covenants.

 

 The Company had an interest rate swap agreement, attached to the Term B loans, that converted a portion of variable rate debt to a fixed rate basis.  This agreement was designated as a hedge against changes in future cash flows.  In accordance with SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”), as amended by SFAS No. 137 and SFAS No. 138, the interest rate swap agreement was reflected at fair value in the Company’s consolidated balance sheet at December 31, 2002, and the related mark-to-market adjustment was recorded in stockholder’s deficit as a component of other comprehensive income.

 

On June 6, 2003, in connection with the payoff of the Term A and B loans, this interest rate swap agreement became an ineffective cash flow hedge.  At this date, the remaining fair market value of the agreement of approximately $1.1 million was expensed and is included in Other, net in the nine months ended September 30, 2003.

 

10.     VERTIS HOLDINGS STOCK AWARD AND INCENTIVE PLAN

 

Employees of the Company participate in Vertis’ parent company, Vertis Holdings, Inc.’s 1999 Equity Award Plan (the “Stock Plan”), which authorizes grants of stock options, restricted stock, performance shares and other stock based awards.  As of September 30, 2003, only options have been granted under the Stock Plan.

 

The Company accounts for the Stock Plan under the intrinsic value method, which follows the recognition and measurement principles of Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees.”  No stock-based employee compensation cost is reflected in net income.  The following table summarizes the effect of accounting for these awards as if the fair value recognition provisions of SFAS No. 123, “Accounting for Stock Based Compensation,” as amended by SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure, an amendment of FASB Statement No. 123,” had been applied.

 

		Three months ended September 30,						Nine months ended September 30,
(In thousands)		2003			2002			2003			2002
Net loss:
As reported		$	(24,026	)	$	(5,264	)	$	(101,782	)	$	(125,662	)
Deduct: total stock-based compensation determined under fair value based method for all awards, net of tax		(284		)	(587		)	(853		)	(1,762		)
Pro forma		$	(24,310	)	$	(5,851	)	$	(102,635	)	$	(127,424	)

 

15

 

11.     INTEREST EXPENSE, NET

 

Interest expense, net consists of the following:

 

		Three months ended September 30,						Nine months ended September 30,
(In thousands)		2003			2002			2003			2002
Interest expense		$	31,664		$	29,197		$	87,339		$	84,556
Amortization of deferred financing fees		1,886			2,464			6,156			7,747
Write-off of deferred financing fees								10,958			8,239
Interest income		(42		)	(63		)	(148		)	(177		)
		$	33,508		$	31,598		$	104,305		$	100,365

 

The Company fully amortized deferred financing fees of $11.0 million in June 2003 in connection with the retirement of the Term A and B loans (see Note 9).  In June 2002, the Company fully amortized $8.2 million in deferred financing fees in connection with the repayments of a portion of the Term A and B loans and the senior subordinated credit facility (see Note 9).

 

12.     OTHER, NET

 

Other, net for the nine months ended September 30, 2003 consists primarily of a $10.1 million recovery from a settlement to the legal proceeding arising from a life insurance policy which covered the former Chairman of Vertis Holdings, Inc.  Offsetting this income are $2.0 million in fees associated with the A/R Facility (see Note 5), the $1.1 million adjustment to record the change in the interest rate swap agreement (see Note 9) and $0.7 million in losses on the sale of property, plant and equipment.

 

Other, net for the nine months ended September 30, 2002 consists primarily of $2.1 million in fees associated with the 1996 Facility (see Note 5), $1.5 million in losses on the sale of property, plant and equipment, and $0.3 million in foreign exchange losses offset by $1.2 million in income earned on investments accounted for as leveraged leases in accordance with SFAS No. 13, “Accounting for Leases.”

 

13.     INCOME TAXES

 

The Company has approximately $248.5 million of federal net operating losses available to carry forward as of December 31, 2002.  These carryforwards expire beginning in 2005 through 2023.  In the nine months ended September 30, 2003 the Company recorded tax expense of $48.1 million, which includes a valuation allowance of $48.8 million against more than half of its tax benefit carryforwards.  The valuation allowance reserves a portion of the net operating losses and tax credit carryforwards that may not be offset by reversing taxable temporary differences.  The valuation allowance was recorded in the second quarter of 2003 due to the continuation of the poor economic climate and the projected increase in annual interest expense resulting from the issuance of the 9 3/4% notes in June 2003 (see Note 9).  The Company

 

16

 

intends to maintain a valuation allowance until sufficient positive evidence exists to support its reversal.

 

14.     GUARANTOR/NON-GUARANTOR CONDENSED CONSOLIDATED FINANCIAL INFORMATION

 

The Company has 9 3/4% notes, 10 7/8% notes, and Exchange Notes (see Note 9), which are guaranteed by certain of Vertis, Inc.’s domestic subsidiaries.  Accordingly, the following condensed consolidated financial information as of September 30, 2003 and December 31, 2002, for the three months ended September 30, 2003 and 2002, and for the nine months ended September 30, 2003 and 2002 are included for (a) Vertis, Inc. (the “Parent”) on a stand-alone basis; (b) the guarantor subsidiaries; (c) the non-guarantor subsidiaries; and (d) the Company on a consolidated basis.

 

Investments in subsidiaries are accounted for using the equity method for purposes of the consolidating presentation.  The principal elimination entries eliminate investments in subsidiaries, intercompany balances and intercompany transactions.  Separate financial statements and other disclosures with respect to the subsidiary guarantors have not been included because the subsidiaries are wholly-owned and the guarantees are full and unconditional and joint and several.

 

17

 

Condensed Consolidating Balance Sheet at September 30, 2003

 

In thousands

 

		Parent			Guarantor Companies			Non-Guarantor Companies			Elimin- ations			Consol- idated
ASSETS
Current Assets:
Cash and cash equivalents		$	6,513		$	308		$	1,606					$	8,427
Accounts receivable, net		129,206			23,242			27,383						179,831
Inventories		29,164			12,420			2,069						43,653
Maintenance parts		16,642			3,134									19,776
Deferred income taxes
Prepaid expenses and other current assets		5,427			1,440			4,930						11,797
Total current assets		186,952			40,544			35,988						263,484
Intercompany receivable		73,830									$	(73,830	)
Investments in subsidiaries		154,339			55,200						(209,539		)
Property, plant and equipment, net		288,151			99,719			19,662						407,532
Goodwill		201,529			48,625			101,084						351,238
Investments								73,587						73,587
Deferred financing costs, net		31,963						101						32,064
Other assets, net		18,224			929			34						19,187
Total Assets		$	954,988		$	245,017		$	230,456		$	(283,369	)	$	1,147,092
LIABILITIES AND STOCKHOLDER’S (DEFICIT) EQUITY
Current Liabilities:
Accounts payable		$	164,685		$	16,360		$	13,966					$	195,011
Compensation and benefits payable		25,117			6,975			574						32,666
Accrued interest		34,350						757						35,107
Accrued income taxes		9,035			(191		)	(1,891		)				6,953
Current portion of long-term debt		611												611
Other current liabilities		7,534			11,598			8,968						28,100
Total current liabilities		241,332			34,742			22,374						298,448
Due to parent					53,037			28,299			$	(73,830	)	7,506
Long-term debt, net of current portion		1,022,143						67,815						1,089,958
Deferred income taxes		67,175			(2,284		)	946						65,837
Other long-term liabilities		24,978			6,584			213						31,775
Total liabilities		1,355,628			92,079			119,647			(73,830		)	1,493,524
Stockholder’s (deficit) equity		(400,640		)	152,938			110,809			(209,539		)	(346,432		)
Total Liabilities and Stockholder’s (Deficit) Equity		$	954,988		$	245,017		$	230,456		$	(283,369	)	$	1,147,092

 

18

 

Condensed Consolidating Balance Sheet at December 31, 2002

 

In thousands

 

		Parent			Guarantor Companies			Non-Guarantor Companies			Elimin- ations			Consol- idated
ASSETS
Current Assets:
Cash and cash equivalents		$	3,590		$	99		$	2,046					$	5,735
Accounts receivable, net		72,106			25,954			33,465						131,525
Inventories		23,906			11,867			1,416						37,189
Maintenance parts		15,799			3,062									18,861
Deferred income taxes		7,790						16						7,806
Prepaid expenses and other current assets		10,647			2,344			2,899						15,890
Total current assets		133,838			43,326			39,842						217,006
Intercompany receivable		80,607									$	(80,607	)
Investments in subsidiaries		98,428			18,240						(116,668		)
Property, plant and equipment, net		305,300			117,877			22,316						445,493
Goodwill		197,202			48,625			96,477						342,304
Investments								72,411						72,411
Deferred financing costs, net		36,985						128						37,113
Other assets, net		19,277			1,361			33						20,671
Total Assets		$	871,637		$	229,429		$	231,207		$	(197,275	)	$	1,134,998
LIABILITIES AND STOCKHOLDER’S (DEFICIT) EQUITY
Current Liabilities:
Accounts payable		$	82,168		$	32,565		$	18,444					$	133,177
Compensation and benefits payable		27,466			9,650			718						37,834
Accrued interest		14,493						2,095						16,588
Accrued income taxes		8,548			(180		)	(2,417		)				5,951
Current portion of long-term debt		5,341			43									5,384
Other current liabilities		16,432			10,435			9,720						36,587
Total current liabilities		154,448			52,513			28,560						235,521
Due to parent					62,597			25,832			$	(80,607	)	7,822
Long-term debt, net of current portion		980,678						107,006						1,087,684
Deferred income taxes		27,447			(2,284		)	910						26,073
Other long-term liabilities		20,578			6,924			388						27,890
Total liabilities		1,183,151			119,750			162,696			(80,607		)	1,384,990
Stockholder’s (deficit) equity		(311,514		)	109,679			68,511			(116,668		)	(249,992		)
Total Liabilities and Stockholder’s (Deficit) Equity		$	871,637		$	229,429		$	231,207		$	(197,275	)	$	1,134,998

 

19

 

Condensed Consolidating Statement of Operations

Three months ended September 30, 2003

 

In thousands

 

		Parent			Guarantor Companies			Non-Guarantor Companies			Elimin- ations			Consol- idated
Net sales		$	272,432		$	89,916		$	32,578		$	(3,983	)	$	390,943
Operating expenses:
Costs of production		218,439			68,480			23,041			(3,983		)	305,977
Selling, general and administrative		29,193			8,907			7,971						46,071
Restructuring charges		6,643			119									6,762
Depreciation and amortization of intangibles		13,764			5,165			1,776						20,705
		268,039			82,671			32,788			(3,983		)	379,515
Operating income		4,393			7,245			(210		)				11,428
Other expenses (income):
Interest expense, net		32,087			(7		)	1,428						33,508
Other, net		726						14						740
		32,813			(7		)	1,442						34,248
Equity in net income (loss) of subsidiaries		5,465									(5,465		)
(Loss) income before income taxes		(22,955		)	7,252			(1,652		)	(5,465		)	(22,820		)
Income tax expense (benefit)		1,071			(3		)	138						1,206
Net (loss) income		$	(24,026	)	$	7,255		$	(1,790	)	$	(5,465	)	$	(24,026	)

 

20

 

Condensed Consolidating Statement of Operations

Three months ended September 30, 2002

 

In thousands

 

		Parent			Guarantor Subsidiaries			Non-Guarantor Subsidiaries			Elimin- ations			Consol- idated
Net sales		$	282,203		$	97,003		$	36,223		$	(5,846	)	$	409,583
Operating expenses:
Costs of production		220,078			71,640			25,741			(5,846		)	311,613
Selling, general and administrative		29,751			10,184			6,956						46,891
Restructuring charges		1,852			717			201						2,770
Depreciation and amortization of intangibles		14,753			6,182			1,882						22,817
		266,434			88,723			34,780			(5,846		)	384,091
Operating income		15,769			8,280			1,443						25,492
Other expenses (income):
Interest expense, net		29,506			(11		)	2,103						31,598
Other, net		1,208			7			676						1,891
		30,714			(4		)	2,779						33,489
Equity in net income (loss) of subsidiaries		13,886									(13,886		)
(Loss) income before income taxes		(1,059		)	8,284			(1,336		)	(13,886		)	(7,997		)
Income tax expense (benefit)		4,205			(6,782		)	(156		)				(2,733		)
Net (loss) income		$	(5,264	)	$	15,066		$	(1,180	)	$	(13,886	)	$	(5,264	)

 

21

 

Condensed Consolidating Statement of Operations

Nine months ended September 30, 2003

 

In thousands

 

		Parent			Guarantor Companies			Non-Guarantor Companies			Elimin- ations			Consol- idated
Net sales		$	788,496		$	261,352		$	103,956		$	(14,298	)	$	1,139,506
Operating expenses:
Costs of production		632,132			198,334			73,130			(14,298		)	889,298
Selling, general and administrative		84,550			27,800			23,949						136,299
Restructuring charges		6,643			119									6,762
Depreciation and amortization of intangibles		41,868			15,831			5,470						63,169
		765,193			242,084			102,549			(14,298		)	1,095,528
Operating income		23,303			19,268			1,407						43,978
Other expenses (income):
Interest expense, net		99,296			(15		)	5,024						104,305
Other, net		(6,685		)	23			16						(6,646		)
		92,611			8			5,040						97,659
Equity in net income (loss) of subsidiaries		15,043									(15,043		)
(Loss) income before income taxes		(54,265		)	19,260			(3,633		)	(15,043		)	(53,681		)
Income tax expense (benefit)		47,517			(10		)	594						48,101
Net (loss) income		$	(101,782	)	$	19,270		$	(4,227	)	$	(15,043	)	$	(101,782	)

 

22

 

Condensed Consolidating Statement of Operations

Nine months ended September 30, 2002

As restated

 

In thousands

 

		Parent			Guarantor Companies			Non-Guarantor Companies			Elimin- ations			Consol- idated
Net sales		$	834,508		$	301,008		$	101,946		$	(17,107	)	$	1,220,355
Operating expenses:
Costs of production		648,568			220,256			70,589			(17,107		)	922,306
Selling, general and administrative		85,867			33,176			19,386						138,429
Restructuring charges		2,191			1,502			2,123						5,816
Depreciation and amortization of intangibles		44,094			17,681			5,498						67,273
		780,720			272,615			97,596			(17,107		)	1,133,824
Operating income		53,788			28,393			4,350						86,531
Other expenses (income):
Interest expense, net		94,539			(101		)	5,927						100,365
Other, net		867			23			2,091						2,981
		95,406			(78		)	8,018						103,346
Equity in net income (loss) of subsidiaries		(19,029		)							19,029
(Loss) income before income taxes		(60,647		)	28,471			(3,668		)	19,029			(16,815		)
Income tax expense (benefit)		1,076			(11		)	(583		)				482
(Loss) income before cumulative effect of accounting change		(61,723		)	28,482			(3,085		)	19,029			(17,297		)
Cumulative effect of accounting change		63,939			22,661			21,765						108,365
Net (loss) income		$	(125,662	)	$	5,821		$	(24,850	)	$	19,029		$	(125,662	)

 

23

 

Condensed Consolidating Statement of Cash Flows

Nine months ended September 30, 2003

 

In thousands

 

		Parent			Guarantor Companies			Non- Guarantor Companies			Consol- idated
Cash Flows from Operating Activities		$	26,968		$	20,805		$	(1,785	)	45,988
Cash Flows from Investing Activities:
Capital expenditures		(17,518		)	(5,215		)	(2,489		)	(25,222		)
Software development costs capitalized		(2,215		)							(2,215		)
Proceeds from sale of property, plant and equipment and divested assets		439						171			610
Acquisition of business, net of cash		(133		)							(133		)
Net cash used in investing activities		(19,427		)	(5,215		)	(2,318		)	(26,960		)
Cash Flows from Financing Activities:
Issuance of long-term debt		340,714									340,714
Net borrowings (repayments) under revolving credit facilities		3,610						(41,804		)	(38,194		)
Repayments of long-term debt		(309,893		)	(43		)	(51		)	(309,987		)
Deferred financing costs		(12,091		)							(12,091		)
Increase (decrease) in outstanding checks drawn on controlled disbursement accounts		2,310			1,489			(1,007		)	2,792
Other financing activities		(29,268		)	(16,827		)	45,769			(326		)
Net cash (used in) provided by financing activities		(4,618		)	(15,381		)	2,907			(17,092		)
Effect of exchange rate changes on cash								756			756
Net (decrease) increase in cash and cash equivalents		2,923			209			(440		)	2,692
Cash and cash equivalents at beginning of year		3,590			99			2,046			5,735
Cash and cash equivalents at end of year		$	6,513		$	308		$	1,606		$	8,427

 

24

 

Condensed Consolidating Statement of Cash Flows

Nine months ended September 30, 2002

As restated

In thousands

 

		Parent			Guarantor Companies			Non- Guarantor Companies			Consol- idated
Cash Flows from Operating Activities		$	5,444		$	26,646		$	19,043		51,133
Cash Flows from Investing Activities:
Capital expenditures		(18,394		)	(2,202		)	(2,077		)	(22,673		)
Software development costs capitalized		(1,916		)							(1,916		)
Proceeds from sale of property, plant and equipment and divested assets		1,088			312			59			1,459
Investments in subsidiaries
Distributions from subsidiaries
Other investing activities
Acquisition of business, net of cash
Net cash used in investing activities		(19,222		)	(1,890		)	(2,018		)	(23,130		)
Cash Flows from Financing Activities:
Issuance of long-term debt		247,500									247,500
Net (repayments) borrowings under revoloving credit facilities revolving credit facilities		(28,461		)				974			(27,487		)
Repayments of long-term debt		(250,938		)	(240		)	(39		)	(251,217		)
Deferred financing costs		(8,883		)							(8,883		)
Increase in outstanding checks drawn on controlled disbursement accounts		4,136			2,325			1,051			7,512
Other financing activities		32,410			(13,007		)	(20,082		)	(679		)
Net cash used in financing activities		(4,236		)	(10,922		)	(18,096		)	(33,254		)
Effect of exchange rate changes on cash								369			369
Net (decrease) increase in cash and cash equivalents		(18,014		)	13,834			(702		)	(4,882		)
Cash and cash equivalents at beginning of year		14,618			(358		)	3,273			17,533
Cash and cash equivalents at end of year		$	(3,396	)	$	13,476		$	2,571		$	12,651

 

25

 

Item 2.  Management’s Discussion and Analysis of Financial Conditions and Results of Operations

 

Introduction

 

Vertis is a leading provider of targeted advertising products and marketing services.  We deliver a comprehensive range of solutions that simplify, improve and maximize the effectiveness of multiple phases of our customers’ marketing campaigns from the inception of an advertising concept, through design, production, targeted distribution, and ultimately to providing advertising effectiveness measurement.

 

We operate through four principal business segments.  Vertis Retail and Newspaper Services (“RNS”), Vertis Direct Marketing Services (“DMS”) and Vertis Advertising Technology Services (“ATS”) provide advertising solutions to clients on a functional basis in the U.S., while Vertis Europe provides both production and direct marketing services to clients overseas, predominantly in the U.K.

 

When we use the terms “Vertis”, the “Company”, “we” and “our”, we mean Vertis, Inc., a Delaware corporation, and its consolidated subsidiaries.  The words “Vertis Holdings” refer to Vertis Holdings, Inc., the parent company of Vertis and its sole stockholder.

 

Corporate Restructuring

 

We began a new restructuring plan in the third quarter of 2003, which is expected to be complete by 2004.  The plan includes the consolidation of pre-press operations within both RNS and DMS in an effort to optimize the pre-press processes for these segments.  Additionally, the plan includes the closure of poorly performing facilities at ATS, where losses generally exceed lease costs.  In order to gain efficiencies as well as lower lease costs, the plan also includes the consolidation of two ATS large format operations, which print banners to go on billboards or buildings; lastly, the plan includes headcount reductions at ATS in both sales and administrative functions.  The restructuring costs associated with these efforts are estimated to include the costs of severance, facility closure costs and asset impairment charges.  In the third quarter of 2003, ATS recorded $1.3 million in severance costs due to headcount reductions of 73 employees and $5.3 million in facility closure costs related to the closure of three facilities.  Additionally, RNS and DMS each recorded $0.1 million in severance costs due to headcount reductions of 36 and 9 employees, respectively.

 

We expect the costs associated with the restructuring plan at ATS to be an estimated $9.6 million (net of estimated sublease income of $7.5 million) of which approximately $4.1 million are non-cash costs.  This plan is expected to e complete in 2003.  The costs associated with the restructuring effort at DMS, which should be complete in 2003, are expected to be approximately $0.2 million.  The Company expects the restructuring plan at RNS to cost approximately $0.5 million and to be complete in 2004.

 

In the nine months ended September 30, 2002, Vertis Europe combined two facilities and recorded $1.9 million in restructuring charges comprised mainly of facility closure costs and severance costs.  ATS recorded $2.7 million in severance costs related to the termination

 

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of approximately 250 employees, and $1.1 million in facility closure costs, both in an effort to streamline operations.  Additionally, DMS recorded $0.8 million in severance costs related to the termination of 133 employees, and RNS recorded $0.6 million in severance costs.  Offsetting these charges is a $1.3 million adjustment to the estimate of 2001 restructuring costs made in 2002.  During the remainder of 2002, we recorded an additional $13.3 million in restructuring costs, for a total 2002 restructuring charge of $19.1 million, related to the closure of five facilities and the termination of approximately 50 employees at ATS and the consolidation of production capabilities within DMS.  The restructuring plan begun in 2000, which encompasses these 2002 programs, was completed at December 31, 2002.

 

We expect to pay approximately $4.0 million of the accrued restructuring costs during the next twelve months, and the remainder, approximately $7.4 million, by 2011.

 

Results Of Continuing Operations

 

The following table presents major components from our consolidated statements of operations and consolidated statements of cash flows.

 

														Percentage of Net Sales				Percentage of Net Sales
		Three months ended September 30,						Nine months ended September 30,						Three months ended September 30,				Nine months ended September 30,
		2003			2002			2003			2002			2003		2002		2003		2002
		(in thousands)						(in thousands)
Net sales		$	390,943		$	409,583		$	1,139,506		$	1,220,355		100.0	%	100.0	%	100.0	%	100.0	%
Costs of production		305,977			311,613			889,298			922,306			78.3	%	76.1	%	78.0	%	75.6	%
Selling, general and administrative		46,071			46,891			136,299			138,429			11.8	%	11.4	%	12.0	%	11.3	%
Restructuring charges		6,762			2,770			6,762			5,816			1.7	%	0.7	%	0.6	%	0.5	%
Depreciation and amortization of intangibles		20,705			22,817			63,169			67,273			5.3	%	5.6	%	5.5	%	5.5	%
Total operating costs		379,515			384,091			1,095,528			1,133,824			97.1	%	93.8	%	96.1	%	92.9	%
Operating income		11,428			25,492			43,978			86,531			2.9	%	6.2	%	3.9	%	7.1	%
Other data:
Cash flows (used in) provided by operating activities		$	(21,317	)	$	40,222		$	45,988		$	51,133
Cash flows used in investing activities		(13,231		)	(9,632		)	(26,960		)	(23,130		)
Cash flows provided by (used in) financing activities		18,175			(23,363		)	(17,092		)	(33,254		)
EBITDA		31,393			46,418			113,793			42,458			8.0	%	11.3	%	10.0	%	3.5	%

 

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EBITDA is included in this document as it is the primary performance measure we use to evaluate our business segments.  EBITDA, as we use it for this purpose, represents net income (loss) plus:

 

•                  interest expense (net of interest income),

 

•                  income tax expense (benefit), and

 

•                  depreciation and amortization of intangibles.

 

We have modified our definition of EBITDA to comply with recent definitional guidance from the Securities and Exchange Commission on EBITDA. This modified definition includes the cumulative effect of accounting change as a deduction in arriving at EBITDA.  This change had the effect of decreasing our EBITDA by $108.4 million for the nine months ended September 30, 2002.

 

We present EBITDA here to provide additional information regarding our performance and because it is the measure by which we gauge the profitability of our segments.  EBITDA is not a measure of financial performance in accordance with accounting principles generally accepted in the United States of America (“GAAP”).  You should not consider it an alternative to net income as a measure of operating performance.  Our calculation of EBITDA may be different from the calculation used by other companies and therefore comparability may be limited.  A full quantitative reconciliation of EBITDA to its most directly comparable GAAP measure, net (loss) income, is provided as follows:

 

		Three months ended September 30,						Nine months ended Septeber 30,
(in thousands)		2003			2002			2003			2002
Net loss		$	(24,026	)	$	(5,264	)	$	(101,782	)	$	(125,662	)
Interest expense, net		33,508			31,598			104,305			100,365
Income tax expense (benefit)		1,206			(2,733		)	48,101			482
Depreciation and amortization of intangibles		20,705			22,817			63,169			67,273
EBITDA		$	31,393		$	46,418		$	113,793		$	42,458

 

General

 

Several factors can affect the comparability of our results from one period to another.  Primary among these factors are the cost of paper, changes in business mix, the timing of restructuring expense and the realization of the associated benefits, and the current economic environment.

 

The cost of paper is a principal factor in our pricing to certain customers since a substantial portion of net sales includes the pass-through cost of paper.  Therefore, changes in the cost of paper and changes in the proportion of paper supplied by our customers significantly affect our net sales, principally at RNS and DMS where paper is a substantial portion of the costs of production.  Changes in the cost of paper do not materially impact our net earnings since we are generally able to pass on increases in the cost of paper to our customers, while decreases in paper costs generally result in lower prices to customers.

 

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Variances in expense category ratios, as percentages of net sales, may reflect business mix and are influenced by the change in revenue directly resulting from changes in paper prices, type of paper, and the proportion of paper supplied by our customers.  As our business mix changes, the nature of products sold in a period can lead to offsetting increases and decreases in different expense categories.

 

In the nine months ended September 30, 2003, the economic environment remained challenging, affecting our performance.  Weak advertising spending continued to result in competitive price pressure within our markets.  A substantial portion of our revenue is generated from customers in various sectors of the retail industry, which have been particularly impacted by the recent prolonged economic downturn.  If this ongoing difficult economic environment continues, it is likely that our results for the remainder of 2003 will be negatively impacted as well.

 

You should consider all of these factors in reviewing the discussion of our operating results.

 

Results of Operations – Three and nine months ended September 30, 2003 compared to 2002

 

For the three months ended September 30, 2003, net sales declined $18.7 million, or 4.6%, from $409.6 million in 2002 to $390.9 million in 2003.  Through the first nine months of 2003, net sales of $1,139.5 million represent an $80.9 million, or 6.6%, decline as compared to 2002 net sales of $1,220.4 million.  The decline reflects competitive pricing pressures, sluggish direct mail business domestically as well as abroad and the weak advertising agency business at ATS.  We believe these declines reflect the challenging macro-economic and geopolitical conditions which have dampened spending for our products and services.  Changes in the cost of paper resulted in an increase in net sales of $2.3 million in the third quarter and a $1.5 million decrease in net sales for the nine months ended September 30, 2003.

 

At RNS, net sales declined $12.1 million, or 4.7%, from $258.9 million to $246.8 million for the three months ended September 30, 2003.  Through the first nine months, net sales of $720.0 million represent a $43.3 million, or 5.7%, decline versus 2002 net sales of $763.3 million.  The primary factor driving the declines in net sales was the ongoing decline in pricing due to the competitive pricing pressure and changes in product mix toward simpler formats.  Generally, competitive price pressures exist in periods when advertisers reduce spending, as we have seen in the current environment.  In addition, advertisers may change product types to reduce their overall cost of advertising, which will have a downward impact on our net sales.  Volume at RNS was essentially flat in the third quarter and nine months ended September 30, 2003 as compared to the comparable 2002 periods.  Changes in the cost of paper had an upward impact on net sales of $2.5 million in the three months ended September 30, 2003.  Results for the first nine months of 2003 were negatively impacted by $1.7 million due to the decline in the cost of paper.

 

At DMS net sales for the three months ended September 30, 2003 amounted to $70.5 million compared to $72.6 million in the comparable 2002 period, representing a decline of $2.1 million, or 2.9%.  Through the first nine months of 2003, net sales declined $21.2 million, or 9.4%, from $224.8 million to $203.6 million. The revenue decline in the third quarter of 2003, as compared to the comparable 2002 period, was largely the result of our

 

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chemical and digital printing businesses.  Our traditional direct mail business was up $2.1 million in the third quarter of 2003 versus the prior year due to higher volume partially offset by lower pricing.  For the nine-month period, these declines were the result of decreases in volume compounded by lower pricing.  The decline in pricing reflects increased overall price competition commensurate with the weak advertising environment and changes in product mix.  Product mix changes reflect shifts by advertisers from more complex direct mail pieces, such as highly personalized pieces and pieces that require complex configurations, to less complex direct mail pieces, which lower our customers’ advertising costs and our net sales per direct mail piece.  Simpler products are produced using less sophisticated equipment, which has resulted in increased competition and, in-turn, decreased pricing.  We believe these negative impacts on net sales are a result of the current environment.

 

At ATS, net sales declined $2.1 million, or 4.3%, from $48.6 million in the three months ended September 30, 2002 to $46.5 million in the three months ended September 30, 2003.  Through the first nine months, net sales of $128.9 million represent a decline of $20.8 million, or 13.9%, compared to 2002 net sales of $149.7 million.  These declines are primarily due to weak demand, largely from advertising agency customers.  The decline in sales to advertising agency customers amounted to $5.0 million in the third quarter and $24.2 million through September 2003 as compared to the comparable 2002 periods.  These declines reflect the weak advertising environment as well as advertising agencies increasingly producing the products and services in-house.  We do not expect this trend in our business with advertising agencies to change.  Through September 30, 2003, we have mitigated a portion of the decline in net sales from advertising agency customers with increases in other lines of business, including net sales to packaging customers of $0.3 million, and increases in our digital solutions services of $1.7 million and other media and marketing services of $6.9 million, which include TNN sales of $3.6 million since acquisition (see Note 4 to our condensed consolidated financial statements).  Management expects to continue aggressively pursuing growth opportunities in these lines of business.

 

At our Vertis Europe segment, for the three months ended September 30, 2003, net sales amounted to $31.2 million versus $35.3 million in the comparable 2002 period, a decrease of $4.1 million, or 11.6%.  For the first nine months of 2003, net sales of $101.3 million were $1.6 million, or 1.6%, higher than 2002 net sales, which totaled $99.7 million.  Results for the three and nine months ended September 30, 2003, were positively impacted by foreign exchange rate fluctuations in the amount of $1.2 million and $8.2 million, respectively.  Excluding the positive impact of these foreign exchange rate fluctuations, Vertis Europe’s net sales in the three and nine months ended September 30, 2003, were below the comparable 2002 periods due to weakness in our direct mail business.  In local currency, net sales in our Europe direct mail business declined 20.0% in the third quarter and 10.1% through September 30, 2003, due to poor conditions similar to those that exist in our U.S. direct mail business.  Industry wide excess capacity has resulted in lower prices which have more than offset an increase in direct mail packages.

 

For the three months ended September 30, 2003, our consolidated costs of production decreased $5.6 million, or 1.8%, from $311.6 million in 2002 to $306.0 million in 2003.  Through the first nine months of 2003, costs of production decreased $33.0 million, or 3.6%, from $922.3 million in 2002 to $889.3 million in 2003.  As a percentage of net sales, cost of

 

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production increased 2.2 percentage points for the three months ended September 30, 2003 and 2.4 percentage points for the nine months ended September 30, 2003, largely due to the noted decline in net sales.  The cost of paper and ink consumed represents $0.9 million and $21.1 million of the decline in costs of production for the three and nine months ended September 30, 2003, respectively.  The balance of the decline in costs of production reflects the noted declines in sales, cost management initiatives, and the ongoing efforts to improve operating efficiencies.

 

Selling, general and administrative expenses decreased $0.8 million, or 1.7%, and $2.1 million, or 1.5%, for the three and nine months ended September 30, 2003, respectively.  In 2003, selling, general and administrative expenses as a percentage of net sales were 11.8% for the three months ended September 30, and 12.0% for the nine months ended September 30, which represent 0.4 and 0.7 percentage point increases versus the comparable 2002 periods, largely due to the noted decline in net sales.

 

Results for both the three months and nine months ended September 30, 2003 include $6.8 million of restructuring charges which are comprised of $1.3 million in severance costs and $5.3 million in facility closure costs related to the closure of three facilities at ATS, as well as $0.1 million in severance costs recorded at both RNS and DMS.  Restructuring charges were $2.8 million and $5.8 million for the three months and nine months ended September 30, 2002, respectively.   In the nine months ended September 30, 2002, Vertis Europe combined two facilities and recorded $1.9 million in restructuring charges comprised mainly of facility closure costs and severance costs.  ATS recorded $2.7 million in severance costs related to the termination of approximately 250 employees, and $1.1 million in facility closure costs, both in an effort to streamline operations.  Additionally, DMS recorded $0.8 million in severance costs related to the termination of 133 employees, and RNS recorded $0.6 million in severance costs.  Offsetting these charges is a $1.3 million adjustment to the estimate of 2001 restructuring costs made in 2002.

 

Depreciation expense decreased $4.0 million, or 6.0%, from $67.0 million for the nine months ended September 30, 2002 to $63.0 million for the comparable 2003 period.  This decrease is primarily due to a decrease in property, plant and equipment at ATS due to the closure of four facilities (See “– Corporate Consolidation and Restructuring” above).  Amortization expense was relatively flat when comparing 2003 to 2002.

 

Operating income amounted to $11.4 million for the three months ended September 30, 2003, a decline of $14.1 million, or 55.2%, compared to operating income of $25.5 million in the comparable 2002 period. Through the first nine months of 2003, operating income declined $42.5 million, or 49.1%, from $86.5 million in 2002 to $44.0 million in 2003.  As a percentage of net sales, operating income decreased 3.3 percentage points to 2.9% for the three months ended September 30, 2003 as compared to 6.2% in 2002.  For the nine months ended September 30, 2003, operating income as a percent of net sales totaled 3.9% which was a 3.2 percentage point decline from the 7.1% realized in the in the comparable 2002 period.  The reductions in operating income are primarily attributable to the noted declines in net sales in addition to an increase in restructuring costs of $4.0 million and $0.9 million for the three months and nine months ended September 30, 2003, respectively.  These costs were only partially offset by reductions in staffing costs of $1.2 million and $7.7 million for the three months and nine months ended September 30, 2003, respectively.

 

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Additional savings of $0.7 million for the three months and $3.5 million for the nine months ended September 30, 2003 were associated with an internal program to improve processes in many of our plants.  The remainder of the offset is attributable to a decrease in variable costs.

 

Interest expense increased $2.7 million in the nine months ended September 30, 2003 as compared to 2002, due to the interest associated with the issuance of the 9 3/4% notes in June 2003 and the issuance of the 10 7/8% notes in June and November 2002, offset by the decrease in interest expense due to the payments on the revolver and term loans related to such issuances.

 

The increase in other non-operating income of $9.6 million when comparing the nine months ended September 30, 2003 to the comparable 2002 nine-month period, is primarily due to a $10.1 million recovery from a settlement to the legal proceeding arising from a life insurance policy which covered the former Chairman of Vertis Holdings, Inc.  Offsetting this income are $2.0 million in fees associated with the A/R Facility, as defined below under “Liquidity and Capital Resources – Contractual Obligations – Off-Balance Sheet Arrangements”, a $1.1 million adjustment to record the changes in the interest rate swap agreement and $0.7 million in losses on the sale of property, plant and equipment, which decreased $0.8 million from the prior year.

 

Net loss for the three and nine months ended September 30, 2003 was $24.0 million and $101.8 million, an increase in loss of $18.8 million for the three months and a decrease in loss of $23.9 million for the nine months as compared to the comparable 2002 periods.  Included in the nine months ended September 30, 2003 net loss is a $48.8 million tax valuation allowance on deferred tax assets (see “-Seasonality and Other Factors” below).   Included in the 2002 net loss for the first nine months is a $108.4 million charge for the cumulative effect of accounting change resulting from our adoption of Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangibles” (see “-New Accounting Pronouncements” below).  Loss before income tax expense and cumulative effect of accounting change for the nine months ended September 30, 2003 increased from the comparable prior year period by $36.9 million.  This increase is a result of the aforementioned changes in net sales and costs, as discussed above.

 

In accordance with Item 303 of Regulation S-K under the Securities Act, set forth below is a discussion of the performance of our business segments based on the measure reported to our chief operating decision maker for the purpose of making decisions about allocating resources to the segment and assessing the performance of the segment; namely, EBITDA, as defined above (see “-Results of Continuing Operations”).  A tabular reconciliation of segment EBITDA to the directly comparable consolidated GAAP measure, net (loss) income, in accordance with SFAS Statement No. 131, Disclosure about Segments of an Enterprise and Related Information, is contained in Note 7 to our condensed consolidated financial statements.

 

At RNS, EBITDA amounted to $30.4 million for the three months ended September 30, 2003, a decrease of $7.6 million, or 20.0%, compared $38.0 million in the comparable 2002 period.  For the first nine months of 2003, RNS EBITDA of $89.4 million is $28.6 million, or 24.2%, below the comparable 2002 EBITDA of $118.0 million.  These declines reflect competitive pricing pressures and changes in product mix toward simpler formats.  In

 

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addition, through September 30, 2003, EBITDA was negatively impacted by severance costs of $1.5 million, higher insurance costs and higher energy costs.

 

At DMS, EBITDA amounted to $7.8 million and $22.0 million, for the three and nine months ended September 30, 2003, respectively.  These results represent a decline from the comparable 2002 periods of $1.1 million, or 12.0%, and $8.5 million, or 27.9%, respectively.  These declines reflect the downward impact on net sales attributable to the shift by our customers to simpler products, lower quantities per order, and general competitive pricing pressure.  Costs were reduced commensurate with the decline in net sales and managed tightly, which partially offset the negative impact on EBITDA of the decline in net sales.

 

ATS EBITDA for the three months ended September 30, 2003 was a loss of $5.6 million, which was $6.2 million less than prior year.  Through the first nine months of 2003, ATS EBITDA was a loss of $7.4 million, which represents an increase in EBITDA of $79.4 million, or 91.5%, from the comparable 2002 period.  The increase in the nine-month period primarily reflects an $86.6 million change in EBITDA due to the impairment loss recorded by ATS in January 2002 to reduce the carrying value of their goodwill in accordance with SFAS 142 (see “—New Accounting Pronouncements” below).  Additionally, lower costs reflect the right-sizing initiatives implemented in 2002, but the lower cost base only partially mitigated the decline in net sales due to the poor advertising environment.  The noted changes in EBITDA for the three and nine months ended September 30, 2003, were also negatively impacted by increases in restructuring charges of $4.8 million and $3.4 million, respectively.

 

At Vertis Europe, EBITDA of $1.2 million for the three months ended September 30, 2003, represents a decline of $1.9 million, or 61.3% as compared to EBITDA of $3.1 million in the comparable prior year period.  For the first nine months of 2003, Vertis Europe totaled $6.4 million, which was $18.6 million, or 152.3%, greater than the comparable period in 2002.  The increase in the nine-month period primarily reflects a $21.8 million change in EBITDA due to the impairment loss recorded by Vertis Europe in January 2002 to reduce the carrying value of their goodwill in accordance with SFAS 142 (see” –New Accounting Pronouncements” below).  The offsetting decline reflects the poor conditions in our direct mail business in Europe, largely due to product simplification and price competition.  In addition, costs were higher in 2003, largely due to increased selling costs to develop and expand our product offering in response to the sluggish direct mail business.

 

Liquidity and Capital Resources

 

Sources of Funds

 

We fund our operations, capital expenditures and investments with internally generated funds, revolving credit facility borrowings, sales of accounts receivable, and issuances of debt.

 

We believe that the facilities in place, as well as our cash flows, will be sufficient to meet our operational needs, including capital expenditures and restructuring costs, for the next twelve months.  Although the revolving credit facility allows us

 

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to borrow up to $250 million, and the unused portion of that amount is $125.8 million including letters of credit that have been issued, the amount we can actually borrow and still remain in compliance with the leverage ratio required in the covenants associated with the revolving credit facility is $81.1 million at September 30, 2003.  (See Note 9 to the condensed consolidated financial statements for further discussion of covenants).  There can be no assurance that our operations will generate sufficient cash flows or that we will always be able to refinance our current debt or obtain additional financing to refinance debt we assume in acquisition transactions.  In the event we are unable to obtain sufficient financing, we would pursue other sources of funding such as debt offerings by Vertis Holdings, equity offerings by us and/or Vertis Holdings or asset sales.

 

Items that could impact liquidity are described below.

 

Contractual Obligations

 

The following table discloses aggregate information about our contractual obligations as of September 30, 2003 and the periods in which payments are due:

 

Contractual Obligations (In millions)		Total			Less than 1 year			1-3 years			4-5 years			After 5 years
Long-term debt		$	1,091		$	1		$	120					$	970
Operating leases		137			31			44			$	30		32
Total contractual cash obligations		$	1,228		$	32		$	164		$	30		$	1,002

 

Foreign Currency

 

Fluctuation in foreign currency would affect approximately $67.8 million of the British pound sterling based debt as of September 30, 2003.

 

Off-Balance Sheet Arrangements

 

In 1996, we entered into a six-year agreement to sell substantially all trade accounts receivable generated by subsidiaries in the U.S. (as amended, the “1996 Facility”) through the issuance of $130.0 million of variable rate trade receivable backed certificates.  In April 2002, the revolving period for these certificates was extended and the certificates were refinanced.  In December 2002, the 1996 Facility expired and we entered into a new three-year agreement terminating in December 2005 (the “A/R Facility”) through the issuance of $130.0 million variable rate trade receivable backed notes.  The proceeds from the A/R Facility were used to retire the certificates issued under the 1996 Facility.

 

The A/R Facility allows for a maximum of $130.0 million of trade accounts receivable to be sold at any time based on the level of eligible receivables.  Under the 1996 Facility and the A/R Facility, we sell our trade accounts receivable through a bankruptcy-remote wholly-owned subsidiary.  However, we maintain an interest in the receivables and have been contracted to service the accounts receivable.  We received cash proceeds for servicing of $2.4 million for both the nine months ended September 30, 2003 and 2002, respectively.  These proceeds are fully offset by servicing costs.

 

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At September 30, 2003 and December 31, 2002, accounts receivable of $113.5 million and $125.9 million, respectively, had been sold under the facilities and, as such, are reflected as reductions of accounts receivable.  At September 30, 2003 and December 31, 2002, we retained an interest in the pool of receivables in the form of overcollateralization and cash reserve accounts of $50.1 million and $46.3 million, respectively which is included in Accounts receivable, net on our condensed consolidated balance sheet at allocated cost, which approximates fair value.  The proceeds from collections reinvested in securitizations amounted to $1,048.9 million and $1,115.2 million in the nine months ended September 30, 2003 and 2002, respectively.

 

Fees for the program under the facilities vary based on the amount of interests sold and the London Inter Bank Offered Rate (“LIBOR”) plus an average margin of 90 basis points in 2003 and 37 basis points in 2002.  The loss on sale, which approximated the fees, totaled $2.0 million and $2.1 million for the nine months ended September 30, 2003 and 2002, and is included in Other, net on our condensed consolidated statement of operations.

 

We have no other off-balance sheet arrangements that may have a material current or future effect on financial condition, changes in financial condition, results of operations, liquidity, capital expenditures, capital resources or significant components of revenues or expenses.

 

Debt

 

In June 2003, we issued $350.0 million of senior secured second lien notes with an interest rate of 9 3/4% (the “9 3/4% notes) and maturity date of April 1, 2009.  After deducting the initial purchasers discount and transaction expenses, the net proceeds received by us from the sale of these notes were $330.3 million.  We used these net proceeds to pay off $267.9 million remaining on the term loans outstanding under our senior credit facility and $62.4 million of our revolving credit facility.

 

In 2002, we issued $350.0 million of 10 7/8% senior unsecured notes (the “10 7/8% notes”) with a maturity date of June 15, 2009.  After deducting the initial purchasers’ discounts and transaction expenses, the net proceeds received by us from the sale of these notes were approximately $338.0 million.  We used these net proceeds to repay $181.5 million of the term loans and $156.5 million of debt outstanding under our senior subordinated credit facility.  In addition, pursuant to the senior subordinated credit facility, we issued $210.7 million 13 1/2% senior subordinated notes due December 7, 2009, in the first nine months of 2003 in exchange for some of the term notes under the senior subordinated credit facility.

 

On May 7, 2003, in the course of our internal financial review, we became aware of a required payment due under the senior credit facility to the holders of our term loans in the amount of $40.9 million.  This past due payment was discovered during a review of the definition of “excess cash flow”, as defined in the senior credit facility agreement, resulting in a revision of the previously calculated “excess cash flow” out of which a prepayment was required to be made.  The only period where this re-calculation resulted in a required prepayment was for the year ended December 31, 2002, which was due on March 31, 2003.  On May 8, 2003, we received the required waivers for this technical default and made the payment with borrowings from the revolving credit facilities.  The remainder of the term

 

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loans, $267.9 million, was paid off in connection with the issuance of the 9 3/4% notes, as discussed above, and the provision under the senior credit facility requiring prepayment out of “excess cash flow” was eliminated.  Following the payment of the term loans in their entirety, the senior credit facility consists solely of the revolving credit facility.

 

Our senior credit facility, senior subordinated credit facility, the outstanding 9 3/4% notes due April 1, 2009, the outstanding 10 7/8% notes due June 15, 2009, and the outstanding 13 1/2% senior subordinated notes due December 7, 2009 contain customary covenants limiting our ability to engage in various activities including restrictions on capital expenditures, dividends, investments and indebtedness. In particular, these debt instruments all contain customary high-yield debt covenants imposing limitations on the payment of dividends or other distributions on or in respect of us or the capital stock of our restricted subsidiaries.   Substantially all of our assets are pledged as collateral for the outstanding debt under our senior credit facility.  All of our debt has customary provisions requiring prepayment in the event of a change in control and from the proceeds of asset sales, as well as cross-default provisions.  In addition, our senior credit facility agreement has customary provisions requiring prepayment from the proceeds of issuances of debt and equity securities, and financial covenants that require us to maintain specified interest coverage ratios, leverage ratios and senior secured leverage ratios.  If we are unable to maintain those financial ratios, the bank lenders could require us to repay any amounts owing under the senior credit facility.  At September 30, 2003, we are in compliance with our debt covenants.  While we currently expect to be in compliance in future periods, if the fragile economic conditions and pricing pressures that have influenced our results to date continue, there can be no assurance that these financial covenants will continue to be met. Based upon our latest projections for the fourth quarter of 2003, including actual results for October 2003, we believe we will be in compliance at December 31, 2003.

 

For further information on our long-term debt, see Note 9 to the condensed consolidated financial statements.

 

Working Capital

 

Our current liabilities exceeded current assets by $35.0 million at September 30, 2003 and by $18.5 million at December 31, 2002.  This represents a decrease in working capital of $16.5 million for the nine months ended September 30, 2003.  The excess of current liabilities over current assets reflects the impact of accounts receivable sold under the A/R Facility.  We use the proceeds from such accounts receivable sales to reduce long-term borrowings under our revolving credit facility.  After the sale of all trade accounts receivable, however, we still retain an interest in the receivables in the form of over-collateralization and cash reserve accounts, and we have been contracted to service the receivables.  Therefore, if we add back the accounts receivable of $113.5 million and $125.9 million sold under the A/R Facility as of September 30, 2003 and December 31, 2002, and reflect the offsetting increase in long-term debt as if the A/R Facility were not in place, our working capital at September 30, 2003 and December 31, 2002 would have been $78.5 million and $107.3 million, respectively.  The ratio of current assets to current liabilities as of September 30, 2003 was 0.88 to 1 (1.26 to 1, excluding the impact of the A/R Facility) compared to 0.92 to 1 as of December 31, 2002 (1.46 to 1, excluding the impact of the A/R Facility).

 

The decrease in working capital was primarily due to fluctuations in operating assets and liabilities, a portion of which were associated with our acquisition of the sales, marketing and media planning assets of The Newspaper Network, Inc.  (See Note 4 to the condensed

 

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consolidated financial statements for further discussion.)  Offsetting these fluctuations was the increase in accrued interest due to the timing of scheduled interest payments and the elimination of the current deferred tax asset related to the recording of the valuation allowance in June 2003(see “–Seasonality and Other Factors”).

 

Summary of Cash Flows

 

Cash Flows from Operating Activities

 

Net cash provided by operating activities for the nine months ended September 30, 2003 decreased by $5.1 million from the 2002 level.   Adjusted for the increase (decrease) in outstanding checks drawn on controlled disbursement accounts, which are classified as a financing activity, net cash provided by operating activities decreased $9.9 million when comparing the first nine months of 2003 to 2002.  This is a largely a result of the increase in loss before cumulative effect of accounting change offset by the timing of payments and collection of receivables, and the increase in deferred income taxes related to the valuation allowance that was recorded in June 2003(see “–Seasonality and Other Factors”).

 

Cash Flows from Investing Activities

 

Net cash used for investing activities in the nine months ended September 30, 2003 increased $3.8 million from the 2002 primarily due to an increase in capital expenditures.

 

Cash Flows from Financing Activities

 

In June 2003, we issued $350 million of senior secured second lien notes, which after deducting the initial purchasers discount and transaction expenses, netted proceeds of approximately $330.3 million.  In June 2002, we issued $250 million of senior unsecured notes, which netted proceeds of approximately $240.0 million after deducting the debt discount and fees.  The proceeds from both issuances were used to repay existing debt.  These two transactions, which are the primary financing activities in each respective period, are the primary reasons for the decline in cash used in financing activities from $33.3 million in 2002 to $17.1 million in 2003

 

Seasonality and Other Factors

 

While our advertising insert business is generally seasonal in nature, the expansion of other product lines and the expansion of advertising insert business to year-round customers have reduced the overall seasonality of our revenues.  Of our full year 2002 net sales, 24.0% were generated in the first quarter, 24.4% in the second, 24.4% in the third and 27.2% in the fourth.  Profitability, however, continues to follow a more seasonal pattern due to the higher margins and efficiencies gained from running at full capacity during the year-end holiday production season.  On the other hand, lower margins in the first quarter do not fully leverage fixed depreciation, amortization and interest costs that are incurred evenly throughout the year. Based on our historical experience and projected operations, we expect our operating results in the near future to be strongest in the fourth quarter and softest in the first.

 

We have approximately $248.5 million of federal net operating losses available to carry forward as of December 31, 2002.  These carryforwards expire beginning in 2005 through 2023.  In the first nine months of 2003 we recorded tax expense of $48.1 million which included an additional valuation allowance against more than half of our tax benefit carryforwards.  The

 

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valuation allowance reserves a portion of the net operating losses and tax credit carryforwards that may not be offset by reversing taxable temporary differences.  We intend to maintain a valuation allowance until sufficient positive evidence exists to support its reversal. (See Note 13 to the condensed consolidated financial statements for further discussion.)

 

New Accounting Pronouncements

 

Effective January 1, 2002, we adopted SFAS No.142 (“SFAS 142”).  Under this statement, goodwill and intangible assets with indefinite lives are no longer amortized.  Under the transitional provisions of SFAS 142, our goodwill was tested for impairment as of January 1, 2002.  Each of our reporting units was tested for impairment by comparing the fair value of the reporting unit with the carrying value of that unit.  Fair value was determined based on a valuation study performed by an independent third party using the discounted cash flow method and the guideline company method.  As a result of our impairment test completed in the third quarter of 2002, we recorded an impairment loss of $86.6 million at ATS and $21.8 million at Vertis Europe to reduce the carrying value of goodwill to its implied fair value.  Impairment in both cases was due to a combination of factors including operating performance and acquisition price.  In accordance with SFAS 142, the impairment charge was reflected as a cumulative effect of accounting change in the accompanying 2002 condensed consolidated statements of operations and cash flows.  The amount of the impairment charge includes the effect of taxes of $6.8 million, which had not been initially recorded in the Company’s September 30, 2002 financial statements.  As a result, the operating results and cash flows for the nine months ended September 30, 2002 have been restated, net of tax.

 

Goodwill is now reviewed for impairment on annual basis, or more frequently if events or circumstances indicate that the carrying value may not be recoverable.  Our goodwill was tested for impairment again in the first quarter of 2003 and there was no impairment of goodwill found based on the valuation results.

 

In June 2002, the FASB issued Statement No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.”  This statement requires recording costs associated with exit or disposal activities at their fair value when a liability has been incurred.  Under previous guidance, various exit costs were accrued upon management’s commitment to an exit plan, which is generally before an actual liability has been incurred.  In the first quarter of 2003, we adopted the provisions of this statement, which were incorporated in our condensed consolidated financial statements.

 

In November 2002, the FASB issued Interpretation No. 45, “Guarantors Accounting and Disclosure Requirements for Guarantees.”  The disclosure requirements are effective for financial statements issued after December 15, 2002, and the recognition/measurement requirements are effective on a prospective basis for guarantees issued or modified after December 31, 2002.  In the first quarter of 2003, we adopted the provisions of this interpretation, which does not impact on our condensed consolidated financial statements.

 

In December 2002, the FASB issued SFAS No. 148, “ Accounting for Stock-Based Compensation – Transition and Disclosure.”  This statement amends SFAS No. 123, “Stock-Based Compensation,” to provide alternative methods of transition for a voluntary change to

 

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the fair value based method of accounting for stock-based employee compensation.  In addition, this Statement amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results.  The disclosure provisions of this standard are effective for fiscal years ending after December 15, 2002 and have been incorporated into our financial statements and accompanying notes included elsewhere in this document.

 

In January 2003, the FASB issued Interpretation No. 46, “Consolidation of Variable Interest Entities” to provide new guidance with respect to the consolidation of all previously unconsolidated entities, including special-purpose entities.  This interpretation applies to variable interest entities created after January 31, 2003 and to entities in which an enterprise obtains an interest after that date.  For entities created prior to January 31, 2003, this interpretation is to be adopted on December 31, 2003.  We believe that the adoption of this interpretation will not have a material impact on our condensed consolidated financial position or results of operations.

 

In April 2003, the FASB issued Statement No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.”  This statement amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.”  In general, this statement is effective for contracts entered into or modified after June 30, 2003, and for hedging relationships designated after June 30, 2003.  We believe the adoption of this statement did not have a material impact on our condensed consolidated financial position.

 

In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.”  This statement establishes standards for how an issuer classifies and measures in its statement of financial position certain financial instruments that embody obligations for the issuer that are required to be classified as liabilities.  This statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise shall be effective at the beginning of the first interim period beginning after June 15, 2003.  We believe the provisions of the statement do not have a significant impact on our condensed consolidated financial position.

 

 

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Item 3. Qualitative and Quantitative Disclosures about Market Risk

 

Qualitative Information

 

Our primary exposure to market risks relates to interest rate fluctuations on variable rate debt, which bears interest at both the Prime rate and the LIBOR rate. Generally, our exposure to foreign currency exchange rate fluctuations is immaterial as foreign operations are a small proportion of the total company and foreign currency borrowings act as a natural hedge against fluctuations in net asset values.

 

The objective of our risk management program is to seek a reduction in the potential negative earnings effects from changes in interest and foreign exchange rates.  To meet this objective, consistent with past practices, we intend to vary the proportions of fixed-rate and variable-rate debt based on our perception of interest rate trends and the marketplace for various debt instruments.  Except for those used to meet hedging requirements in our credit facility, we generally do not use derivative financial instruments in our risk management program.  This practice may change in the future as market conditions change.  We do not use any derivatives for trading purposes.

 

Quantitative Information

 

At September 30, 2003, 19.4% of our long-term debt held a variable interest rate (including off-balance sheet debt related to the accounts receivable securitization facility, the fees on which are variable).

 

If interest rates increased 10%, the expected effect related to variable-rate debt would be to increase net loss for the twelve months ended September 30, 2003 by approximately $1.3 million.

 

For the purpose of sensitivity analysis, we assumed the same percentage change for all variable-rate debt and held all other factors constant.  The sensitivity analysis is limited in that it is based on balances outstanding at September 30, 2003 and does not provide for changes in borrowings that may occur in the future.

 

Item 4. Controls and Procedures

 

As of the end of the period covered by this quarterly report on Form 10-Q, an evaluation was carried out under the supervision and with the participation of Vertis’ management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 15d-15(e) under the Securities Exchange Act of 1934, as amended).  Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the design and operation of these disclosure controls and procedures were effective.  No significant changes were made during our third fiscal quarter of 2003 in our internal controls or in other factors that could materially affect, or are reasonable likely to materially affect, these controls over our financial reporting.

 

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PART II – OTHER INFORMATION

 

Item 1. Legal Proceedings

 

Certain claims, suits and complaints (including those involving environmental matters) which arise in the ordinary course of our business have been filed or are pending against us.  We believe, based upon the currently available information, that all the results of such proceedings, individually, or in the aggregate would not have a material adverse effect on our consolidated financial condition or results of operations.

 

Item 5. Other Information

 

Forward Looking Statements

 

We have included in this quarterly report on Form 10-Q, and from time to time our management may make, statements which may constitute “forward-looking statements” within the meaning of the safe harbor provisions of The Private Securities Litigation Reform Act of 1995.  You may find discussions containing such forward-looking statements in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” as well as within this quarterly report generally.  In addition, when used in this quarterly report, the words “believes,” “anticipates,” “expects,” “estimates,” “plans,” “projects,” “intends” and similar expressions are intended to identify forward-looking statements.  These forward-looking statements include statements other than historical information or statements of current condition, but instead represent only our belief regarding future events, many of which, by their nature, are inherently uncertain and outside of our control.  It is possible that our actual results may differ, possibly materially, from the anticipated results indicated in these forward-looking statements.  Important factors that could cause actual results to differ from those in our specific forward-looking statements include, but are not limited to those discussed in our annual report on Form 10-K dated March 26, 2003, under “Certain Factors That May Affect Our Business” as well as:

 

•              general economic and business conditions in the United States and other countries;

•              changes in the advertising, marketing and information services markets;

•              the financial condition of our customers;

•              the possibility of future terrorist activities or the continuation or escalation of hostilities in the Middle East or elsewhere;

•              our ability to execute key strategies;

•              fluctuations in the cost of raw materials we use;

•              the effects of supplier price fluctuations on our operations;

•              downgrades in our credit ratings;

•              changes in interest and foreign currency exchange rates; and

•              matters discussed in this document generally.

 

Consequently, readers of this quarterly report should consider these forward-looking statements only as our current plans, estimates and beliefs.  We do not undertake and specifically decline any obligation to publicly release the results of any revisions to these forward-looking statements that may be made to reflect future events or circumstances after

 

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the date of such statements or to reflect the occurrence of anticipated or unanticipated events.  We undertake no obligation to update or revise any forward-looking statement in this document to reflect any new events or any change in conditions or circumstances.  All of the forward-looking statements in this document are expressly qualified by these cautionary statements.  Even if these plans, estimates or beliefs change because of future events or circumstances after the date of these statements, or because anticipated or unanticipated events occur, we disclaim any obligation to update these forward-looking statements.

 

Item 6. Exhibits and Reports on Form 8-K

 

	(a)	Exhibits
		Exhibit 31.1   Certification of the Chief Executive Officer, pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
		Exhibit 31.2   Certification of the Chief Financial Officer, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
		Exhibit 32.1   Certification of the Chief Executive Officer, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
		Exhibit 32.2   Certification of the Chief Financial Officer, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
	(b)	Reports on Form 8-K
		On August 1, 2003, Vertis, Inc. filed a Current Report on Form 8-K reporting its earnings for the three and six months ended June 30, 2003.

 

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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.

 

	VERTIS, INC.
		/s/ Donald E. Roland
		Donald E. Roland,
		Chairman, President and Chief Executive Officer
		/s/ Dean D. Durbin
		Dean D. Durbin
		Chief Financial Officer
Date:  November 12, 2003

 

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EXHIBIT INDEX

 

EXHIBIT NO.		DESCRIPTION
31.1		Certification of the Chief Executive Officer, pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2		Certification of the Chief Financial Officer, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1		Certification of the Chief Executive Officer, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2		Certification of the Chief Financial Officer, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 

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