WASHINGTON, D. C.  20549

 

FORM 10-K

 

 

Commission File Number: 0- 20330

 

GARDENBURGER, INC.

(Exact name of registrant as specified in its charter)

 

OREGON		93-0886359
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

 

15615 Alton Parkway, Suite 350, Irvine, California 92618

(Address of principal executive offices)

 

Registrant’s telephone number, including area code:   (949) 255-2000

 

Securities registered pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, no par value

(Title of Class)

 

 

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days:         Yes ý            No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K, or any amendment to this Form 10-K.   o

 

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

Yes o     No ý

 

The aggregate market value of the voting and non-voting common equity held by non-affiliates of the Registrant was $2,092,203 computed by reference to the last sales price as reported by the NASD’s OTC Bulletin Board ($0.30) as of the last business day of the Registrant’s most recently completed second fiscal quarter, March 31, 2004.

 

The number of shares outstanding of the Registrant’s Common Stock as of February 17, 2005 was 9,002,101 shares.

 

 

Documents Incorporated by Reference

 

None.

 

 

GARDENBURGER, INC.

2004 FORM 10-K ANNUAL REPORT

TABLE OF CONTENTS

 

	PART I	Page
Item 1.	Business	2
Item 2.	Properties	15
Item 3.	Legal Proceedings	16
Item 4.	Submission of Matters to a Vote of Security Holders	16
	PART II
Item 5.	Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities	16
Item 6.	Selected Financial Data	17
Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	18
Item 7A.	Quantitative and Qualitative Disclosures About Market Risk	30
Item 8.	Financial Statements and Supplementary Data	30
Item 9.	Changes in and Disagreements With Accountants on Accounting and Financial Disclosure	31
Item 9A.	Controls and Procedures	31
Item 9B.	Other Information	33
	PART III
Item 10.	Directors and Executive Officers of the Registrant	33
Item 11.	Executive Compensation	36
Item 12.	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters	40
Item 13.	Certain Relationships and Related Transactions	42
Item 14.	Principal Accountant Fees and Services	43
	PART IV
Item 15.	Exhibits, Financial Statement Schedules	43
Signatures		48

 

1

 

PART I

 

Item 1.  Business

 

Where You Can Find More Information

We file annual, quarterly and special reports, proxy statements and other information with the Securities and Exchange Commission (“SEC”) under the Securities Exchange Act of 1934 as amended (“Exchange Act”). You can inspect and copy our reports, proxy statements, and other information filed with the SEC at the offices of the SEC’s Public Reference Room in Washington, D.C. Please call the SEC at 1-800-SEC-0330 for further information on the Public Reference Room. The SEC maintains an Internet site at http://www.sec.gov/ where you can obtain most of our SEC filings. We also make available, free of charge on our website at www.gardenburger.com, our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act as soon as reasonably practicable after they are filed electronically with the SEC.  The information found on our website is not part of this Form 10-K. You can also obtain copies of these reports by contacting Investor Relations at (949) 255-2000.

 

General

Gardenburger, Inc. was organized in 1985 as an Oregon corporation under the name Wholesome & Hearty Foods, Inc. and completed its initial public offering in 1992.  In October 1997 we changed our name to Gardenburger, Inc; and, as our product line expanded to include meat alternative offerings beyond veggie burgers, began doing business in 2002 as Gardenburger Authentic Foods Company.  Our common stock trades on the over-the-counter market and is quoted on the NASD’s OTC Bulletin Board.

 

Overview

We believe we are one of the leading producers and marketers of meat alternative products and branded veggie burgers. The Gardenburger® product line is a national brand in the retail grocery, food service, club store and natural foods channels of distribution and features core burger offerings such as the Original Gardenburger® veggie burger, meatless soy burgers such as Gardenburger Flame Grilled, and innovative meatless specialty items and new Gardenburger Meals.

 

Several factors beyond healthy eating have contributed to the growth of meat substitutes over the past five years.  Consumer reaction to bad publicity related to meat recalls and the heightened publicity surrounding meat farming practices and their effect on human health and the environment has fueled the growth of imitation meat sales in the United States and Canada.  However, the popularity of protein based low carbohydrate diets like Atkins and South Beach have positively impacted the sales of beef, pork and chicken and have negatively impacted the meatless category.  We were a pioneer in the meatless burger segment of the category and, in tandem with recent consumer trends favoring low-carbohydrate foods, have expanded our product offerings to include center-of-the-plate, soy-based meatless specialties and entrees. In addition, we reformulated our veggie burgers to reduce carbohydrates while increasing protein and improving taste.

 

Approximately 69% of our gross sales are attributable to the Gardenburger® veggie burger and soy burger products, with the remaining 31% of our gross sales attributable to our newer meat alternative products. Consumers have been moving to the wider range of meat alternative products becoming available in the marketplace.  In response to this development in consumer tastes, in fiscal 2003 we added five new products, including BBQ Chik’n and Meatless Meatloaf.  In the third quarter of fiscal 2004, we introduced a new line of six microwaveable meatless entrees to capitalize on the consumers’ need for convenience.

 

While we believe Gardenburger enjoys solid brand awareness, our industry is highly competitive and includes both large food companies and smaller independent manufacturers.  In the first quarter of fiscal 2004, we began shipping reformulated grain burgers and using redesigned packaging consistent with our efforts to position our products as supporting a 100% natural and healthy lifestyle.  Fat gram, protein

 

2

 

gram and net carbohydrate gram information have been added to the front of the packaging to help consumers better understand the nutritional value of our products.  Weight Watcher points and diabetic exchanges are included on the back of the package to support popular diet plans.

 

We intend to continue as an innovative force in the meat alternative category with the objective of being a leading provider of meatless meal alternatives in the four primary distribution channels in which we distribute our products: retail grocery stores; food service, including restaurants, universities and other commercial outlets; club stores; and natural foods outlets. We currently distribute our products through more than 24,000 retail outlets, 30,000 food service outlets, 265 club store locations and 3,500 natural foods stores.

 

Within the retail grocery channel, our largest channel of distribution, we have approximately 190,000 retail grocery placements of our products, representing an all commodity volume (“ACV”)(1) penetration of approximately 79% as of September 30, 2004, with an average of 7.9 product variations available in each retail outlet.  Each product is commonly referred to as a stock keeping unit (“SKU”).

 

Business Strategy

In recent years, we have seen increased competition in the meat alternative category, including the veggie burger segment, and have seen our market share of meat alternative burgers decline due to heavy spending by competitors and changes in consumers’ eating habits.  Our business strategy consists of the following key elements:

 

Focus on Achieving Profitability.  We are focused on achieving near-term profitability.  In furtherance of this goal, fixed overhead is closely monitored and, in November 2003, our Portland, Oregon administrative office was closed with four positions eliminated, certain positions relocated to our Utah manufacturing facility and the remainder relocated to a new, smaller office in Irvine, California. Trade and marketing spending is focused on new product support and incentives to customers and end consumers as we believe this approach has the quickest and most direct impact on sales. There is no assurance that we will be able to successfully achieve near-term profitability or maintain our market share in the veggie burger segment, particularly given the current highly competitive retail market.

 

Introduce New Products Beyond Veggie Burgers.  As discussed above, we continue to move beyond the veggie burger segment of the meat alternative category. While veggie burger category sales have declined the past 18 months, consumers are adding new items to their menu with increasing frequency and the meat alternative category volume is primarily found in the non-burger segment.  We believe that our new product introductions in other segments of the meat alternative category, such as entrees, will support our efforts to maintain a strong position in all channels and reinforce our brand equity.

 

Increase Key Channel Penetration.  We believe that we are one of the leading producers and marketers of meatless products in the retail grocery, food service, club store and natural foods distribution channels.  Our goal is to manage a strong brand position in these channels with profitability in all channels.  We recognize that increased competition in the grocery channel may result in a loss of grocery market share.  We are pursuing profitable growth in the food service channel where we have a strong market position across key business segments.  We were selected as a vendor of choice in the Sysco Corporation launch of its Moonrose Vegetarian line, a private label brand of premium products targeted at the emergent food service natural foods segment. In addition, we believe that other distribution channels, such as sandwich chains, K-12 schools and colleges and universities, present growth opportunities, and we continue to actively pursue these opportunities through sales calls to potential customers and research into product types that best suit the particular markets.

 

(1) ACV calculates the percentage of U.S. stores that carry at least one Gardenburger product.

 

3

 

Products

Gardenburger is committed to offering great tasting, better-for-you, convenient meatless food choices to consumers.  All of our products are frozen and include: grain-based and soy-based veggie burgers, which are offered in eleven varieties, and include specialized burger products in certain channels, including Gardenburger Sub™ for food service and GardenVegan® for natural food stores.  We also offer a variety of meat analog products including Chik’n Grill, Meatless Riblets, Meatless Meatloaf, and Herb Crusted Cutlet, all of which imitate the taste and texture of meat, chicken or pork products. In addition, in the third quarter of fiscal 2004, we introduced a new line of six microwaveable meatless entrees in the retail and natural food channels to capitalize on the consumers’ need for convenience.

 

The recipes for our products are proprietary, although they contain commonly known ingredients.  Veggie-grain based burgers contain fresh mushrooms, brown rice or other whole grains, onions, rolled oats, cheeses, bulgur wheat, natural seasonings and spices.  Soy-based products are seasoned to taste like chicken, pork or beef.  All of our meat alternative products are considerably lower in fat and calories than respective meat products of comparable weight, are good sources of protein and are 100% natural.

 

Our products are as follows:

 

Retail Grocery Burger Products

 

 

4

 

Retail Grocery Meatless Specialty Products

 

 

5

 

Retail Grocery Meatless Meals

 

 

Club Channel Products

 

Product		Description		Characterizing Ingredients		Fat		Calories
Original Gardenburger sold in packages of 17/3.5 oz. servings		Veggie-grain style burger		Mushrooms, brown rice, soy, onions, rolled oats and low-fat cheese		4g		130
Gardenburger Meatless Riblets sold in packages of 8/5.0 oz. servings		Analog pork rib with sauce		Soy, wheat gluten, barbecue sauce		5g		210

 

6

 

Food Service Products

 

 

7

 

Distribution

We primarily distribute our products into four channels: retail grocery, food service, club stores and natural foods stores.

 

Retail Grocery. Gardenburger products can now be found in more than 24,000 grocery stores with over 190,000 placements.  Our ACV penetration in the U.S. retail grocery channel was approximately 79% as of September 30, 2004, with an average of 7.9 SKUs.  Our products are currently carried in the majority of the major U.S. retail grocery chains.

 

Food Service. We distribute our products to more than 30,000 food service outlets throughout the U.S. and Canada, including restaurant chains such as Applebee’s, Fuddruckers, Red Robin, Subway and T.G.I. Friday’s.  In many of these restaurants, the Gardenburger brand name appears on the menu.  Additional points of food service distribution include academic institutions, hotels, amusement parks and sports stadiums.  In the United States, there are approximately 800,000 outlets in the food service channel.  We rely primarily on distributors such as Sysco for distribution to this channel.

 

Club Stores. Our products are distributed to club stores with over 265 locations, primarily Costco.  Currently, these stores carry the Original Gardenburger.

 

Net sales to Costco decreased by $3.2 million, or 41%, in fiscal 2004 compared to fiscal 2003 as a result of Costco’s decision to remove the Kirkland Signature co-branding label from our Gardenburger original packaging, effective the second quarter of fiscal 2004, which means that our product is no longer required to be carried by all Costco stores.  After numerous regional presentations, approximately 80% to 85% of the Costco stores have agreed to carry our Gardenburger product going forward.

 

Natural Foods. Our products are distributed to more than 3,500 natural food stores, including Whole Foods and Wild Oats.  We utilize food brokers that specialize in natural foods stores.

 

Our ability to expand distribution in each of the described channels will depend in part on consumer preferences, and to a certain extent on continuation of the current trends of health awareness.  There is always a risk that further development of low fat red or white meat products or technological advances that limit food-borne disease risks may lead to a change in consumer preferences and reduce demand for meat replacement products.  Demand for our products may be adversely affected by external factors, including dietary concerns about carbohydrates and ingredient preferences, which may occur rapidly and without warning. Because of our current dependence on meatless burgers and meat analogs, any changes in consumer preferences or increase in competition in the meat alternative market segment would adversely affect our business to a greater degree than if we had multiple product lines.

 

We sell our products in North America, primarily through more than 100 independent, commissioned food brokers and 1,000 active distributors. The retail food brokers are independent sales organizations, which have close working relationships with the leading grocery chains, club stores and natural food stores. The food brokers arrange for sales of Gardenburger products, which we then ship and bill directly to the retailers.  Products sold into the food service channel are purchased directly by distributors, which arrange for shipment by temperature-controlled truck to their frozen storage warehouses in principal cities throughout the U.S. for distribution to U.S. food service outlets and some Canadian grocery and food service outlets. Sales to distributors and retailers are final sales and, historically, we have not experienced significant levels of return product requests.

 

We have no non-cancelable long-term contracts with our food brokers or distributors and occasionally change brokers or distributors in an effort to increase coverage in a geographic region.  We could experience a substantial temporary or permanent decline in net sales if one or more of our major food brokers or distributors were to discontinue handling our products, go out of business, or decide to emphasize distributing products of our competitors.

 

8

 

Contract Management Companies, which manage cafeterias and other institutional eating establishments, also purchase our products. Examples of the additional points of food service distribution reached through the Contract Management Companies include academic institutions, hotels, amusement parks and sports stadiums. Contract Management Companies typically purchase our products through distributors and provide us with an additional means to distribute our products.

 

The following table lists selected retailers, distributors and food service outlets that offer our products for sale to consumers:

Retail

 

Grocery

A&P

AWG

Albertsons

Burris Foods Wholesale

C&S Wholesale

Cub Stores

Demoulas

Dillon’s Stores

Dominick’s

Fleming Wholesale

Fred Meyer

Giant Eagle

Giant Food

Hannaford

Jewel

King/Cullen

King Soopers

Kroger

Marsh

Meijers

Publix Super Markets

QFC

Rainbow Foods

Raley’s

Ralph’s

Randall’s

Safeway

Shaw’s

Smith’s

Shoprite

Stop and Shop

Supervalu Wholesale

Thriftway

Tops

Von’s

Wakefern

Wal-Mart

Wegmans

White Rose Wholesale

Winn-Dixie

 

Natural Foods

Wild Oats

Whole Foods

 

Club Stores

Costco

 

Food Service

 

Distributors

Food Services of America

Dot Foods

Sysco

Gordon Food Service

Reinhart Food Service

U. S. Foodservice

 

Restaurants

Applebee’s

Arctic Circle

A&W

Burgerville

Friendly’s

Dairy Queen

Damon’s

Flamers

Foster Freeze

Fuddruckers

IHOP

Lyons

Red Robin

Subway

T.G.I. Friday’s

 

Hotels

Marriott

Sheraton

 

Universities

Colorado University

DePaul

Harvard

Indiana University

Johns Hopkins University

MIT

Princeton

Purdue

Stanford

University of California, Berkeley

UCLA

University of Chicago

USC

 

Sports/Entertainment

Dodger Stadium

Yankee Stadium

Rose Garden Arena

Six Flags

Universal Studios

 

Contract Management Companies

ARAMARK

Avendra

Foodbuy

Gukenheimer

Sodexho

 

9

 

Our sales by region were as follows:

 

		% of Gross Sales
Region		FY 2004		FY 2003		FY 2002
Northeast		27	%	24	%	31	%
Midwest		20		18		16
Northwest		20		26		36
Southwest		16		12		5
Southeast		14		16		8
Canada		3		4		4
		100%		100	%	100	%

 

To date, we have focused our sales efforts primarily in North America, and international sales have not been material.

 

Sales and Marketing

 

Sales.  Our sales objective is to manage a strong market position with our veggie burgers and other meat alternative products in the retail grocery, food service, club store and natural foods store channels and to continue our expansion beyond veggie burgers in the meat alternative category.  Our use of regional food brokers as our representatives allows us to maintain contact with the nation’s major retail grocery chains and food service outlets without a large internal sales force.  Brokers are paid sales commissions on all products sold.

 

Our regional sales force is located strategically in our primary geographic sales regions and in proximity to our brokers and is divided into a food service division and a retail and club division.  The regional sales directors have substantial sales and industry experience. These regional sales directors coordinate the efforts of the food brokers and distributors.

 

Marketing.  Our marketing efforts focus on key seasonal periods for healthy eating.  Factors such as the aging population, obesity concerns and consumer interest in good-for-you products continue to stimulate positive consumer acceptance. We utilize free standing inserts, targeted marketing, website communication and in-store advertising to market our products.

 

Research and Development

Our research and development activities are focused on the development of new meat alternative products outside the veggie burger sub-category of the meat alternative market, as well as improvement and increased efficiency in the manufacturing process.  We continue to develop non-burger items such as breakfast sausage, cutlets and nuggets to meet the needs of the variety-seeking consumer. We conduct our research and development activities at our facilities in Clearfield, Utah.  In fiscal 2004, 2003 and 2002, we spent approximately $272,000, $235,000 and $222,000, respectively, on research and development activities, which are included in sales and marketing expense.

 

Manufacturing

Our 120,000 square-foot Clearfield facility handles multiple manufacturing lines for our products.  We believe the Clearfield facility will be able to support our growth plans for the foreseeable future.

 

The manufacturing process involves cleaning, chopping and mixing the ingredients; then forming, baking and quick-freezing the products and finally packaging them. The manufacturing process at our Clearfield facility is highly automated, mixing and baking products in assembly-line fashion with minimal human interaction.  The Clearfield facility also utilizes newly-developed, proprietary ovens that quickly cook the products.  Products are shipped, fully cooked, frozen and packaged, via temperature controlled trucks to distributors throughout North America.

 

10

 

We consider food safety a high priority and have prepared, in conjunction with government agencies, a Hazard Analysis and Critical Control Point (“HACCP”) system and other programs directed at ensuring the safety of our products.  HACCP is a comprehensive system that food companies use to monitor specific steps in food production to identify safety issues.  Using this type of system, we can focus on the areas in which greatest risks exist and implement preventive measures.

 

A significant disruption in our Clearfield facility’s production capacity as a result of, for instance, fire, severe weather, regulatory actions, work stoppages or other factors, could disable our capacity to manufacture our products.  If our meat alternative products become less available, consumers may switch to another brand of products and grocery stores may reduce shelf space allocated to our products.  Any significant unplanned disruption in manufacturing would likely have a material adverse effect on our results of operations and financial condition.

 

Seasonality

The third and fourth quarters of our fiscal year typically have stronger sales due to the impact of the summer grilling season on our veggie burger business.  We typically build inventories during the first and second quarters of each fiscal year in anticipation of increased sales in the third and fourth fiscal quarters, although in fiscal 2005, we plan to reduce inventory levels that have built up over the 2002 to 2004 time period.

 

Competition

The market for veggie burgers and other meat alternative products is highly competitive. Our products compete primarily on the basis of brand preference, taste, innovation, quality of natural ingredients, ease of preparation, availability, price and consumer awareness. We believe that our products compare favorably to those offered by our competitors in all of these areas.  We price our products competitively to our primary competitors. The calorie and fat content of Gardenburger® products is generally equivalent to that of competitors’ products. According to AC Nielsen, sales of our Gardenburger products represented 10.5% and 10.7% of meatless category sales during fiscal 2004 and fiscal 2003, respectively.

 

We believe that our principal competitors are The Kellogg Company, which distributes its products under the “Morningstar Farms” brand name to the food service, retail grocery, club and natural food channels; and Kraft Foods, which distributes soy-based meat analog products primarily in the food service, retail grocery, club and natural food channels under the “Boca Burger” label.   These companies have substantially greater financial and marketing resources than us.  In addition, other major national food products companies could decide to produce meat alternative products at any time in the future.

 

Our products also compete indirectly with other low fat meat products, such as ConAgra’s Healthy Choice 96% Extra Lean Ground Beef burger, and chicken or turkey based low fat products distributed by several large companies such as Tyson Foods, and with frozen, mass-produced low calorie/low fat entrees, including national brands such as Healthy Choice, Lean Cuisine and Smart Ones. Large companies with substantially greater financial resources, name recognition and marketing resources than us produce these products.

 

Significant Customers

Sysco Foods, Dot Foods, Inc. and C&S Wholesale Grocers, Inc. accounted for approximately 12%, 10% and 8%, respectively, of our fiscal 2004 gross revenue before trade discounts.  At September 30, 2004, Sysco Foods (“Sysco”), Dot Foods, Inc. (“Dot”) and C&S Wholesale Grocers, Inc. (“C&S”) accounted for approximately 7%, 12% and 14% of the gross outstanding accounts receivable balance, respectively.

 

Sysco is a food service distributor and sells our products to restaurants, hotels, and other food service customers. Dot is a redistributor; they sell our products to other, smaller distributors.  C&S is a retail food distributor and sells our products to grocery stores. The loss of these customers could have a material adverse effect on our business; however, there are competing distributors through which our products could be purchased by the end users.

 

11

 

Sources of Supply

We use natural ingredients such as mushrooms, oats, rice, onions and soy protein.  These are common agricultural items typically available in most parts of the United States.  In addition, we use packaging and other materials that are common in the food industry.  As a result, we believe, but cannot guarantee, that our sources of supply are reasonably reliable and that we are at no greater risk regarding supply issues than other similar food processors and producers.

 

Employees

After a reduction in force was implemented in early October 2004, we had approximately 172 full-time equivalent employees, with approximately 144 of them employed at our Clearfield facility.  None of our employees are subject to a collective bargaining agreement, and we believe our relations with our employees to be good.

 

Intellectual Property

We have approximately 22 U.S. registered trademarks, including “Gardenburger,” “Gardenburger Hamburger Classic,” and “GardenSausage.”  We have registered certain trademarks in Australia, Canada, France, Germany, Japan, Mexico and the United Kingdom, along with other smaller countries.

 

We actively monitor use of our trademarks by food service customers and others and take action we believe appropriate to halt infringement or improper usage. We defend our intellectual property aggressively and, from time to time, have been engaged in infringement protection activities.  Nonetheless, in the event third parties infringe or misappropriate our trademarks, we may have to incur substantial costs to protect our intellectual property or risk losing our rights. Any large expenditure or loss of rights could have a material adverse effect on our results of operations, cash flows and financial position.

 

We generally do not seek patents for our recipes or production methods and, therefore, can protect them only as trade secrets.  Some or all of these trade secrets could be obtained by others or could enter the public domain, which could place us at a competitive disadvantage.

 

In an effort to protect our trade secrets, all of our employees sign an “Employees Proprietary Rights and Confidentiality Agreement,” which states that they will not disclose our manufacturing processes, recipes, customer lists or other confidential material vital to our business.  In addition, senior sales, marketing and administrative personnel sign non-compete agreements, which prohibit them from working for a competitor for specified periods of time upon the termination of their employment with Gardenburger.

 

Management Information Systems

We utilize a single Baan enterprise resource planning system, which is expected to meet our information system needs for the foreseeable future.  In addition to integrating manufacturing, sales and accounting functions, the Baan system provides real-time information for management analysis and use in operations.  The Baan system aids management with production planning (planning of raw material purchases) and demand forecasting (matching supply to distribution centers with order volume) capabilities.  The Baan system also includes pallet tagging, bar coding and scanning applications that facilitate tracking of raw materials and finished goods through our manufacturing operation.  The Baan system enables us to use electronic data interchange (“EDI”) if desired by customers and suppliers, which we believe expedites order entry, payment and cash collection processes.

 

Government Regulation

The manufacturing, packaging, storage, distribution and labeling of food products are subject to extensive federal and state laws and regulations.  The FDA has issued regulations governing the ingredients that may be used in food products, the content of labels on food products and the labeling claims that may be made for foods.  Foods may only include additives, colors and ingredients that are either approved by the FDA or generally recognized as safe.  Our products must be manufactured in compliance with the FDA’s current Good Manufacturing Practice regulations applicable to food.

 

12

 

Regulators have broad powers to protect public health, including the power to inspect our products and facilities, to order the shutdown of a facility or to seize or stop shipment of our products and order a recall of previously shipped products, as well as the power to impose substantial fines and seek criminal sanctions against us or our officers.  While we currently carry $1 million of insurance against the cost of a product recall, a significant recall could have an adverse effect on our results of operations, cash flows and financial condition. In addition, negative publicity may result if regulators take any of the foregoing actions against us or if we were to voluntarily recall products to avoid regulatory enforcement.

 

Insurance

We maintain insurance against various risks related to our business.  This includes property and casualty, business interruption, director and officer liability, food spoilage, product liability, product recalls and workers’ compensation insurance.  We currently maintain $1 million of product recall insurance coverage, $2 million of product liability insurance coverage and $20 million of general umbrella coverage.  We consider our policies adequate to cover the major risks in our business, but there can be no assurance that this coverage will be sufficient to cover the cost of defense or damages in the event of a significant product liability claim.

 

Risk Factors

This Annual Report on Form 10-K contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934.  Our actual results may differ materially from the results projected in the forward-looking statements.  Factors that might cause such a difference include, but are not limited to, the following:

 

Our success depends on our ability to attract and retain key personnel.

We believe that our success will depend, in part, on the continuing services of our key management personnel.  The loss of the services of key personnel could have a material impact on our financial results.  Additionally, our success may depend on our ability to attract and retain additional skilled management personnel.

 

Our success depends on our ability to judge the impact of competitive products and pricing.

Successful operation of our business requires the ability to identify the effects of product and pricing trends.  If we are unable to evaluate the impact of product or pricing trends effectively, we may fail to implement strategies allowing us to capitalize on those trends, which may result in decreased sales or increased costs.

 

Our success depends on our ability to compete with our competitors.

The foodservice industry is intensely competitive with respect to the quality and value of food products offered and price.  Many of our competitors have substantially greater financial, marketing, operating and other resources than we have, which may give them competitive advantages.  Our competitors could also make changes to pricing or other marketing strategies which may impact us detrimentally. As our competitors expand operations, we expect competition to intensify. Such increased competition could have a material adverse effect on our financial position and results of operations.

 

We face commodity price and availability risks.

We purchase energy and agricultural products that are subject to price volatility caused by weather, market conditions and other factors that are not predictable or within our control. Increases in commodity prices could result in lower operating margins. Occasionally, the availability of commodities can be limited due to circumstances beyond our control. If we are unable to obtain such commodities, we may be unable to offer related products, which would have a negative impact on our profitability.

 

13

 

We depend on our suppliers to deliver quality products to us timely.

Our profitability is dependent on, among other things, our continuing ability to offer fresh, high-quality food at moderate prices.  Our dependence on frequent deliveries of food and paper products subjects our business to the risk that shortages or interruptions in supply, caused by adverse weather or other conditions, could adversely affect the availability, quality and cost of ingredients.  Any disruption in these distribution services could have a material adverse effect on our financial position and results of operations.

 

Consumer preferences and perceptions may have significant effects on our business.

Foodservice businesses are often affected by changes in consumer tastes and perceptions.  Foodservice businesses such as ours can also be affected materially and adversely by publicity resulting from poor food quality, illness, injury or other health concerns or operating issues stemming from one or a limited number of products.  We can be similarly affected by consumer concerns with respect to the nutritional value of our products.

 

Our business may be impacted by increased insurance costs.

We may be negatively affected by rising healthcare costs.  Although we seek to manage our claims to prevent increases, such increases can occur unexpectedly and without regard to our efforts to limit them. If such increases occur, we may be unable to pass them along to the consumer through product price increases, resulting in decreased operating results.

 

The nature of our business exposes us to potential litigation.

We have thousands of interactions or transactions each day with vendors, customers, employees and others.  In the ordinary course of business, disputes may arise for a number of reasons.  We may also be subject to liability claims or product recalls for products to be distributed in the future or products that have already been distributed.  We cannot be certain that we will prevail in every legal action brought against us.

 

Governmental regulations may change and require us to incur substantial expenditures to comply.

We are subject to governmental regulation at the federal, state and local level in many areas of our business, such as food safety and sanitation, environmental issues and minimum wage.  Governmental entities may change regulations that may require us to incur substantial cost increases in order to comply with such laws and regulations.  While we endeavor to comply with all applicable laws and regulations, we cannot assure you that we are in full compliance with all laws and regulations at all times or that we will be able to comply with any future laws or regulations.  If we fail to comply with applicable laws and regulations, we may be subject to sanctions or civil remedies, including fines and injunctions. The cost of compliance or the consequences of non-compliance could have a material adverse effect on our business and results of operations.

 

Compliance with environmental laws may affect our financial condition.

We are subject to various federal, state and local environmental laws.  These laws govern discharges to air and water, as well as handling and disposal practices for solid and hazardous wastes.  These laws may also impose liability for damages from and the costs of cleaning up sites of spills, disposals or other releases of hazardous materials.  We may be responsible for environmental conditions or contamination relating to our facilities and the land on which our facilities are located, regardless of whether we lease or own the facility or land in question and regardless of whether such environmental conditions were created by us or by a prior owner or tenant.  The costs of any cleanup could be significant and have a material adverse effect on our financial position and results of operations.

 

We have received a “going concern” opinion from our independent registered public accounting firm, which may negatively impact our business.

We have received a report from our independent registered public accounting firm regarding our financial statements for the fiscal year ended September 30, 2004 that included an explanatory paragraph which stated that the financial statements have been prepared assuming we will continue as a going concern. The explanatory paragraph stated that our working capital deficiency, negative operating cash flow, and

 

14

 

substantial recurring losses have raised substantial doubt about our ability to continue as a going concern.  As a result of our financial condition, we may find it difficult to operate our business in a normal fashion.  In addition, our ability to continue as a going concern could adversely affect our ability to enter into collaborative relationships with business partners and our ability to sell our products and could have a material adverse effect on our business, financial condition and results of operations.

 

Evolving regulation of corporate governance and public disclosure may result in additional expenses and continuing uncertainty.

Changing laws, regulations and standards relating to corporate governance and public disclosure, including the Sarbanes-Oxley Act of 2002 and new SEC regulations are creating uncertainty for companies such as ours. These new or changed laws, regulations and standards are subject to varying interpretations in many cases due to their lack of specificity, and, as a result, their application in practice may evolve over time as new guidance is provided by regulatory and governing bodies, which could result in continuing uncertainty regarding compliance matters and higher costs necessitated by ongoing revisions to disclosure and governance practices. We are committed to maintaining high standards of corporate governance and public disclosure. As a result, we intend to invest resources to comply with evolving laws, regulations and standards, and this investment may result in increased general and administrative expenses and a diversion of management time and attention from revenue-generating activities to compliance activities.  If our efforts to comply with new or changed laws, regulations and standards differ from the activities intended by regulatory or governing bodies due to ambiguities related to practice, our reputation may be harmed.

 

We may have difficulty implementing, in a timely manner, the internal controls procedures necessary to allow our management to report on the effectiveness of our internal controls.

Pursuant to Section 404 of Sarbanes-Oxley, we will be required to furnish an internal controls report of management’s assessment of the effectiveness of our internal controls as part of our Annual Report on Form 10-K for the fiscal year ended September 30, 2005. Our auditors will then be required to attest to, and report on, our assessment. In order to issue our report, our management must document both the design of our internal controls and the testing processes that support management’s evaluation and conclusion. Our management has begun the necessary processes and procedures for issuing its report on our internal controls. However, we may face significant challenges in implementing the required processes and procedures. There can be no assurance that we will be able to complete the work necessary for our management to issue its management report in a timely manner, or that management will be able to report that our internal controls over financial reporting are effective.

 

Item 2.  Properties

 

We lease approximately 5,200 square feet of administrative office space in Irvine, California pursuant to an operating lease with an initial term of three years. Current monthly rent is approximately $10,800.  This lease expires October 31, 2006 and has one renewal option for 24 months.

 

We lease 120,000 square feet of production space at Freeport Center, Building A-16, in Clearfield, Utah, pursuant to a lease that will terminate on December 31, 2007.  We have the option to renew the lease for one additional five-year term commencing January 1, 2008.  The monthly rent on this facility is currently $33,500.  Our Clearfield, Utah production facility can support sales levels of approximately $220 million at current pricing levels.  Given our current level of sales, we are operating the facility at approximately 30% of overall capacity.

 

We also lease 22,000 square feet of storage space at the Freeport Center in Clearfield on a month-to-month basis.  The monthly rent for the storage space is approximately $7,500.

 

15

 

Item 3.  Legal Proceedings

 

There are currently no material, pending legal proceedings to which we are a party.  From time to time, we become involved in ordinary, routine or regulatory legal proceedings incidental to our business.

 

Item 4.  Submission of Matters to a Vote of Security Holders

 

No matters were submitted to a vote of security holders during the quarter ended September 30, 2004.

 

PART II

 

Item 5.  Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

 

Our common stock trades on the over-the-counter market and is quoted on the NASD’s OTC Bulletin Board.  Over-the-counter market quotations reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not necessarily represent actual transactions. The high and low bid quotations for the last two fiscal years were as follows:

 

Fiscal 2003		High			Low
Quarter 1		$	0.85		$	0.25
Quarter 2		0.51			0.25
Quarter 3		0.55			0.26
Quarter 4		0.53			0.24

 

Fiscal 2004		High			Low
Quarter 1		$	0.54		$	0.20
Quarter 2		0.40			0.27
Quarter 3		0.36			0.21
Quarter 4		0.28			0.16

 

The number of shareholders of record and approximate number of beneficial owners of our common stock at February 14, 2005 were 689 and 4,000, respectively.

 

There were no cash dividends declared or paid in fiscal 2004 or 2003 on our common stock and we do not anticipate declaring cash dividends on our common stock in the foreseeable future.  Under the terms of our loan agreement with CapitalSource Finance LLC, we may not pay any cash dividends or other distributions with respect to, or redeem any of, our capital stock.  We also may not, without the consent of Annex Holdings I LP (“Annex”), the current holder of our convertible senior subordinated note, declare or pay any cash dividends or make any distributions with respect to our capital stock or other equity securities to the extent that at least $5 million in principal amount remains outstanding under our convertible senior subordinated note and Annex owns a majority of the then outstanding principal amount of such notes.

 

In addition, no cash dividends may be paid on our common stock unless dividends have been paid on all outstanding shares of our Series C and Series D Convertible Preferred Stock in an amount equal to 12% cumulative dividends accrued on such preferred shares through the record date for the common stock dividend (or, if greater, the amount of the common stock dividend payable on the preferred shares on an as-converted basis). The quarterly dividend accruing on the preferred shares is $975,000.

 

There were no sales of unregistered securities during fiscal 2004 and we did not purchase any of our outstanding securities during the fourth quarter of fiscal 2004.

 

Information regarding securities authorized for issuance under equity compensation plans is included in Item 12.

 

16

 

Item 6.  Selected Financial Data

 

			Year Ended September 30,
In thousands, except per share amounts			2004			2003			2002			2001			2000
Statement of Operations Data(1)
Net sales			$	48,580		$	49,447		$	54,596		$	50,751		$	61,113
Gross margin			16,307			18,738			22,907			18,193			24,976
Sales and marketing expense			13,844			14,208			13,711			13,586			18,358
General and administrative expense			3,898			5,218			4,210			4,997			7,304
Other operating expense (income), net			(16		)	105			184			57			303
Operating income (loss)			(1,419		)	(793		)	4,802			(447		)	(989		)
Other expense, net			(4,618		)	(4,409		)	(3,721		)	(2,342		)	(1,698		)
Cumulative effect of a change in accounting for slotting fees			(1,150		)	—			—			—			—
Cumulative effect of a change in accounting for goodwill			—			(411		)	—			—			—
Preferred dividends and accretion			4,839			5,177			4,955			4,367			12,492
Net loss applicable to common shareholders			$	(12,026	)	$	(10,790	)	$	(3,874	)	$	(7,156	)	$	(32,653	)
Basic and diluted loss per share before cumulative effect of a change in accounting principle			$	(1.21	)	$	(1.15	)	$	(0.43	)	$	(0.80	)	$	(3.67	)
Basic and diluted loss per share for cumulative effect of a change in accounting principle			(0.13		)	(0.05		)	—			—			—
Basic and diluted net loss per share applicable to common shareholders			$	(1.34	)	$	(1.20	)	$	(0.43	)	$	(0.80	)	$	(3.67	)
Balance Sheet Data
Working capital (deficit)			$	(616	)	$	5,937		$	10,245		$	9,857		$	8,058
Total assets			24,484			28,228			31,062			22,061			25,160
Long-term debt, less current maturities			3,513			4,979			6,540			—			—
Convertible note payable			19,392			18,672			17,596			17,364			15,000
Convertible redeemable preferred stock			55,851			51,012			45,835			40,880			36,513
Total shareholders’ deficit			(68,026		)	(56,000		)	(45,210		)	(41,431		)	(34,311		)

 

(1)          Revenues and sales and marketing expenses each decreased by $8,806 and $9,930, respectively, in fiscal 2001 and 2000 upon adoption of FASB EITF 00-14, “Accounting for Certain Sales Incentives,” and EITF 00-25, “Vendor Income Statement Characterization of Consideration Paid to a Reseller of the Vendor’s Products.”

 

17

 

Item 7.           Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Forward-Looking Statements

This Annual Report on Form 10-K contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 and we intend that such forward-looking statements be subject to the safe harbors created thereby. Words such as “may,” “will,” “expect,” “believe,” “anticipate,” “intend,” “could,” “estimate,” “should,” or “continue” or the negative or other variations thereof or comparable terminology are intended to identify forward-looking statements. In addition, any statements that refer to projections of our future financial performance, trends in our businesses, or other characterizations of future events or circumstances are forward-looking statements.  The forward-looking statements included herein are based on current expectations and involve a number of risks and uncertainties, all of which are difficult or impossible to predict accurately and many of which are beyond our control.  As such, our actual results may differ significantly from those expressed in any forward-looking statements.  Factors that may cause or contribute to such differences include, but are not limited to: (i) consumers’ concerns or adverse publicity regarding our products; (ii) effectiveness of operating initiatives and advertising and promotional efforts; (iii) changes in consumer preferences; (iv) the availability and pricing of competitive products; (v) changes in our suppliers’ ability to provide quality and timely products to us; (vi) availability of financing; (vii) new legislation or government regulation concerning packaging or our ability to produce or sell our products; (viii) the availability of distributors, such as retail grocery stores, food services outlets, such as restaurants, club stores and natural food stores to carry our products; (ix) the success of our research and development activities to develop new meat alternative products; (x) the availability of our manufacturing facilities; and (xi) the costs to protect our intellectual property rights.  Readers should carefully consider these risks, as well as the additional risks described elsewhere in this Annual Report on Form 10-K.  We undertake no obligation to revise the forward-looking statements contained herein to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events.

 

General

Approximately 69% of our gross sales were attributable to the Gardenburger® veggie burger and soy burger products, with the remaining 31% of our gross sales attributable to our newer meat alternative products during fiscal 2004. Consumers have been moving to the wider range of meat alternative products becoming available in the marketplace. In response to this development in consumer tastes, in fiscal 2003, we added five new products, including BBQ Chik’n and Meatless Meatloaf.  In the third quarter of fiscal 2004, we introduced a new line of six microwaveable meatless entrees to capitalize on the consumers’ need for convenience.  Sales of this new line of Gardenburger Meals added $2.3 million of net sales after shipments began in June 2004.

 

Our results have been, and continue to be, adversely affected by consumer trends favoring a low-carbohydrate diet.  This shift in consumer demand contributed to an 8.7% decrease and an 11% decrease, respectively, in sales of our veggie burger products in fiscal 2004 compared to fiscal 2003 and in fiscal 2003 compared to fiscal 2002.  In response, we reformulated our veggie burgers to reduce carbohydrates while increasing protein and improving taste. Demand for veggie burgers may continue to decrease in the future.  In addition, effective the second quarter of fiscal 2004, the Costco club stores ceased to require system-wide distribution of The Original Gardenburger® product, which resulted in a $3.2 million, or 41%, decrease in sales to Costco in fiscal 2004 compared to fiscal 2003.  Beginning in fiscal 2002, we launched a variety of new soy-based, meat alternative product offerings.  Sales of meat alternative products launched since the end of fiscal 2003 contributed approximately $5.2 million, including the $2.3 million of entree sales discussed above, to our net sales in fiscal 2004.  We expect sales of our meat alternative products, including our new entrees, to continue to increase. We also expect our new packaging, which started shipping at the end of the first quarter of fiscal 2004, to increase consumers’ awareness of how our products can fit into their diet choices and lifestyles, including low carbohydrate choices.

 

18

 

Results of Operations

 

The following table is derived from our Statements of Operations for the periods indicated and presents our results of operations in dollars, as well as a percentage of net sales (dollars in thousands).

 

Year Ended  September 30,		2004				2003				2002
Net sales		$		48,580		$	49,447			$	54,596
Cost of goods sold		32,273				30,709				31,689
Gross margin		16,307				18,738				22,907
Sales and marketing expense		13,844				14,208				13,711
General and administrative expense		3,898				5,218				4,210
Other operating expense (income), net		(16			)	105				184
Operating income (loss)		(1,419			)	(793			)	4,802
Other expense, net		(4,618			)	(4,409			)	(3,721			)
Income (loss) before cumulative effect of a change in accounting for slotting fees and goodwill and before preferred dividends		(6,037			)	(5,202			)	1,081
Cumulative effect of a change in accounting for slotting fees		(1,150			)	—				—
Cumulative effect of a change in accounting for goodwill		—				(411			)	—
Net income (loss)		(7,187			)	(5,613			)	1,081
Preferred dividends and accretion		4,839				5,177				4,955
Net loss applicable to common shareholders		$	(12,026		)	$		(10,790	)	$		(3,874	)

 

Year Ended  September 30,		2004		2003		2002
(amounts may not add due to rounding)
Net sales		100.0	%	100.0	%	100.0	%
Cost of goods sold		66.4		62.1		58.0
Gross margin		33.6		37.9		42.0
Sales and marketing expense		28.5		28.7		25.1
General and administrative expense		8.0		10.6		7.7
Other operating expense (income), net		—		0.2		0.3
Operating income (loss)		(2.9	)	(1.6	)	8.8
Other expense, net		(9.5	)	(8.9	)	(6.8	)
Income (loss) before cumulative effect of a change in accounting for slotting fees and goodwill and before preferred dividends		(12.4	)	(10.5	)	2.0
Cumulative effect of a change in accounting for slotting fees		(2.4	)	—		—
Cumulative effect of a change in accounting for goodwill		—		(0.8	)	—
Net income (loss)		(14.8	)	(11.3	)	2.0
Preferred dividends and accretion		(10.0	)	(10.5	)	(9.1	)
Net loss applicable to common shareholders		(24.8	)%	(21.8	)%	(7.1	)%

 

Net Sales

The decrease in net sales in fiscal 2004 compared to fiscal 2003 is a result of an 8.7% decrease in sales of our veggie burger products, a decrease in sales to Costco and an increase in trade spending, offset in part by continuing growth in meat alternative products, including our new entrees.

 

Sales of products launched after the end of fiscal 2003, which are all meat alternative products, contributed $5.2 million to our net sales in fiscal 2004.

 

Net sales to Costco decreased by $3.2 million, or 41%, in fiscal 2004 compared to fiscal 2003 as a result of Costco’s decision to remove the Kirkland Signature co-branding label from our Gardenburger original packaging, effective the second quarter of fiscal 2004, which means that our product is no longer required to be carried by all Costco stores.  After numerous regional presentations, approximately 80% to 85% of the Costco stores have agreed to carry our Gardenburger product going forward.

 

19

 

The decrease in fiscal 2003 compared to fiscal 2002 was due to an 11% decrease in sales of veggie burger products, primarily due to lower unit sales, and increased trade spending, offset in part by increased unit sales of new products. Sales of our new Herb Crusted Cutlet™ and Crispy Nuggets™ products, which began selling during the fourth quarter of fiscal 2002, accounted for $2.4 million of our sales during fiscal 2003 compared to $219,000 in fiscal 2002.  We launched two additional products in the second quarter of fiscal 2003, our BBQ Chik’n and Meatless Meatloaf, which had sales of $1.8 million in fiscal 2003.

 

Trade spending totaled $12.1 million in fiscal 2004, $11.8 million in fiscal 2003 and $9.5 million in fiscal 2002. Trade spending includes promotions, discounts, contract origination fees and slotting fees. Pursuant to EITF No. 01-9 “Accounting for Consideration Given by a Vendor to a Customer or a Reseller of the Vendor’s Products,” these costs are recorded at the later of when revenue is recognized or when the sales incentive is offered, and are generally classified as a reduction of revenue.

 

Gross Margin

The decreases in gross margin and gross margin as a percentage of net sales in fiscal 2004 compared to fiscal 2003 are due to decreased veggie burger sales, which have lower production costs than our other products, unfavorable manufacturing variances, which primarily resulted from inefficiencies related to the introduction of our new entrees in the third quarter of fiscal 2004, and higher trade spending.  Except for an increase in certain commodity prices, primarily cheese, and certain shipping materials, we have not experienced material changes to our raw material costs in fiscal 2004 compared to fiscal 2003.  We have not made any material selling price changes in fiscal 2004 compared to fiscal 2003, and we do not anticipate any material selling price changes in fiscal 2005.

 

The decrease in gross margin in fiscal 2003 compared to fiscal 2002 is due primarily to lower unit sales as discussed above and lower gross margin as a percentage of net sales in fiscal 2003 compared to fiscal 2002.

 

The lower gross margin percentage resulted from:

•                  an increase in non-burger sales in the product sales mix, which have higher production costs than our veggie burgers;

•                  increased trade spending in 2003;

•                  new product production start-up costs; and

•                  increased depreciation in fiscal 2003, due primarily to the purchase of the previously-leased Clearfield manufacturing equipment in early January 2002.

 

These factors were offset in part by reduced lease expense in fiscal 2003 due to the termination of the Clearfield equipment operating leases.

 

Sales and Marketing Expense

Sales and marketing expense in fiscal 2004 includes approximately $57,000 of costs related to our move to Irvine, California from Portland, Oregon compared to $150,000 of such costs in fiscal 2003. Sales and marketing expenditures in fiscal 2004 also include certain termination and recruitment costs related to changes in certain sales positions.  The decrease in sales and marketing expense in fiscal 2004 compared to fiscal 2003 was primarily due to the following:

•                  a $282,000 decrease in in-store product demonstration expense in the club store channel;

•                  a $236,000 decrease in coupon design, production and insertion costs attributable to one fewer coupon drop;

•                  a $173,000 decrease in severance pay;

•                  a $136,000 decrease in inventory storage costs achieved through better inventory management;

•                  a $117,000 decrease in sales commission and broker incentives expense due to negotiating lower commission rates for some brokers and restricting some incentive programs;

•                  a $99,000 decrease in product contributions; and

 

20

 

•                  a $95,000 decrease in advertising agency fees by eliminating the use of an advertising agency for the retail sales channel.

 

These decreases were partially offset by the following:

•                  a $111,000 increase in travel expense;

•                  a $190,000 increase in sales bonuses; and

•                  a $218,000 increase in freight delivery costs.

 

The increase in sales and marketing expenditures in fiscal 2003 compared to fiscal 2002 are primarily due to the following:

•                  a $225,000 increase in inventory storage costs due to higher inventory levels;

•                  a $220,000 increase in in-store product demonstration and sampling expense in the club channel;

•                  a $600,000 increase in other trade promotions; and

•                  $150,000 of costs, primarily severance, related to the relocation of our corporate offices from Portland, Oregon to Irvine, California.

 

These increases were partially offset by the following:

•                  a $240,000 decrease in sales commissions due to lower sales; and

•                  a $775,000 decrease in media spending as we moved away from this type of advertising and increased our trade spending.

 

General and Administrative Expense

The decrease in general and administrative expense in fiscal 2004 compared to fiscal 2003 is primarily due to the following:

•                  a $688,000 decrease in costs incurred for outside services and legal fees;

•                  a $100,000 decrease in bad debt expense;

•                  a $364,000 decrease in depreciation expense due primarily to the elimination of depreciation related to our computer system, which has reached the end of its depreciable life; and

•                  a $70,000 reduction in rent expense due to our move to smaller quarters in Irvine, California.

 

The increase in general and administrative expense in fiscal 2003 compared to fiscal 2002 is due primarily to a $650,000 increase in costs incurred in development of a long-term business strategy, which primarily included costs related to our failed attempt to sell the Company, and $300,000 of costs related to the relocation of our corporate offices from Portland, Oregon to Irvine, California.  We did not have any relocation expenses in fiscal 2002.

 

Legal Settlement

Legal settlement of $108,000 in fiscal 2002 relates to a settlement received from a raw material supplier due to an August 2001 recall of our Chik’n Grill product due to the omission of sulfites, which are known allergens, from the ingredient label.  The raw material supplier reimbursed us for lost operating profits associated with the recall. This is a final settlement and no further amounts will be received from this supplier related to this recall.

 

Debt Restructuring Costs

Debt restructuring costs of $716,000 in fiscal 2002 include an early termination fee of $175,000 for our previous line of credit facility, the write-off of $279,000 of unamortized financing fees, $95,000 for the value of common stock warrants issued in connection with the restructuring of our Restated Convertible Senior Subordinated Notes (the “Convertible Note”) and preferred stock and $167,000 of legal fees.

 

21

 

Other Operating Expense (Income), Net

Other operating income of $16,000 in fiscal 2004 represents a gain on the sale of other assets.

 

Other operating expense of $105,000 in fiscal 2003 represents losses on the disposal of fixed assets.

 

Other operating income in fiscal 2002 includes $303,000 related to the reversal of restructuring reserves, which were established in fiscal 1999 and, in the first quarter of fiscal 2002, were determined to no longer be required, as well as $117,000 related to the recognition of a deferred gain on our Clearfield operating lease upon its early termination in conjunction with our purchase of the related equipment.

 

Interest Expense

In connection with the amendment of our senior and subordinated debt instruments in December 2003, the interest rate on our subordinated debt increased to 13% from 10%, retroactive to October 1, 2003, until our interest payments are current, which is not expected to occur during fiscal 2005. This increase in rate increased our interest expense by approximately $127,000 per quarter in fiscal 2004 compared to fiscal 2003.

 

In March 2004, we amended our Articles of Incorporation to extend the earliest mandatory redemption date of our Series C and Series D convertible preferred stock to as late as June 30, 2008.  As a result, we also extended the maturity dates under our CapitalSource Loan Agreement and our Convertible Note to January 31, 2007 and June 15, 2007, respectively. The extended maturity dates decreased our interest expense related to exit fees by approximately $186,000 per quarter to approximately $112,000 per quarter.

 

The increase in interest expense in fiscal 2003 compared to fiscal 2002 is due to an increase in outstanding debt as a result of the purchase of manufacturing equipment in January 2002 utilizing an $8.0 million term loan, as well as an increase in the outstanding balance on our line of credit.

 

Income Taxes

A valuation allowance has been recorded for the full amount of deferred tax assets due to the uncertainty regarding the realization of the net deferred tax assets consisting primarily of net operating loss and credit carryforwards.  Accordingly, no benefit has been recorded related to our losses in fiscal 2004, 2003 or 2002.

 

Cumulative Effect of Change in Accounting for Slotting Fees

Slotting fees refer to oral arrangements pursuant to which the retail grocer allows our products to be placed on the store’s shelves in exchange for a slotting fee. As reported in prior filings, slotting fees were initially recorded as a prepaid asset and the related expense was recognized ratably over a 12-month period beginning two months following product shipment as an offset to sales.  Typically, 12 months is the estimated minimum period during which a retailer agrees to allocate shelf space.  However, given that there are no written contractual commitments requiring the retail grocers to allocate shelf space for twelve months, in fiscal 2004, we determined that it was a preferable accounting method to expense the slotting fees at the time revenue is recognized.  We recorded a cumulative effect of a change in accounting for slotting fees totaling $1.2 million and recorded the amount as if the change in accounting principle had taken effect on October 1, 2003.  Accordingly, the effect of the change is recorded in the fiscal 2004 quarterly data presented herein.

 

Cumulative Effect of Change in Accounting for Goodwill

In accordance with the adoption provisions of SFAS No. 142, “Goodwill and Other Intangible Assets,” in the first quarter of fiscal 2003, we tested the carrying value of our goodwill utilizing a discounted cash flow analysis and determined that the remaining balance of $411,000 should be written off.  There was no goodwill on our balance sheet at September 30, 2004 or 2003.

 

22

 

Preferred Dividends and Accretion

As approved by our shareholders at our 2004 Annual Shareholder Meeting in March 2004, the terms of our Series C and Series D convertible preferred stock were amended to defer the earliest date on which holders may require redemption of their shares of Series C and Series D convertible preferred stock to as late as June 30, 2008 instead of March 31, 2006. Accordingly, the amount of the 10% redemption premium not previously accreted will be accreted over a longer period of time, which reduced our quarterly preferred dividend and accretion charge from $1.3 million to approximately $1.2 million beginning in the third quarter of fiscal 2004.

 

Due to the addition of a 10% exit premium in conjunction with the changes made to the outstanding preferred stock during the second quarter of fiscal 2002, the quarterly dividend and accretion charge increased from $1.1 million to $1.3 million.

 

Detail of our preferred dividends and accretion is as follows (in thousands):

 

		Year Ended September 30,
		2004			2003			2002
12% cumulative dividends		$	3,900		$	3,900		$	3,900
Accretion of 10% redemption premium		769			1,022			741
Accretion of original issue discount		170			255			314
		$	4,839		$	5,177		$	4,955

 

Inflation

We believe that the impact of inflation was not material for fiscal years 2004, 2003 and 2002.

 

Liquidity and Capital Resources

Our financial statements have been presented on a going concern basis, which contemplates the realization of assets and satisfaction of liabilities in the normal course of business.  As shown in the 2004 financial statements, we incurred net losses applicable to common shareholders for fiscal years 2004, 2003 and 2002 and had a total shareholders’ deficit at September 30, 2004.  We are highly leveraged and have significant annual interest and dividend accruals related to our convertible note payable and convertible redeemable preferred stock, which, although not payable until June 2007 and June 2008, respectively, contribute to our net losses and shareholders’ deficit.

 

During the fourth quarter of fiscal 2004, we experienced sales declines due to one of our major competitors initiating a program of price discounting at unprecedented levels. These sales declines resulted in operating performance that was lower than our plans.  When combined with the significant cash outlays for capital expenditures, slotting fees and other product introduction costs associated with the launch of our new microwavable meals, these events caused a higher than expected use of our line of credit.  We ended fiscal 2004 with $4.8 million outstanding on the line of credit, compared to $2.2 million at the end of fiscal 2003.

 

At September 30, 2004, we had $1.7 million available on our line of credit.  Cash required to meet our required interest and principal payments on our debt outstanding at September 30, 2004 totals approximately $2.8 million in the next twelve months as follows (in thousands):

 

Principal payments due on long-term debt		$	2,000
Interest on long-term debt		378
Estimated interest on short-term note payable		413
Estimated unused line of credit fee related to short term note payable		36
Total		$	2,827

 

These factors raise substantial doubt about our ability to continue as a going concern.

 

23

 

To improve our cash flow and liquidity, we have identified the following initiatives, among others for fiscal 2005 (unaudited):

•                  A reduction of $2 million in finished goods inventories which were built up over the 2002-2004 timeframe;

•                  A reduction in slotting fees from approximately $3.1 million in 2004 to a planned $737,000 in 2005;

•                  A reduction in capital expenditures from approximately $1.4 million in 2004 to a planned $325,000 in 2005;

•                  The completion on October 1, 2004 of a reduction in force at our manufacturing facility;

•                  A ban on non-essential travel and other administrative costs;

•                  The negotiation of extended payment terms with several of our major vendors; and

•                  The institution of additional cash management and tracking procedures.

 

We also negotiated waivers with CapitalSource Finance LLC (“CapitalSource”) and Annex Holdings I LP (“Annex”) for all 2004 covenant defaults and set new financial covenants going forward which we expect to achieve.  In addition, CapitalSource has agreed to provide a $500,000 over advance facility from February 18, 2005 to May 31, 2005 as part of the loan amendments.  We agreed to pay CapitalSource a fee of $110,000 in connection with the amendment and a fee of $25,000 for the additional availability under the revolving credit facility.  In addition, we are required to pay a $500,000 fee to CapitalSource if our ratio of total debt under the Loan Agreement plus the Convertible Note with Annex to earnings (as defined) exceeds 1.25:1.00 as of September 30, 2005 and a $250,000 fee if such ratio exceeds 1.25:1.00 as of the end of each quarterly period thereafter.  Based on our current total debt level, it is likely that these fees will be paid.  See Note 19 of Notes to Financial Statements for a discussion of the amendments.

 

As a result of the various initiatives, during the first quarter of fiscal 2005, we were able to reduce our line of credit by $497,000 (unaudited), make scheduled principal payments of $500,000 (unaudited) on our long-term debt and fund all interest payments on our CapitalSource debt.

 

We anticipate funding our cash commitments for the next twelve month period out of operating cash flows and line of credit borrowings, bolstered by the impact of the cash initiatives and over advance facility discussed above.  There can be no assurance that our various sources of cash will be sufficient to sustain operations.

 

Our financial statements have been prepared assuming that we will continue as a going concern and do not include any adjustments relating to the recoverability and classification of recorded asset amounts or the amounts and classification of liabilities that might be necessary should we be unable to continue as a going concern.  Our continuation as a going concern is dependent on our ability to generate sufficient cash flow to meet our obligations on a timely basis, to comply with the terms of our financing agreements and ultimately to attain profitable operations.

 

At September 30, 2004, working capital was a negative $0.6 million.  Working capital decreased by $6.6 million at September 30, 2004 compared to September 30, 2003 and the current ratio decreased to 1.0:1 from 1.6:1.  The decrease in working capital in 2004 includes the write-off of $1.2 million of prepaid slotting fees resulting from the cumulative effect adjustment. In addition, working capital has been reduced by $3.2 million in accrued interest on our Convertible Note, which is not currently eligible for payment.

 

Cash and cash equivalents at September 30, 2004 decreased $1.1 million from September 30, 2003, primarily due to $572,000 used in operations, $1.4 million used for the purchase of equipment, $1.5 million used for payments on long-term debt and $315,000 used to pay financing fees related to our debt amendments, offset by $2.6 million of net proceeds from our line of credit and $113,000 of proceeds from the sale of assets.

 

Accounts receivable decreased $112,000 to $2.8 million at September 30, 2004 from $3.0 million at September 30, 2003.  Decreases due to lower net sales in the fourth quarter of 2004 compared to the fourth quarter of 2003 were mostly offset by a $176,000 increase in other receivables (primarily insurance receivables) and an $89,000 reduction in our allowance for bad debts. Days sales outstanding were approximately 22 days at September 30, 2004 compared to approximately 20 days at September 30, 2003.

 

24

 

Inventories decreased $0.2 million to $9.0 million at September 30, 2004 compared to $9.2 million at September 30, 2003.  Inventory turned approximately 3.9 times on an annualized basis in the fourth quarter of fiscal 2004 compared to approximately 3.4 times in the fourth quarter of fiscal 2003.  Inventories have grown $1.6 million over the last three years, and we intend to decrease production and reduce our inventories during fiscal 2005.

 

Prepaid expenses decreased $0.9 million to $1.2 million at September 30, 2004 compared to $2.1 million at September 30, 2003, due primarily to a $1.2 million decrease in prepaid slotting fees as a result of our change in accounting.

 

Other current liabilities increased $1.3 million to $3.6 million at September 30, 2004 compared to $2.3 million at September 30, 2003, due primarily to $3.2 million of accrued interest due on our Convertible Note at September 30, 2004 compared to $845,000 of such accrued interest at September 30, 2003.  This increase was partially offset by a $937,000 decrease in coupon liability and a $340,000 decrease in accrued severance.

 

Capital expenditures of $1.4 million during fiscal 2004 were primarily used for manufacturing equipment relating to the introduction of our six microwaveable entrée products in the third quarter of fiscal 2004.  As amended in August 2004, our CapitalSource Loan Agreement limited our fiscal 2004 capital expenditures to $1.55 million.  The Loan Agreement limits our fiscal 2005 capital expenditures to $1.1 million.  We anticipate spending approximately $0.3 million on capital expenditures in fiscal 2005 primarily for manufacturing equipment.

 

Other long-term assets include unamortized capitalized financing fees totaling $359,000 at September 30, 2004, which are currently being amortized at the rate of approximately $50,000 per quarter.

 

Our Loan Agreement with CapitalSource provides for an $8.0 million term loan and a $7.0 million line of credit (together, “the Loans”).  The Loan Agreement permits us to request advances under the $7.0 million line of credit up to the sum of 85% of eligible receivables and 60% of eligible inventory.  At September 30, 2004, there was approximately $1.7 million remaining available on the CapitalSource line of credit, which will be used as needed for working capital.  The balance outstanding of $5.5 million on the term loan includes $652,000 of accrued exit fees at September 30, 2004.

 

In September 2004, Dresdner Kleinwort Benson Private Equity Partners LP (“Dresdner”), the original holder of our Convertible Note, transferred all rights, including interest accrued from September 30, 2001, pursuant to the Convertible Note, to Annex Holdings I LP (“Annex”). We have approximately $16.9 million of principal and $2.5 million of accretion related to exit fees due on the Convertible Note as of September 30, 2004. The Convertible Note requires payment of a 20% premium on the principal plus accrued but unpaid interest at repayment or maturity. The Convertible Note is convertible into common stock at the election of the holder; the conversion price at September 30, 2004 was $9.78 per share.

 

Pursuant to the CapitalSource Loan Agreement and Convertible Note, as amended, we currently record quarterly interest expense of approximately $21,000 and $91,000, respectively, for the accretion related to the exit fees. These amounts are added to the long-term debt and Convertible Note balances, respectively.

 

In September 2003, Dresdner agreed to permit the deferral of our September 30, 2003 interest payment, which totaled $845,000, to December 31, 2003.  In December 2003, this interest payment was further deferred to no earlier than September 30, 2004.  In addition, $576,000 was accrued in each of the first and second quarters of fiscal 2004, and $604,000 was accrued in the third and fourth quarters of fiscal 2004.  Accordingly, we included the total of $3.2 million and $845,000, respectively, on our balance sheets as of September 30, 2004 and September 30, 2003 in other current liabilities.

 

In order to address issues relating to our ability to meet our financial obligations and to address non-compliance with certain of our financial covenants, we entered into amendments to our Loan

 

25

Agreement with CapitalSource and our Convertible Note, which was then held by Dresdner, in late December 2003.  The amendments were contingent upon amending our Articles of Incorporation to extend the date on which our holders of Series C and Series D convertible preferred stock could redeem their shares of preferred stock, which shareholder approval was obtained at our Annual Shareholder Meeting in March 2004.

 

The amendments extend the maturity of the Loan Agreement from December 15, 2004 to January 31, 2007 and of the Convertible Note from March 31, 2005 to June 15, 2007.

 

In late December 2003, we also negotiated amendments to our financial covenants in the Loan Agreement and the Convertible Note.  Beginning December 31, 2003, we are required under the Loan Agreement to maintain compliance with the following financial covenants (in some cases as further modified by the amendments entered into on August 13, 2004, discussed below), measured quarterly unless otherwise noted:

•                  a maximum ratio of long-term indebtedness to earnings (as defined below) ranging from a high of 3.60:1.00 for the quarter ended March 31, 2004,  to a low of 2.50:1.00 for each quarter ending on or after June 30, 2004;

•                  minimum earnings for a rolling 12-month period, as adjusted to exclude certain expenses and non-cash charges, ranging from a low of $3,000,000 for the quarter ended June 30, 2004, to a high of $6,000,000 for the quarter ending September 30, 2005, and thereafter (“minimum adjusted EBITDA”);

•                  a minimum senior fixed charge coverage ratio (which excludes from fixed charges both interest expense and accrued premium on the Convertible Note) ranging from a low of 0.90:1.00 for the quarter ended June 30, 2004, to a high of 1.57:1.00 for the quarter ending June 30, 2005;

•                  a minimum fixed charge coverage ratio of 1.10:1.00 for the quarter ending September 30, 2005 and 1.25:1.00 thereafter; and

•                  capital expenditures in an amount per fiscal year not exceeding $1,200,000 for the fiscal year ending September 30, 2004, and $1,100,000 for fiscal years ending thereafter.

 

The financial covenants applicable to the Convertible Note are similar, but in each case slightly less restrictive.

 

In consideration of the maturity date extensions, the financial covenant amendments, and the waivers received for prior violations discussed above, we paid a loan amendment fee to CapitalSource of approximately $130,000 and agreed to pay interest on the unpaid principal and accrued interest on the Convertible Note at the annual rate of 13% rather than 10%, which is the default interest rate provided in the note, beginning October 1, 2003, and continuing until our interest payments to Annex are brought current. The Loan Agreement, as amended, prohibits us from paying accrued interest on the Convertible Note to Annex prior to September 30, 2004, and permits us to pay interest to Annex on or after September 30, 2004, only if and to the extent that we comply with specified financial covenants and levels of capital availability. Interest due Annex at September 30, 2004 totaled approximately $3.2 million and is included in other current liabilities on our balance sheet.

 

We also received an agreement that future failures to pay interest on the Convertible Note when due will not be deemed, under specified conditions, to be an event of default under the Convertible Note.

 

In addition to the December 2003 amendments discussed above, on August 13, 2004, we entered into an amendment of our Loan Agreement with CapitalSource, and an amendment of our Convertible Note. These amendments were not subject to shareholder approval. Under the amendment of the Loan Agreement, we are now required to comply with the following financial covenants:

•                  if repayment or termination occur on or before August 13, 2005, a termination fee is due (unless CapitalSource is the lender in the credit facility which replaces or refinances the Loan Agreement) equal to 1% of the sum of (A) the maximum amount of the revolving credit facility under the Loan Agreement and (B) the outstanding balance of the term loan under the Loan

 

26

 

Agreement, minus the amount of scheduled principal payments made between August 13, 2004 and the date of such repayment or termination;

•                  capital expenditures in an amount per fiscal year not exceeding $1,550,000 for the fiscal year ending September 30, 2004, and $1,100,000 for fiscal years ending thereafter; and

•                  a minimum senior fixed charge coverage ratio for the following quarterly periods: a ratio of 1.35:1.00 for the quarter ended September 30, 2004, a ratio of 1.25:1.00 for the quarter ended December 31, 2004, a ratio of 1.48:1.00 for the quarter ended March 31, 2005, and a ratio of 1.57:1.00 for the quarter ended June 30, 2005.

 

The financial covenants regarding capital expenditure limitations and minimum senior fixed charge coverage ratios applicable to the Convertible Note (as amended) are similar, but in each case slightly less restrictive.

 

At September 30, 2004, we were out of compliance with the following debt covenants:

 

Covenant		Requirement			As calculated September 30, 2004			Required by
Minimum adjusted EBITDA		$4.9 million/ $4.4 million			$0.6 million			Loan Agreement/ Convertible Note
Maximum leverage ratio		2.50:1.00/ 2.75:1.00			16.41:1.00			Loan Agreement/ Convertible Note
Minimum senior fixed charge coverage ratio		1.35:1.00/ 1.22:1.00			0.15:1.00			Loan Agreement/ Convertible Note

 

In order to address issues relating to our ability to meet our financial obligations and to address non-compliance with certain of our financial covenants, we entered into amendments to our Loan Agreement with CapitalSource and our Convertible Notes held by Annex on February 18, 2005, following fiscal year-end.  See Note 19 of Notes to Financial Statements for a discussion of the amendments.

 

Contractual Payment Obligations

Principal payments under our term loan, our Convertible Note and our operating leases are significant.  A schedule of payments remaining due at September 30, 2004 in the next five fiscal years, including exit fees of $750,000 for the term loan and approximately $3.5 million for the Convertible Note, is as follows (in thousands):

 

		Total			Fiscal 2005			Fiscal 2006-2007			Fiscal 2008-2009			Thereafter
Term Loan		$	5,611		$	2,000		$	3,611		$	—		$	—
Convertible Note		20,379			—			20,379			—			—
Operating Leases		2,112			684			1,269			159			—
Purchase Order Obligations		794			794			—			—			—
License Agreement		346			75			150			121			—
Retention Agreements		1,445			—			1,445			—			—
Total		$	30,687		$	3,553		$	26,854		$	280		$	—

 

We have 552,500 shares of Series C Convertible Preferred Stock and 97,500 shares of Series D Convertible Preferred Stock outstanding. The Series C preferred shares are convertible into common stock at a price of $10 per share and the Series D preferred shares are convertible at $3.75 per share (subject to antidilution adjustments), in each case based on a base price of $50.00 per share, at any time at the discretion of the holder.  Both series of preferred stock are entitled to a 12% cumulative annual dividend payable upon redemption of the stock or in the event of a sale or liquidation of Gardenburger.  The terms of the Series C and Series D Stock provide for a 10% premium on any liquidation or redemption.  As approved by our shareholders at our March 2004 Annual Shareholders Meeting, the earliest date on which holders may require redemption of their shares was deferred from March 31, 2006 to as late as June 30, 2008, at which point they may be redeemed at the election of the holders or, under certain conditions, at our discretion. The 10% redemption premium, which totals $4.3 million, is being accreted over the redemption period.  At September 30, 2004, $2.5 million of the

 

27

 

redemption premium has been accreted and is included in the preferred stock balance on the balance sheet. The liquidation preference of the Series C and Series D Stock was $58.1 million at September 30, 2004.

 

Seasonality

The third and fourth quarters of our fiscal year typically have stronger sales due to the summer grilling season.  We typically build inventories during the first and second quarters of each fiscal year in anticipation of increased sales in the third and fourth fiscal quarters, although in fiscal 2005, we plan to reduce inventory levels that have built up over the 2002 to 2004 time period.

 

New Accounting Pronouncements

 

EITF 04-8

In October 2004, the FASB ratified EITF 04-8, “Accounting Issues Related to Certain Features of Contingently Convertible Debt and the Effect on Diluted Earnings Per Share.”  The new rules require companies to include shares issuable upon conversion of contingently convertible debt in their diluted earnings per share (EPS) calculations regardless of whether the debt has a market price trigger that is above the current fair market value of the company’s common stock that makes the debt currently not convertible. The new rules are effective for reporting periods ending on or after December 15, 2004.

 

The shares issuable upon conversion of our Convertible Note were previously required, and are still required under the new rules, to be included in our diluted EPS calculation, if the effect of the conversion is dilutive (e.g., the EPS calculation including the deemed conversion of the notes is lower than the EPS calculation excluding such deemed conversion). Given that the current impact of our Convertible Note on our diluted EPS calculations is anti-dilutive, the shares issuable upon conversion are excluded from our reported diluted EPS calculations and, as long as they remain anti-dilutive, shall remain excluded from our diluted EPS calculations under the new rules.

 

SFAS No. 151

In November 2004, the FASB issued SFAS No. 151, “Inventory Costs: an amendment of ARB No. 43, Chapter 4,” to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs and wasted material.  SFAS No. 151 is effective for inventory costs incurred during fiscal years beginning after June 15, 2005.  We do not believe the provisions of SFAS No. 151, when applied, will have a material impact on our financial position or results of operations.

 

SFAS No. 123R

In December 2004, the FASB issued SFAS No. 123R, “Share-Based Payment: an amendment of FASB Statements No. 123 and 95,” which requires companies to recognize in their income statement the grant-date fair value of stock options and other equity-based compensation issued to employees.  SFAS No. 123R is effective for interim or annual periods beginning after June 15, 2005.  Accordingly, we will adopt SFAS No. 123R in our fourth quarter of fiscal 2005. Unamortized stock-based compensation expense, on a pro forma basis, as of September 30, 2004 totaled $355,000, with $165,000 to be amortized in fiscal 2005 (including $41,000 in the fourth quarter of fiscal 2005), $144,000 to be amortized in fiscal 2006 and $46,000 to be amortized in fiscal 2007.

 

Critical Accounting Policies and Estimates

The discussion and analysis of our financial condition and results of operations are based upon our financial statements, which have been prepared in accordance with the standards of the Public Company Accounting Oversight Board (United States).  The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses.  On an ongoing basis, we evaluate our estimates, including those related to inventory reserves and allowance for doubtful accounts. We base our estimates on historical experience and on various other assumptions. Actual results may differ from these estimates if conditions turn out differently from our assumptions.  We believe the following critical accounting policies and the related judgments and estimates affect the preparation of our financial statements.

 

28

 

Revenue Recognition

In accordance with Staff Accounting Bulletin No. 104, Revenue Recognition (“SAB 104”), revenues are recognized upon passage of title to the customer, typically upon product pick-up, shipment or delivery to customers.

 

Our revenue arrangements with our customers often include sales incentives and other promotional costs such as coupons, volume-based discounts, slotting fees and off-invoice discounts. These costs are typically referred to collectively as “trade spending.”  Pursuant to EITF No. 00-14, EITF No. 00-25 and EITF No. 01-09, “Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor’s Products),” these costs are recorded when revenue is recognized and are generally classified as a reduction of revenue.  We do not provide for a sales returns since, historically, sales returns have not been significant.

 

Trade Spending

Certain trade spending items are subject to estimation (i.e. volume discounts). Estimated trade spending is reviewed and recorded on a monthly basis based on information provided by our regional sales managers as to the types of arrangements that have been made with our customers and are recorded on the balance sheet as an offset to trade receivables.  Actual dollar amounts associated with trade spending can vary with sales volumes achieved and other factors.  Accordingly, the ultimate liabilities associated with trade spending may materially differ from those recorded due to changes in estimates and actual results achieved.

 

Slotting Fees

Slotting fees refer to oral arrangements pursuant to which the retail grocer allows our products to be placed on the store’s shelves in exchange for a slotting fee. As reported in prior filings, slotting fees were initially recorded as a prepaid asset and the related expense was recognized ratably over a 12-month period beginning two months following product shipment as an offset to sales. Typically, 12 months is the estimated minimum period during which a retailer agrees to allocate shelf space.  However, given that there are no written contractual commitments requiring the retail grocers to allocate shelf space for twelve months, in fiscal 2004, we determined that it was a preferable accounting method to expense the slotting fees at the time the revenue is recognized.  Accordingly, there were no slotting fees included in prepaid assets at September 30, 2004, while $1.2 million was included at September 30, 2003.  The $1.2 million of slotting fees capitalized on our balance sheet at September 30, 2003 was expensed in the first quarter of fiscal 2004 as a change in accounting principle. 

 

Inventory Valuation Allowance

We regularly evaluate the realizability of our inventory based on a combination of factors including the following: historical usage rates, forecasted sales or usage, historical spoilage rates and other factors.  Raw materials are reviewed periodically by our operating personnel for spoilage.  Finished goods are reviewed periodically by operating personnel to determine if inventory carrying costs exceed market selling prices.  If circumstances related to our inventories change, our estimates of the realizability of inventory could materially change. Our inventory valuation allowance totaled $140,000 and $138,000 at September 30, 2004 and 2003, respectively.  We have not experienced material losses related to our inventories in the past and believe that the current level of valuation allowance is adequate.

 

Accounts Receivable and Allowances for Uncollectible Accounts

Credit limits are established through a process of reviewing the financial history and stability of each customer.  We regularly evaluate the collectibility of our trade receivable balances by monitoring past due balances.  If it is determined that a customer will be unable to meet its financial obligation, we record a specific reserve for bad debts to reduce the related receivable to the amount we expect to recover.  Historically, bad debts have not had a material effect on us.  If circumstances related to specific customers deteriorate, our estimates of the recoverability of receivables associated with those customers could materially change.

 

29

 

Off-Balance Sheet Arrangements

We do not have any off-balance sheet arrangements that have or are reasonably likely to have a material current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.

 

Item 7A.  Quantitative and Qualitative Disclosures About Market Risk

 

Amounts outstanding under our Loan Agreement bear interest at rates tied to the prime rate with a minimum rate of 10% on the term loan and 8% on the line of credit. At September 30, 2004, we had $4.9 million outstanding at an interest rate of 10% on the term loan and $4.8 million outstanding at an interest rate of 8% on the line of credit.  A hypothetical 10% increase in the prime rate would not have any effect on the interest rates currently being charged under the Loan Agreement because the prime rate would still be below the minimum rates charged on the term loan and line of credit.

 

Our Convertible Note is at a fixed interest rate and, therefore, a change in market interest rates would not affect interest expense related to the Convertible Note.

 

We do not currently utilize, nor do we anticipate utilizing, derivative financial instruments.

 

Item 8.  Financial Statements and Supplementary Data

 

The financial statements and notes thereto required by this item begin on page F-1 as listed in Item 15 of Part IV of this document. In fiscal 2004, we changed our accounting policy regarding accounting for slotting fees.  See Note 3. of Notes to Financial Statements.  In accordance with Accounting Principles Board Opinion (“APB”) 20, “Accounting Changes,” the cumulative effect of the change in accounting for slotting fees is reflected in the first quarter of fiscal 2004.  The unaudited quarterly results for the first, second and third quarters of fiscal 2004 are restated for this change in accounting policy as indicated below.  Unaudited quarterly financial data for each of the four quarters in the period ended September 30, 2004 is as follows:

 

In thousands, except per share data		1st Quarter (Restated)			2nd Quarter (Restated)			3rd Quarter (Restated)			4th Quarter
		(Unaudited)			(Unaudited)			(Unaudited)			(Unaudited)
2004
Net sales, as reported		$	10,761		$	12,584		$	14,240		$	10,787
Effect of change in accounting for slotting fees		9			330			(131		)	n/a
Net sales, as adjusted		10,770			12,914			14,109			10,787
Gross margin, as adjusted		4,206			4,792			5,177			2,132
Net loss applicable to common shareholders, as reported		(3,024		)	(2,519		)	(1,041		)	(4,500		)
Effect of change in accounting for slotting fees		(1,141		)	330			(131		)	n/a
Net loss applicable to common shareholders, as adjusted		(4,165		)	(2,189		)	(1,172		)	(4,500		)
Basic and diluted net loss per share applicable to common shareholders, as reported		(0.34		)	(0.28		)	(0.12		)	(0.50		)
Effect of change in accounting for slotting fees		(0.13		)	0.04			(0.01		)	n/a
Basic and diluted net loss per share applicable to common shareholders, adjusted(1)		(0.46		)	(0.24		)	(0.13		)	(0.50		)
2003
Net sales		$	8,989		$	12,408		$	15,040		$	13,010
Gross margin		3,364			4,367			6,551			4,456
Net loss applicable to common shareholders		(3,626		)	(2,476		)	(856		)	(3,832		)
Basic and diluted net loss per share applicable to common shareholders		(0.40		)	(0.28		)	(0.10		)	(0.43		)

 

(1)          Per share amounts may not add due to rounding.

 

30