SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
[X] QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
OF 1934 FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2004.
[ ] TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
OF 1934 FOR THE TRANSITION PERIOD FROM TO
-------------- ----------------
Commission File No. 333-22997
SPECTRUM ORGANIC PRODUCTS, INC.
----------------------------------------------------
(Exact name of Registrant as specified in its charter)
California 94-3076294
---------------------- ------------------------------
(State of incorporation) (I.R.S. Employer Identification
Number)
5341 Old Redwood Highway, Suite 400
Petaluma, California 94954 (707)778-8900
---------------------------- -------------------------
(Address of executive offices) (Issuer's telephone number)
Indicate by check mark whether the Registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Exchange Act during the past 12 months
(or for such shorter period that the Registrant was required to file such
reports), and (2) has been subject to such filing requirements for the past 90
days. Yes |X| No [ ]
Indicate by check mark whether the Registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2). Yes [ ] No |X|
APPLICABLE ONLY TO ISSUERS INVOLVED IN BANKRUPTCY
PROCEEDINGS DURING THE PRECEEDING FIVE YEARS:
Indicate by check mark whether the Registrant filed all documents and reports
required to be filed by Section 12, 13 or 15(d) of the Exchange Act after the
distribution of securities under a plan conformed by a court. Yes [ ] No [ ]
APPLICABLE ONLY TO CORPORATE ISSUERS:
State the number of shares outstanding of each of the issuer's classes of common
equity, as of the latest practicable date: Common Stock, no par value,
46,389,943 shares issued and outstanding as of November 8, 2004.
Transitional Small Business Disclosure Format: Yes [ ] No |X|
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
- -----------------------------
SPECTRUM ORGANIC PRODUCTS, INC.
BALANCE SHEETS
ASSETS
(Unaudited)
September 30, December 31,
2004 2003
------------ ------------
Current Assets:
Cash $ 7,500 $ 7,300
Accounts receivable, net 4,436,300 4,163,200
Inventories, net 9,843,000 8,007,200
Deferred income taxes - current 739,500 514,200
Prepaid expenses and other current assets 514,100 297,500
------------ ------------
Total Current Assets 15,540,400 12,989,400
Property and Equipment, net 4,841,300 4,338,700
Other Assets:
Deferred income taxes - long-term 797,000 1,087,700
Intangible assets, net 585,300 586,800
Other assets 228,600 218,300
------------ ------------
Total Assets $ 21,992,600 $ 19,220,900
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities:
Bank overdraft $ 121,400 $ 513,800
Line of credit 6,792,100 4,833,000
Accounts payable, trade 5,624,900 4,168,000
Accrued expenses 794,400 1,307,700
Current maturities of term notes payable and capital lease
obligations 420,700 322,300
Current maturities of notes payable, related parties 255,500 275,200
Income taxes payable -- 9,900
------------ ------------
Total Current Liabilities 14,009,000 11,429,900
Notes payable and capitalized lease obligations, less
current maturities 1,336,800 1,104,200
Notes payable, related parties, less current maturities 371,900 549,200
Deferred rent 40,400 50,700
------------ ------------
Total Liabilities 15,758,100 13,134,000
------------ ------------
Commitments and Contingencies
Stockholders' Equity:
Preferred stock, 5,000,000 shares authorized, no shares
issued or outstanding -- --
Common stock, no par value, 60,000,000 shares authorized,
46,386,943 and 46,254,777 issued and outstanding at
September 30, 2004 and December 31, 2003, respectively 9,625,400 9,579,500
Accumulated deficit (3,390,900) (3,492,600)
------------ ------------
Total Stockholders' Equity 6,234,500 6,086,900
------------ ------------
Total Liabilities and Stockholders' Equity $ 21,992,600 $ 19,220,900
============ ============
The accompanying notes are an integral part of the financial statements.
2
SPECTRUM ORGANIC PRODUCTS, INC.
STATEMENTS OF OPERATIONS
(Unaudited) (Unaudited)
Three Months Ended Nine Months Ended
Sept. 30, Sept. 30, Sept. 30, Sept. 30,
2004 2003 2004 2003
------------ ------------ ------------ ------------
Net Sales $ 12,189,400 $ 12,168,900 $ 37,733,900 $ 33,858,000
Cost of Goods Sold 9,411,700 9,069,100 29,093,900 24,719,800
------------ ------------ ------------ ------------
Gross Profit 2,777,700 3,099,800 8,640,000 9,138,200
------------ ------------ ------------ ------------
Operating Expenses:
Sales and Marketing 1,697,000 1,634,200 5,401,900 4,699,000
General and Administrative 932,500 959,300 2,836,300 2,774,500
------------ ------------ ------------ ------------
Total Operating Expenses 2,629,500 2,593,500 8,238,200 7,473,500
------------ ------------ ------------ ------------
Income from Operations 148,200 506,300 401,800 1,664,700
------------ ------------ ------------ ------------
Other Income (Expense):
Interest Expense (98,300) (164,200) (250,100) (317,200)
Other 3,900 -- 17,700 10,600
------------ ------------ ------------ ------------
Total Other Expenses (94,400) (164,200) (232,400) (306,600)
------------ ------------ ------------ ------------
Income Before Income Taxes 53,800 342,100 169,400 1,358,100
Provision for Income Taxes 21,500 16,800 67,700 81,200
------------ ------------ ------------ ------------
Net Income $ 32,300 $ 325,300 $ 101,700 $ 1,276,900
============ ============ ============ ============
Basic and Fully Diluted Income Per Share $ 0.00 $ 0.01 $ 0.00 $ 0.03
============ ============ ============ ============
Weighted Average Shares Outstanding 46,386,943 45,911,672 46,328,147 45,775,026
============ ============ ============ ============
Fully Diluted Average Shares Outstanding 48,278,211 48,146,790 48,629,181 46,768,085
============ ============ ============ ============
The accompanying notes are an integral part
of the financial statements.
3
SPECTRUM ORGANIC PRODUCTS, INC.
STATEMENTS OF CASH FLOWS
(Unaudited)
Nine Months Ended
Sept.30, Sept. 30,
2004 2003
------------ ------------
Cash Flows from Operating Activities:
Net Income $ 101,700 $ 1,276,900
Adjustments to Reconcile Net Income to Net
Cash used in Operating Activities:
Provision for uncollectible receivables 38,700 77,900
Provision for inventory obsolescence 168,100 132,000
Depreciation and amortization expense 460,900 350,200
Imputed interest on note payable, related party 15,200 14,200
Write-down of bottling equipment due to reconfiguration -- 53,000
Changes in Assets and Liabilities:
Accounts receivable (311,800) (1,295,700)
Inventories (2,003,900) (3,689,000)
Other assets (161,500) (148,500)
Accounts payable 1,456,900 1,618,400
Accrued expenses and other liabilities (533,400) (82,300)
------------ ------------
Net Cash Used in Operating Activities (769,100) (1,692,900)
------------ ------------
Cash Flows from Investing Activities:
Purchase of property and equipment (962,100) (1,152,200)
Purchase of intellectual property -- (275,000)
------------ ------------
Net Cash Used in Investing Activities (962,100) (1,427,200)
------------ ------------
Cash Flows from Financing Activities:
Decrease in bank overdraft (392,400) (573,800)
Proceeds from line of credit 16,413,300 31,762,000
Repayment of line of credit (14,454,200) (28,818,000)
Proceeds from note payable 554,100 1,495,200
Repayment of bank term notes payable (187,500) (491,300)
Repayment of capitalized lease obligations (35,500) (36,900)
Repayment of notes payable, related parties (212,300) (205,600)
Proceeds from exercise of common stock equivalents 45,900 70,700
------------ ------------
Net Cash Provided by Financing Activities 1,731,400 3,202,300
------------ ------------
Net Increase in Cash 200 82,200
Cash, beginning of the year 7,300 1,000
------------ ------------
Cash, end of the period $ 7,500 $ 83,200
============ ============
Supplemental Disclosure of Cash Flow Information:
Cash paid for income taxes $ 16,000 $ 311,000
Cash paid for interest $ 243,300 $ 313,900
Non-Cash Financing Activities:
Purchase of intellectual property with debt -- $ 275,000
The accompanying notes are an integral part
of the financial statements.
4
SPECTRUM ORGANIC PRODUCTS, INC.
NOTES TO FINANCIAL STATEMENTS
1. Basis of Presentation:
These are unaudited interim financial statements and include all
adjustments that, in the opinion of Management, are necessary in order to
make the financial statements not misleading. The financial statements have
been prepared in accordance with the instructions to Form 10-Q and do not
include certain disclosures required by accounting principles generally
accepted in the United States of America. Accordingly, the statements
should be read in conjunction with Spectrum Organic Products, Inc.'s
financial statements and notes thereto included in the Company's Annual
Report on Form 10-K for the year ended December 31, 2003. Operating results
for the nine month period ended September 30, 2004 are not necessarily
indicative of the results that may be expected for the entire year ending
December 31, 2004 or future periods.
Certain reclassifications have been made to the prior year unaudited
interim financial statements to be consistent with the presentation at
September 30, 2004. These reclassifications had no impact on net income or
retained earnings.
2. Nature of Operations and Business Segments:
Spectrum Organic Products, Inc. ("Spectrum", the "Registrant" or the
"Company") competes primarily in three business segments: natural and
organic foods under the Spectrum Naturals(R) brand, essential fatty acid
nutritional supplements under the Spectrum Essentials(R) brand, and
industrial ingredients for use by other manufacturers sold under the
Spectrum Ingredients name. The vast majority of the Company's products are
oil-based and the Company has positioned itself as "The Good Fats Company."
Within the natural and organic foods segment, the Company's products
include olive oils and other culinary oils, salad dressings, condiments and
butter-substitutes such as Spectrum Organic Margarine(R) and Spectrum
Spread(R). All of the Company's culinary products feature healthy fats,
contain no hydrogenated or trans fats and are offered in a variety of sizes
and flavors in both organic and conventional, non-GMO offerings.
Within the nutritional supplement segment, the Company's products include
organic flax oils, evening primrose oil, borage oil, Norwegian fish oil and
other essential fatty acids in both liquid and capsule forms. The Spectrum
Essentials(R) products are cold-pressed, nutritionally rich sources of
Omega-3 and Omega-6 essential fatty acids and are also offered in a variety
of sizes and styles.
The Spectrum Ingredients(R) (formerly known as Spectrum Commodities, Inc.)
segment includes organic and conventional non-GMO culinary oils, organic
vinegar, condiments and nutritional oils offered to other manufacturers for
use in their products. In addition, they bring incremental purchasing power
to the Company resulting in higher margins for the consumer branded
products.
Operating data is captured by segment to the gross profit level. However,
operating statement data below gross profit and balance sheet data have not
been disaggregated and captured by business segment since the information
is presently unavailable to the Company's chief operating decision maker.
5
Accordingly, the following segment information is currently captured by the
Company:
Three Months Ended September 30,
2004 2003 % Change
----------- ------------ ------------
Net Sales:
Spectrum Naturals(R) $ 6,069,200 $ 5,796,500 +5%
Spectrum Essentials(R) 2,281,100 2,761,100 -17%
Spectrum Ingredients/Other 3,839,100 3,611,300 +6%
----------- ------------ ------------
Total Net Sales $12,189,400 $ 12,168,900 --
=========== ============ ============
Gross Profit:
Spectrum Naturals(R) $ 1,259,000 $ 1,383,700 -9%
Spectrum Essentials(R) 1,082,900 1,232,300 -12%
Spectrum Ingredients/Other 435,800 483,800 -10%
----------- ------------ ------------
Total Gross Profit $ 2,777,700 $ 3,099,800 -10%
=========== ============ ============
Nine Months Ended September 30,
2004 2003 % Change
----------- ------------ ------------
Net Sales:
Spectrum Naturals(R) $17,979,100 $ 15,453,600 +16%
Spectrum Essentials(R) 7,080,400 7,737,700 -8%
Spectrum Ingredients/Other 12,674,400 10,666,700 +19%
----------- ------------ ------------
Total Net Sales $37,733,900 $ 33,858,000 +11%
=========== ============ ============
Gross Profit:
Spectrum Naturals(R) $ 4,179,300 $ 4,102,000 +2%
Spectrum Essentials(R) 3,091,500 3,606,800 -14%
Spectrum Ingredients/Other 1,369,200 1,429,400 -4%
----------- ------------ ------------
Total Gross Profit $ 8,640,000 $ 9,138,200 -5%
=========== ============ ============
3. Amendment to Loan and Security Agreement:
On June 4, 2004 the Company entered into the First Amendment (the
"Amendment") to the Loan and Security Agreement (the "Credit Facility")
with its primary lender, Comerica Bank. The Amendment provides the Company
with additional borrowing capacity and flexibility via four significant
changes to the Credit Facility:
a) The maturity date of the Credit Facility was extended an additional
twelve months to June 30, 2006.
b) The maximum borrowing available under the revolving line of credit was
increased from $7,000,000 to $9,000,000, subject to eligible collateral
levels.
c) The maximum borrowings available for eligible inventory under the
revolving line of credit was increased from $1,500,000 in excess of
eligible accounts receivable to $2,000,000 in excess of eligible
accounts receivable, or 60% of eligible inventory collateral, whichever
is less.
6
d) The drawdown period under the Company's $1,000,000 capital expenditures
term note was extended an additional six months to December 31, 2004.
During the nine months ended September 30, 2004 proceeds received under
this note were $554,100.
The Amendment continues to require that the Company meet various financial
covenants for 2004 and beyond related to profitability levels, debt service
coverage, and the ratio of total liabilities to tangible net worth. As of
September 30, 2004 the Company was in compliance with all requirements
under the Credit Facility.
4. Manufacturing Facility Relocation and Reconfiguration:
During the first quarter of 2004, the Company began to implement its plan
to relocate its SpectraVac manufacturing operation from its leased facility
at 133 Copeland Street, Petaluma, California to a leased facility located
in Cherokee, Iowa managed by American Natural Soy Processors, LLC ("ANS").
The SpectraVac operation utilizes the Company's intellectual property
purchased on April 15, 2003 for the benign extraction of oil from vegetable
seeds, and is currently used primarily for the production of flax oil.
The Company is replacing most of the equipment currently used in the
SpectraVac operation in Petaluma with new, more efficient equipment in
Cherokee. Production ceased at the Copeland Street facility on September
24, 2004 and the Company has disassembled and relocated most of the former
Petaluma equipment to Cherokee during the fourth quarter.
ANS will provide labor and management services to the Company for the
SpectraVac operation in Cherokee under contract. The Company will continue
to own the equipment and also intends to enter into other oil seed crushing
arrangements with ANS under a strategic alliance.
During the nine months ended September 30, 2004 capital spending in
Cherokee associated with the Iowa relocation was approximately $586,600.
Additionally, the Company incurred $171,000 in consulting and other
expenses associated with the relocation to Iowa, which was included in
general and administrative expense. The Company anticipates that additional
capital spending of approximately $150,000 and moving expenses of
approximately $250,000 will be incurred during the fourth quarter to
complete the relocation to Iowa.
5. Industrial Accident:
On February 4, 2004 the Company pleaded no contest to two misdemeanor
counts of violations under California Labor Code Section 6425 ("CLCS
6425"), violation of a regulation issued by the California Occupational
Health and Safety Administration ("CAL-OSHA"), requiring employers to
provide, maintain and ensure employees use required confined space
equipment. The plea arose in connection with a tragic production accident
on April 25, 2002 that resulted in the death of two of the Company's
employees. Under the Terms of Settlement and Probation entered into with
the plea, the Company agreed to pay a fine under CLCS 6425 of $150,000 in
three annual installments of $50,000 each on June 1, 2004, 2005 and 2006.
In addition the Company paid $150,000 in restitution to the California
District Attorneys Association Workers Safety Training Account to assist in
the prosecution of worker safety cases in the State of California. The
Company also reimbursed costs of $25,000 each to the Petaluma Police
Department, the Petaluma Fire Department and the Sonoma County District
Attorney's Office. Finally, an additional fine of $250,000 under CLCS 6425
was suspended conditioned upon the Company's compliance with the terms of
court supervised probation for three years. Accordingly, the Company
7
accrued an expense of $375,000 during the year ended December 31, 2003 to
cover the net present value of the above payments, plus attorney's fees.
Total payments made during the nine months ended September 30, 2004 in
connection with the plea were $275,000.
On May 25, 2004 the Company settled one of the appeals filed with the
Workers' Compensation Appeals Board for $35,000 which was paid on June 3,
2004 and charged against the industrial accident reserve.
As of September 30, 2004 the Company had a remaining reserve of $196,500 to
cover the two remaining installments of the fine under CLCS 6425 totaling
$100,000, the anticipated penalties from CAL-OSHA, and the remaining appeal
filed with the Workers' Compensation Appeals Board of California.
CAL-OSHA has completed their investigation of the accident and issued their
report and notice of proposed penalties on October 18, 2002. Their report
included nine citations for safety violations with total proposed penalties
of $137,900. There were no willful citations and the CAL-OSHA report
acknowledged that all the safety violations had been 100% abated prior to
the report's issuance. The Company has filed a formal appeal with CAL-OSHA
in the hopes of reducing the citations and proposed penalties.
The remaining workers compensation appeal is for an additional death
benefit equal to 50% of the eventual death benefit to be paid by the
Company's workers' compensation insurance carrier at the time of the
accident. That amount would be payable by the Company to the dependents of
the deceased worker if the dependents successfully establish that the
Company was guilty of serious and willful misconduct by allowing unsafe
working conditions to exist. If actually litigated, the workers
compensation appeal is an all-or-nothing proposition under which the
Company will either be liable for 50% of the eventual insurance death
benefit or nothing. Based on the advice of counsel, the Company expects the
remaining workers compensation appeal to be settled rather than litigated.
Management believes the remaining reserve of $196,500 will be approximately
adequate to cover the remaining two installments under the CLCS 6425 fine
of $50,000 each, the settlement of the CAL-OSHA penalties and the workers
compensation appeal.
6. Inventories:
Inventories consisted of the following:
Sept. 30, December 31,
2004 2003
----------- -----------
Finished goods $ 7,687,200 $ 6,853,400
Raw materials 2,233,300 1,166,100
Deposits on inventory 168,500 236,200
----------- -----------
Total Inventories 10,089,000 8,255,700
Less: Reserve for obsolete inventory 246,000 248,500
----------- -----------
Net Inventories $ 9,843,000 $ 8,007,200
=========== ===========
Deposits on inventory primarily represent flaxseed paid for prior to its
receipt at the Company's production facility.
8
7. Bottling Equipment Relocation and Reconfiguration:
On July 14, 2003 the Company disassembled its bottling line at its leased
manufacturing facility located at 133 Copeland Street, Petaluma, California
and relocated and reconfigured the line at its new co-packer, Interpac
Technologies, Inc. ("Interpac"), also located in Petaluma, California.
Interpac provides custom bottling services to the Company under contract,
utilizing the Company's bottling equipment.
The bottling line was reconfigured for better efficiency and higher
bottling speeds and included a new labeler and new conveying equipment. As
a result, there was $53,000 included in cost of sales for the prior year
for equipment at Copeland Street which was written down to its estimated
market value or scrapped rather than being relocated.
8. Commitments and Contingencies:
Pending Litigation - Proposition 65 Complaint
On November 26, 2003 the Company was notified by attorneys for the
Environmental Law Foundation (the "ELF") that the Spectrum Naturals(R)
Organic Balsamic Vinegar contains lead in excess of the allowable
quantities under the Safe Drinking Water and Toxic Enforcement Act of 1986,
also known as Proposition 65. The ELF is a California non-profit
organization that represents itself as dedicated to the preservation of
human health and the environment.
ELF's attorneys filed a Complaint for Civil Penalties, Statutory, Equitable
and Injunctive Relief (the "Complaint") against Cost Plus, Inc., Safeway,
Inc., Trader Joe's Company, Williams-Sonoma, Inc., Whole Foods, Inc. and
unspecified defendants one through 100 in the Superior Court of the State
of California on May 20, 2003 alleging violation of Proposition 65 for the
sale of various products that contain lead in excess of the allowable
limits without the required warning label. ELF's attorneys later notified
Spectrum and dozens of other retailers, importers and manufacturers of
vinegar that they would be included as one of the 100 unspecified
defendants in the Complaint.
While lead has been shown to cause cancer and reproductive toxicity in
humans, the Proposition 65 consumption quantity defined as no significant
risk level for cancer was set at 15 micrograms per day. Lead is a naturally
occurring element in all vinegars. Based on the Company's tests, a person
would need to consume somewhere between 1.3-2.6 cups (270-630ml) daily of
the Company's various vinegar products to reach the Proposition 65 lead
level. The small lead content in vinegar occurs naturally in the soil and
is absorbed by the grapes used to make vinegar. The level of lead in
vinegar is not affected by the manufacturing process and, therefore, is not
subject to regulation under Proposition 65.
The Spectrum Naturals(R) brand was built on the premise of providing
consumers with organic healthy oils and condiments. Management does not
believe the consumption of its various vinegar products as condiments or
salad dressings poses any increased risk for cancer or reproductive
toxicity.
The Company has joined a Joint Defense Group established by attorneys
representing several of the defendants in the Complaint. Total attorney's
fees incurred by the Company as a member of the Joint Defense Group for the
nine months ended September 30, 2004 were $11,000. Management believes the
Complaint will eventually be shown to be without merit. Accordingly, no
provision for loss or future attorney's fees has been recorded at September
30, 2004.
9
Pending Litigation - Patent Infringement Complaint
The Company was previously involved in a dispute with GFA Brands, Inc.
("GFA") that the Spectrum Naturals(R) Organic Margarine was infringing upon
two patents issued in the United States that pertain to particular oil
compositions suitable for human consumption. The patents were granted to
Brandeis University, which exclusively licensed them to GFA. The Company
withdrew the margarine from the market and began to evaluate reformulating
the product while pursuing its rights against GFA. On August 28, 2001 the
Company filed a complaint against GFA for declaratory judgment of
non-infringement and invalidity of the patents.
On August 30, 2004 the case was settled via a joint stipulation to dismiss
all claims without prejudice to either party since the Spectrum Naturals(R)
Organic Margarine remains off the market while the Company and its copacker
evaluate the reformulated product. Management continues to believe that the
original formula for the margarine fell outside the claims made in the
Brandeis University patents and that the patents should be declared
invalid. However, the Company cannot justify the excessive legal expenses
associated with patent infringement litigation.
Court Supervised Probation
In connection with the industrial accident on April 25, 2002 the Company
entered a plea on February 4, 2004 of no contest to two misdemeanor counts
of violations under CLCS 6425, violation of a regulation issued by the
California Occupational Health and Safety Administration requiring
employers to provide, maintain and ensure employees use required confined
space equipment. Under the Terms of Settlement and Probation entered into
with the plea, the Company received a suspended fine of $250,000
conditioned upon the Company's compliance with the terms of court
supervised probation for three years. The probation terms require that the
Company submit to a warrant-less search of its premises during business
hours by any local or state law enforcement, safety or health officer; and
that the Company shall be of good conduct and obey all laws, particularly
those laws relating to worker safety and health. Should the Company fail to
honor the probation terms, the suspended fine of $250,000 may be reimposed
by the Sonoma County District Attorney.
9. Stock-based Compensation:
Statement of Financial Accounting Standards ("SFAS") No. 148, "Accounting
for Stock-Based Compensation-Transition and Disclosure" ("SFAS 148") issued
in December 2002 provides alternative methods of accounting for a voluntary
transition to the fair value method of accounting for stock-based employee
compensation as prescribed in SFAS 123, "Accounting for Stock-Based
Compensation" ("SFAS 123"). Additionally, SFAS 148 requires more prominent
and more frequent disclosures in financial statements of the effects of
stock based compensation effective for fiscal years ending after December
15, 2002. As permitted under SFAS 123, the Company has chosen to continue
to account for employee stock-based compensation using the intrinsic value
method prescribed in Accounting Principles Board Opinion No. 25,
"Accounting for Stock Issued to Employees" ("APB 25"). Accordingly,
compensation expense for employee stock options is measured as the excess,
if any, of the fair market price of the Company's stock at the date of
10
grant over the amount an employee must pay to acquire the stock. Options
granted to non-employees are recorded over the service period at the
estimated fair value of the option granted.
All stock options issued to employees have an exercise price not less than
the fair market value of the Company's common stock on the date of grant.
In accordance with the accounting for such options utilizing the intrinsic
value method prescribed in APB 25, there is no related compensation expense
recorded in the Company's financial statements. Had compensation cost for
stock-based compensation been determined based on the fair value of the
options at the grant dates consistent with SFAS 123, the Company's net
income or loss and net income or loss per share for the three and nine
month periods ended September 30, 2004 and 2003 would have been adjusted to
the pro-forma amounts presented below:
Three Months Ended Nine Months Ended
------------------------ ------------------------
Sept. 30, Sept. 30, Sept. 30, Sept. 30,
2004 2003 2004 2003
---------- ---------- ---------- ----------
Net income as reported $ 32,300 $ 325,300 $ 101,700 $1,276,900
Less: Total compensation expense under
fair value method for all stock-based
awards, net of related tax effects 105,100 74,300 270,600 226,600
---------- ---------- ---------- ----------
Pro-Forma net income (loss) $ (72,800) $ 251,000 $ (168,900) $1,050,300
========== ========== ========== ==========
Basic and diluted income (loss) per share:
As reported $ 0.00 $ 0.01 $ 0.00 $ 0.03
Pro-forma $ (0.00) $ 0.01 $ (0.00) $ 0.02
The fair value of the option grants for 2004 was estimated on the date of
grant utilizing the Black-Scholes option pricing model, with the following
assumptions: expected life of five years, risk-free interest rate of 2.0%,
no dividend yield and volatility of 95%. The weighted average fair value of
the option grants during 2004 was $0.61 per share.
The fair value of the option grants for 2003 was estimated on the date of
grant utilizing the Black-Scholes option pricing model, with the following
assumptions: expected life of five years, risk-free interest rate of 2.5%,
no dividend yield and volatility of 115%. The weighted average fair value
of the option grants during 2003 was $0.25 per share.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
- -------------------------------------------------------------------------------
General:
The following discussion should be read in conjunction with the financial
statements and related notes and other information included in this report. The
financial results reported herein are not necessarily indicative of the
financial results that may be achieved by the Company in any future period.
The Company's operating results could vary from period to period as a result of
a number of factors. These factors include, but are not limited to, the
purchasing patterns of significant customers, the timing of new product
introductions by the Company and its competitors, the amount of slotting fees,
11
new product development and advertising expenses incurred by the Company,
variations in sales by distribution channel, fluctuations in market prices and
availability of raw materials, competitive pricing policies and situations that
the Company cannot foresee. These factors could cause the Company's performance
to differ from investor expectations, resulting in volatility in the price of
the common stock.
Investors should carefully consider the following information as well as other
information contained in this report. Information included in this report
contains "forward-looking statements" which can be identified by the use of
forward-looking terminology such as "believes," "expects," "may," "should" or
"anticipates" or the negative thereof or other variations thereon or comparable
terminology, or by discussions of strategy. No assurance can be given that the
future results covered by the forward-looking statements will be achieved. The
following matters constitute cautionary statements identifying important factors
with respect to such forward-looking statements, including certain risks and
uncertainties that could cause actual results to vary materially from the future
results covered in such forward-looking statements. Other factors could also
cause actual results to vary materially from the future results covered in such
forward-looking statements.
Introduction:
Spectrum Organic Products, Inc. ("Spectrum", the "Company", or the "Registrant")
competes primarily in three segments: natural and organic foods sold under the
Spectrum Naturals(R) brand, nutritional supplements sold under the Spectrum
Essentials(R) brand, and industrial ingredients sold by the Spectrum Ingredients
sales force for use by other manufacturers. The vast majority of the Company's
products are oil-based and the Company has positioned itself as "The Good Fats
Company."
Within the Spectrum Naturals(R) brand, the Company's products include olive oil
and other culinary oils, salad dressings, condiments and butter-substitutes such
as Spectrum Organic Margarine(R) and Spectrum Spread(R). All of the Company's
culinary products feature healthy oils, contain no hydrogenated fats and are
offered in a variety of sizes and flavors in both organic and conventional
offerings.
Within the Spectrum Essentials(R) brand, the Company's products include organic
flax oil, borage oil, Norwegian fish oil and other essential fatty acids in both
liquid and capsule forms. The Spectrum Essentials(R) products are cold-pressed,
nutritionally rich sources of Omega-3 and Omega-6 essential fatty acids and are
also offered in a variety of sizes and styles.
The Spectrum Ingredients (formerly known as Spectrum Commodities, Inc.) sales
force offers organic culinary oils, vinegar and nutritional oils to other
manufacturers for use in their products. In addition, they bring incremental
purchasing power to the Company resulting in higher margins for the consumer
branded product lines.
Critical Accounting Policies and Estimates:
The following discussion and analysis of the Company's financial condition and
results of operations is based upon the Company's financial statements, which
have been prepared in accordance with accounting principles generally accepted
in the United States of America. The preparation of these financial statements
requires the Company to make estimates and judgments that affect the reported
amounts of assets, liabilities, revenues and expenses. The Company bases its
estimates on historical experience and various other assumptions that are
12
believed to be reasonable under the circumstances, the results of which form the
basis for the carrying values of assets and liabilities that are not readily
apparent from other sources. On an on-going basis, the Company re-evaluates all
of its estimates, including those related to accounts receivable allowances,
inventory reserves, the industrial accident reserve and the deferred tax asset
valuation allowance. Actual results may differ materially from these estimates
under different assumptions or conditions and as additional information becomes
available in future periods.
The Company believes the following are the more significant judgments and
estimates used in the preparation of its financial statements:
Accounts Receivable Allowances - The Company provides allowances against
accounts receivable for estimated bad debts, returns and deductions by customers
for trade promotions and programs. These allowances are based upon the Company's
historical experience with bad debt write-offs, customer deductions, customer
creditworthiness, payment trends and general economic conditions. Allowances for
bad debts and customer deductions were $485,300 at September 30, 2004 on gross
trade accounts receivable of $4,876,000. While this estimate is one of the more
significant estimates the Company makes in the preparation of its financial
statements, Management does not consider it to be highly uncertain.
Inventory Reserves - The Company establishes reserves for obsolete, excess and
slow-moving inventories in order to properly value its inventory at the lower of
cost or market. The reserve estimates are based upon historical inventory usage,
spoilage, current market conditions, and anticipated future demand. Reserves for
obsolete inventories were $246,000 at September 30, 2004 on total gross
inventories of $10,089,000. While this estimate is one of the more significant
estimates the Company makes in the preparation of its financial statements,
Management does not consider it to be highly uncertain.
Industrial Accident Reserve - During the fourth quarter of 2003 the Company
accrued an expense of $375,000 to record the Terms of Settlement and Probation
(the "Settlement") entered into on February 4, 2004 with the Sonoma County
District Attorney's Office with regards to an industrial accident that occurred
on April 25, 2002 (see Note 5 to the financial statements). As of September 30,
2004 the industrial accident reserve remaining was $196,500. In addition to
covering the Settlement, the reserve also covers the estimated settlement of
citations and fines from CAL-OSHA, the remaining application to the Workers'
Compensation Appeals Board of the State of California for serious and willful
misconduct penalties to be levied against the Company, and attorney's fees. This
reserve is highly uncertain because the CAL-OSHA proposed fines of $137,900 have
been appealed and the application to the Workers' Compensation Appeals Board for
serious and willful misconduct penalties, if litigated, is an all-or-nothing
proposition under which the Company will either be liable for 50% of the
eventual death benefit to be paid by the Company's workers' compensation
insurance carrier at the time of the accident or nothing. The Company does not
anticipate that the workers' compensation appeal will be litigated based upon
the advice of its attorneys; however expenses in excess of the reserve could be
incurred if the worker's compensation appeal is litigated.
Deferred Tax Asset Valuation Allowance - As of December 31, 2003 the Company had
net deferred tax assets of $1,601,900 primarily resulting from net operating
loss carryforwards ("NOLs"), which consisted of $4,431,000 of Federal NOLs that
expire at various times through 2020, and $3,150,000 of state NOLs that expire
at various times through 2010. The majority of the NOLs originated from the
pre-merger operations of the Company's predecessor entity, Organic Food
Products, Inc. ("OFPI"). As a result of OFPI's acquisition by Spectrum, OFPI
13
experienced an ownership change in excess of 50% for federal and state income
tax purposes. Therefore, an annual limitation is placed by the taxing
authorities on the Company's right to realize the benefit of the pre-merger
NOLs. Management eliminated the deferred tax asset valuation reserve that had
been maintained since the 1999 merger as of December 31, 2003. The Company has
reported taxable income to the various taxing authorities for 2001, 2002 and
2003. The reserve was reversed because Management believes that it is more
likely than not that the Company will continue to report sufficient taxable
income in the foreseeable future, allowing utilization of 100% of its deferred
tax assets. Management will continue to evaluate the Company's deferred tax
assets in the future to determine whether a deferred tax asset reserve should be
reinstated at some future point.
- --------------------------------------------------------------------------------
Results of Operations for the Three Month Periods Ending September 30, 2004 and
September 30, 2003
- --------------------------------------------------------------------------------
Summary Discussion:
In general, the Company continued to benefit from the ongoing trend away from
hydrogenated culinary oils towards a healthier alternative during the third
quarter. The Company's Spectrum Naturals(R) brand of expeller-pressed oils,
condiments and butter substitutes delivered 5% net sales growth in the third
quarter. Additionally, small and medium sized food manufacturers continued their
push to eliminate partially hydrogenated oils from their products which drove
the Spectrum Ingredients industrial sales up 6% versus the prior year.
The Spectrum Essentials(R) brand of nutritional supplements posted a decline in
net sales of 17% versus the prior year, primarily as a result of the Company's
new Fresh and Cold program instituted during the third quarter. The Fresh and
Cold program features an Every Day Low Pricing concept and requires the
Company's distributors to handle the Spectrum Essentials(R) products like a
perishable product line. Previously, distributors purchased forward when the
Spectrum Essentials(R) brand was on promotion. This resulted in older product on
the retail shelf, which left the Company at a disadvantage versus its primary
competitor in the category which ships direct to retail. The Fresh and Cold
program discontinued the practice of occasionally promoting the Spectrum
Essentials(R) brand and required distributors to reduce their inventories to
approximately a thirty day supply. This one-time inventory adjustment by
distributors was the primary cause behind the 17% reduction in net sales for
Spectrum Essentials(R) versus the prior year. Sales of the Spectrum
Essentials(R) products are expected to return to normal levels during the fourth
quarter and beyond.
The Company reported net income of $32,300 for the third quarter, which was down
90% versus the prior year. The reduced profitability was primarily due to margin
pressure on the Spectrum Naturals(R) and Spectrum Ingredients product lines as a
result of increased costs for certain key organic raw materials such as olive
oil and canola oil. Gross margin overall (gross profit expressed as a percentage
of net sales) was down almost three points versus the prior year. The Company
increased its selling prices in certain culinary product lines for the third
time this year on August 15, 2004.
14
Looking ahead, the Company expects its gross margins to improve versus the 22.8%
achieved during the third quarter as a result of a number of initiatives that
are expected to improve performance in this area during 2005:
1. The Company will begin to produce flax oil in the new Iowa facility
during the fourth quarter, which will result in improved margins for
the Spectrum Essentials(R) segment.
2. During the fourth quarter and beyond, the Company will enjoy the
benefits afforded by all three of the price increases executed on the
culinary product lines during 2004.
3. The Company is currently evaluating the possibility of a hedging and
futures program for certain key raw materials as well as certain
foreign currencies.
4. The Company intends to complete the investments in cooperage and
equipment required at the new Iowa facility to crush certain key
culinary oilseeds for the first time in its history, resulting in
lower cost of goods for the Spectrum Naturals(R) and Spectrum
Ingredients segments.
5. Finally, the Company's sales mix was particularly unfavorable during
the third quarter as a result of the Fresh and Cold program, which
required a one-time reduction of trade inventories of the Spectrum
Essentials(R) products, the Company's highest margin segment. The
extent of the unfavorable sales mix for the third quarter is not
expected to recur.
Also contributing to the reduced net income for the third quarter was increased
spending on several new sales and marketing initiatives in 2004. In particular,
there was increased spending on the Company's new advertising campaign, the
Fresh and Cold program and the re-positioning of the Spectrum Essentials(R) line
with new packaging.
Management believes that Earnings Before Interest, Taxes, Depreciation and
Amortization ("EBITDA") is an important measure of the Company's operating
performance. Management incentive compensation is earned, in part, based on the
achievement of EBITDA targets that are established and approved by the Company's
Compensation Committee of the Board of Directors prior to the beginning of the
year. For the three months ended September 30, 2004 EBITDA was $310,800 compared
to $645,200 for the prior year, a decrease of $334,400 or 52%. The reduced
performance in 2004 is discussed in detail below, but was primarily attributable
to decreased gross profit and increased sales and marketing expenses.
While Management believes that EBITDA is a useful measure of the Company's
financial performance, it should not be construed as an alternative to income
from operations, net income or cash flows from operating activities as
determined in accordance with accounting principles generally accepted in the
United States of America. Furthermore, the Company's calculation of EBITDA may
be different from the calculation used by other companies, thereby limiting
comparability.
15
The Company's calculations to arrive at EBITDA are detailed in the following
table:
Three Months Ended
Sept. 30,
2004 2003
-------- --------
Net income $ 32,300 $325,300
Add back: Provision for income taxes 21,500 16,800
Interest expense 98,300 164,200
Depreciation and amortization expense 158,700 138,900
-------- --------
EBITDA $310,800 $645,200
======== ========
The following is Managements' discussion and analysis of the significant line
items within the financial statements and the reasons behind the trends and
variances versus the prior year.
Revenues:
Spectrum's net sales for the third quarter were $12,189,400 compared to
$12,168,900 for 2003, an increase of $20,500 or less than 1%. The increase is
detailed by segment in the following table:
Three Months Ended September 30,
2004 2003 % Change
----------- ----------- -----------
Spectrum Naturals(R) Culinary Products $ 6,069,200 $ 5,796,500 +5%
Spectrum Essentials(R) Nutritional Supplements 2,281,100 2,761,100 -17%
Spectrum Ingredients/Other 3,839,100 3,611,300 +6%
----------- ----------- -----------
Total Net Sales $12,189,400 $12,168,900 --
=========== =========== ===========
Within the Spectrum Naturals(R) culinary products, sales were significantly
higher than prior year in olive oil (+24%), food service oils (+15%) and vinegar
(+10). The Company's culinary oils continued to benefit from increased consumer
awareness of the importance of avoiding hydrogenated oils.
Spectrum Essentials(R) nutritional supplement sales decreased 17% versus the
prior year, primarily as a result of the Fresh and Cold program and the related
one-time reduction in distributor inventory levels. Packaged liquid supplements,
which encompass the majority of the Spectrum Essentials(R) line, decreased by
24% versus the prior year. Sales of encapsulated nutritional supplements,
primarily flax and fish oil, increased 7% versus the prior year as a result of
increased demand for fish oil. The Company anticipates continued strong demand
for its fish oil products in the near future as health practitioners continue to
extol the benefits of Omega-3 supplementation of one's diet via fish oil.
The Spectrum Ingredients sales increased 6% versus the prior year on the
strength of increased industrial demand for non hydrogenated oils. Many small
and mid-sized food manufacturers are eliminating partially hydrogenated oils
from their products, which lends itself directly to the Spectrum Ingredients
product offerings. The Company expects this to continue as the FDA-mandated
disclosure of trans fats on packaged food labels takes effect on January 1,
2006.
16
Cost of Goods Sold:
The Company's cost of goods sold for the third quarter was $9,411,700 versus
$9,069,100 for the prior year, an increase of 4%. The increase was primarily
volume-related with respect to the Spectrum Essentials(R) segment and both
volume and rate driven in the Spectrum Naturals(R) and Spectrum Ingredients(R)
segments, as detailed in the following table:
Three Months Ended September 30,
2004 2003 % Change
---------- ---------- ----------
Spectrum Naturals(R) Culinary Products $4,810,200 $4,412,800 +9%
Spectrum Essentials(R) Nutritional Supplements 1,198,200 1,528,800 -22%
Spectrum Ingredients/Other 3,403,300 3,127,500 +9%
---------- ---------- ----------
Total Cost of Goods Sold $9,411,700 $9,069,100 +4%
========== ========== ==========
Cost of goods sold as a percent of net sales increased to 77.2% in 2004 versus
74.5% in 2003. The increase was primarily due to increased raw material costs in
most of the Company's culinary product lines and an unfavorable sales mix that
featured a higher concentration of Spectrum Ingredients products, the Company's
lowest margin items and an unusually low concentration of Spectrum Essentials(R)
products, the Company's highest margin items, as a result of the Fresh and Cold
program. Imported olive oil from Europe was sharply higher than the prior year
as a result of the dollar's weakness versus the euro, which drove the cost of
the Spectrum Naturals(R) packaged olive oils up. Organic canola oil, a key raw
material in many of the culinary products, was also higher as a result of
increased demand and the dollar's weakness versus the Canadian dollar. Partially
offsetting the higher raw material costs on the culinary products was lower
flaxseed costs which have returned to historically normal levels. As a result,
the Spectrum Essentials(R) cost of goods sold as a percent of net sales was
three points less than the prior year. The Company expects to maintain gross
margins near 50% for the Spectrum Essentials(R) segment for the foreseeable
future.
Gross Profit:
Gross profit for the third quarter was $2,777,700 versus $3,099,800 for the
prior year, a decrease of 10%. The decrease was primarily attributable to the
raw material cost increases described above, partially offset by volume
increases in the Spectrum Naturals(R) and Spectrum Ingredients segments, as
detailed in the following table:
Three Months Ended September 30,
2004 2003 % Change
---- ---- ----------
Spectrum Naturals(R) Culinary Products $1,259,000 $ 1,383,700 - 9%
Spectrum Essentials(R) Nutritional Supplements 1,082,900 1,232,300 -12%
Spectrum Ingredients/Other 435,800 483,800 -10%
---------- ----------- ----------
Total Gross Profit $2,777,700 $ 3,099,800 -10%
========== =========== ==========
Gross profit as a percent of net sales (gross margin) was 22.8% for 2004 versus
25.5% for 2003, primarily as a result of the increased raw material costs in the
Company's culinary product lines and the unfavorable sales mix.
17
Sales and Marketing Expenses:
The Company's sales and marketing expenses for the third quarter were $1,697,000
or 13.9% of net sales, versus $1,634,200 or 13.4% of net sales for the prior
year. The increase in spending of $62,800 is detailed in the following table
which reconciles sales and marketing spending for the third quarter of 2004
versus 2003, and discloses the significant variances by spending category:
Total sales and marketing expenses, third quarter 2003 $ 1,634,200
Increased advertising 101,300
Increased compensation and benefits 59,600
Decreased broker commissions (51,300)
Decreased trade show and public relations spending (44,300)
All other, net (2,500)
-----------
Total sales and marketing expenses, third quarter 2004 $ 1,697,000
===========
The increased advertising spending was related to the launch of the new "I am
Spectrum" campaign for 2004. The increased compensation and benefits was
attributable to increased staffing in the Marketing Department. The decreased
broker commissions were related to the decreased sales of the Spectrum
Essentials(R) products. The decreased trade show and public relations expenses
were primarily due to the timing of the Expo-East trade show, which fell in
September 2003 versus October 2004.
General and Administrative Expenses:
The Company's general and administrative expenses for the third quarter were
$932,500 or 7.7% of net sales, versus $959,300 or 7.9% of net sales for the
prior year. The decrease in spending of $26,800 is detailed in the following
table which reconciles general and administrative spending for the third quarter
of 2004 versus 2003, and discloses significant variances by spending category:
Total general and administrative expenses, third quarter 2003 $ 959,300
Iowa relocation expenses 30,800
Decreased compensation and benefits expense (55,500)
All other, net (2,100)
---------
Total general and administrative expenses, third quarter 2004 $ 932,500
=========
The Iowa relocation expenses were primarily associated with consulting in
conjunction with the Company's relocation of its manufacturing facility to
Cherokee, Iowa. The decreased compensation and benefits expense was primarily
associated with reduced accruals in 2004 for incentive compensation as a result
of the lower profitability of the Company versus the prior year.
Interest Expense:
The Company's interest expense for the third quarter was $98,300 versus $164,200
for the prior year. The decrease of $65,900 (40%) was primarily attributable to
the early termination expense in the prior year of $70,400 associated with the
change in primary lenders on July 11, 2003. The Company paid a one-time fee of
$62,400 to its former primary lender and wrote-off the remaining unamortized
loan fee of $8,000 associated with that loan and security agreement.
18
Provision for Income Taxes:
The Company recorded a provision for income taxes of $21,500 for the three
months ended September 30, 2004 versus a provision for state income taxes of
$16,800 for the prior year. The provision for 2004 was estimated at 40% of the
Company's income before taxes.
- --------------------------------------------------------------------------------
Results of Operations for the Nine Month Periods Ending September 30, 2004 and
September 30, 2003
- --------------------------------------------------------------------------------
Summary Discussion:
In general, the Company continued to deliver strong sales growth on the culinary
side of the business for the nine months ended September 30, 2004. Net sales
growth versus the prior year was 19% for the Spectrum Ingredients segment and
16% for the Spectrum Naturals(R) segment, as both industrial customers and the
retail consumer continued their shift toward non-hydrogenated oils. The Spectrum
Essentials(R) segment net sales were down 8% versus the prior year, primarily as
a result of the Fresh and Cold program and increased competition in the organic
flax oil category.
The Company reported net income of $101,700 for the nine months ended September
30, 2004, a decline of 92% versus the prior year. The decline was primarily due
to margin pressure in all three segments as a result of increased costs for
certain key organic raw materials such as canola oil and olive oil. Gross margin
overall was down four points versus the prior year as a result of the increased
raw material costs and a particularly unfavorable sales mix as a result of the
Fresh and Cold program, which required a one-time reduction of trade inventories
of the Spectrum Essentials(R) products, the Company's highest margin segment.
The Company has taken three separate price increases within the Spectrum
Naturals(R) segment; the most recent was effective on August 15, 2004. The
Company is planning a price increase of the Spectrum Naturals(R) products for
the Canadian market to be effective on January 1, 2005. Despite these price
increases, Management has been unable to pass on all of its cost increases to
consumers.
Management anticipates that margins will improve in 2005 as a result of several
initiatives. In addition to the actions described in managements' discussion and
analysis of the results of operations for the third quarter, the following are
additional items that had a detrimental impact on gross margins during the nine
months ended September 30, 2004 that are not expected to recur:
1. During the first four months of 2004, the Company sold through all the
high cost Chinese flax seed purchased during 2003. Since then, the
Company's raw material cost for flaxseed has been 40%-50% less.
2. The commodity cycle has been particularly unfavorable during 2004,
with the edible fats and oils index hitting a twenty year high as a
result of increased demand, short crops and transportation and
importation cost increases. Like all commodity cycles, the Company
anticipates a reversion to the mean to eventually occur, primarily due
to factors outside its control, such as weather and crop harvest
sizes.
Management believes that Earnings Before Interest, Taxes, Depreciation and
Amortization ("EBITDA") is an important measure of the Company's operating
performance. For the nine months ended September 30, 2004 EBITDA was $880,400
19
compared to $2,025,500 for the prior year, a decrease of $1,145,100 or 57%. The
reduced EBITDA in 2004 is discussed in detail below, but was primarily
attributable to decreased gross profit and increased sales and marketing
expenses.
While Management believes that EBITDA is a useful measure of the Company's
financial performance, it should not be construed as an alternative to income
from operations, net income or cash flows from operating activities as
determined in accordance with accounting principles generally accepted in the
United States of America. Furthermore, the Company's calculation of EBITDA may
be different from the calculation used by other companies, thereby limiting
comparability.
The Company's calculations to arrive at EBITDA are detailed in the following
table:
Nine Months Ended Sept. 30,
2004 2003
----------- -----------
Net income $ 101,700 $ 1,276,900
Add back: Provision for income taxes 67,700 81,200
Interest expense 250,100 317,200
Depreciation and amortization expense 460,900 350,200
----------- -----------
EBITDA $ 880,400 $ 2,025,500
=========== ===========
The following is Management's discussion and analysis of the significant line
items within the financial statements and the reasons behind the trends and
variances versus the prior year.
Revenues:
Spectrum's net sales for the nine months ended September 30, 2004 were
$37,733,900 compared to $33,858,000 for 2003, an increase of $3,875,900 or 11%.
The increase is detailed by segment in the following table:
Nine Months Ended September 30,
2004 2003 % Change
---- ---- -----
Spectrum Naturals(R) Culinary Products $ 17,979,100 $ 15,453,600 +16%
Spectrum Essentials(R) Nutritional Supplements 7,080,400 7,737,700 -8%
Spectrum Ingredients/Other 12,674,400 10,666,700 +19%
------------ ------------ ------
Total Net Sales $ 37,733,900 $ 33,858,000 +11%
============ ============ ======
Within the Spectrum Naturals(R) culinary products, sales were significantly
higher than prior year in olive oil (+46%), food service oils (+22%), packaged
culinary oils (+15%), vinegar (+24%) and mayonnaise (+9%). The Company's
culinary oils continued to benefit from increased consumer awareness of the
importance of avoiding hydrogenated oils.
Spectrum Essentials(R) nutritional supplement sales decreased 8% versus the
prior year, primarily as a result of the Fresh and Cold program which entailed a
one-time reduction in trade inventory levels in order to improve the freshness
of product at the retail shelf. Also contributing to the lower sales was
increased competition in the organic flax oil category. Packaged liquid
supplements, which encompass the majority of the Spectrum Essentials(R) line,
decreased by 13% versus the prior year. Sales of encapsulated nutritional
20
supplements, primarily flax and fish oil, increased 16% versus the prior year on
the strength of increased consumer demand for fish oil. The increased demand for
fish oil is expected to continue in the foreseeable future due to increased
mainstream media coverage of the benefits of Omega-3 diet supplementation with
cold water fish oils.
The Spectrum Ingredients sales were up 19% versus the prior year on the strength
of increased customer demand for non hydrogenated oils. Many small and mid-sized
food manufacturers are eliminating partially hydrogenated oils from their
products, which lends itself directly to the Spectrum Ingredients product
offerings. This trend is expected to continue as the FDA-mandated disclosure of
trans fats on packaged food labels becomes effective on January 1, 2006.
Cost of Goods Sold:
The Company's cost of goods sold for the nine months ended September 30, 2004
was $29,093,900 versus $24,719,800 for the prior year, an increase of 18%. The
increase was primarily volume-related with respect to the Spectrum Ingredients
segment and both volume and rate driven in the Spectrum Naturals(R) and Spectrum
Essentials(R) segments, as detailed in the following table:
Nine Months Ended September 30,
2004 2003 % Change
---- ---- ----------
Spectrum Naturals(R) Culinary Products $13,799,800 $11,351,600 +22%
Spectrum Essentials(R) Nutritional Supplements 3,988,900 4,130,900 -3%
Spectrum Ingredients/Other 11,305,200 9,237,300 +22%
----------- ----------- -----------
Total Cost of Goods Sold $29,093,900 $24,719,800 +18%
=========== =========== ===========
Cost of goods sold as a percent of net sales increased to 77.1% in 2004 versus
73.0% in 2003. The increase was primarily due to increased raw material costs in
most of the Company's consumer packaged product lines and an unfavorable sales
mix that featured a higher concentration of Spectrum Ingredients products, the
Company's lowest margin items. Raw material costs were higher in the Company's
Spectrum Essentials(R) products as the remaining high cost flaxseed purchased
from China in 2003 sold through during the first four months of 2004. Imported
olive oil from Europe was sharply higher than the prior year as a result of the
dollar's weakness versus the euro, which drove the cost of the Spectrum
Naturals(R) packaged olive oils up. Finally, organic canola oil, a key raw
material in many of the culinary products, was also higher as a result of
increased demand and the dollar's weakness versus the Canadian dollar.
Gross Profit:
Gross profit for the nine months ended September 30, 2004 was $8,640,000 versus
$9,138,200 for the prior year, a decrease of 5%. The decrease was primarily
attributable to the raw material cost increases described above, and the impact
of the Fresh and Cold program on the Spectrum Essential(R) brand, the Company's
most profitable product line. Gross profit by segment is detailed in the
following table:
21
Nine Months Ended September 30,
2004 2003 % Change
---- ---- -----------
Spectrum Naturals(R) Culinary Products $ 4,179,300 $ 4,102,000 +2%
Spectrum Essentials(R) Nutritional Supplements 3,091,500 3,606,800 -14%
Spectrum Ingredients/Other 1,369,200 1,429,400 -4%
----------- ----------- -----------
Total Gross Profit $ 8,640,000 $ 9,138,200 -5%
=========== =========== ===========
Gross profit as a percent of net sales (gross margin) was 22.9% for 2004 versus
27.0% for 2003, primarily as a result of the increased raw material costs in the
Company's consumer packaged product lines and the unfavorable sales mix.
Sales and Marketing Expenses:
The Company's sales and marketing expenses for the nine months ended September
30, 2004 were $5,401,900 or 14.3% of net sales, versus $4,699,000 or 13.9% of
net sales for the prior year. The increase in spending of $702,900 is detailed
in the following table which reconciles sales and marketing spending for 2004
versus 2003, and discloses the significant variances by spending category:
Total sales and marketing expenses, first nine months of 2003 $ 4,699,000
Increased advertising 539,400
Increased compensation and benefits 193,400
Increased sponsorships 76,100
Decreased market research spending (77,400)
Decreased broker commissions (31,800)
All other, net 3,200
-----------
Total sales and marketing expenses, first nine months of 2004 $ 5,401,900
===========
The increased advertising spending was related to the launch of the new "I am
Spectrum" campaign for 2004. The increased compensation and benefits was
primarily associated with increased staffing in the Marketing Department. The
increased sponsorships have enabled the Company to maintain a greater presence
with influential health practitioners with regards to the importance of healthy
oils. The decreased market research spending was primarily attributable to focus
group research conducted in 2003 on the Spectrum Essentials(R) brand. The
decreased broker commissions were primarily attributable to the lower Spectrum
Essentials(R) sales this year as a result of the Fresh and Cold program.
General and Administrative Expenses:
The Company's general and administrative expenses for the nine months ended
September 30, 2004 were $2,836,300 or 7.5% of net sales, versus $2,774,500 or
8.2% of net sales for the prior year. The increase in spending of $61,800 is
detailed in the following table which reconciles general and administrative
spending for 2004 versus 2003, and discloses significant variances by spending
category:
Total G & A expenses, first nine months of 2003 $ 2,774,500
Iowa relocation expenses 171,000
Increased professional fees 35,100
Decreased compensation and benefits expense (159,500)
All other, net 15,200
-----------
Total G & A expenses, first nine months of 2004 $ 2,836,300
===========
22
The Iowa relocation expenses were primarily associated with consulting in
conjunction with the Company's upcoming relocation of its manufacturing facility
to Cherokee, Iowa. The increased professional fees were primarily associated
with increased tax consulting services. The decreased compensation and benefits
expense was primarily associated with reduced accruals in 2004 for incentive
compensation as a result of the lower profitability levels achieved by the
Company in 2004.
Interest Expense:
The Company's interest expense for the nine months ended September 30, 2004 was
$250,100 versus $317,200 for the prior year. The decrease of $67,100 (21%) was
primarily attributable to the early termination expense in the prior year of
$70,400 associated with the change in primary lenders on July 11, 2003. The
Company paid a one-time fee of $62,400 to its former primary lender and
wrote-off the remaining unamortized loan fee of $8,000 associated with that loan
and security agreement.
Provision for Income Taxes:
The Company recorded a provision for income taxes of $67,700 for the nine months
ended September 30, 2004 versus a provision for state income taxes of $81,200
for the prior year. The provision for 2004 was estimated at 40% of the Company's
income before taxes.
Seasonality:
Historically, the Company has experienced little seasonal fluctuation in
revenues. With regards to product purchasing, the Company will seasonally
contract for certain raw materials for the entire year at harvest time or at
planting time. These purchases take place annually from early spring to
mid-summer and are affected to reduce the risk of price swings due to demand
fluctuations. These annual purchases can create overages and shortages in
inventory.
Liquidity and Capital Resources:
On June 4, 2004 the Company entered into the First Amendment to its Credit
Facility with Comerica Bank ("Comerica") that extends the maturity date of the
Credit Facility to June 30, 2006. The Amendment also increases the revolving
line of credit up to a maximum of $9,000,000, and extends the drawdown period
under the capital expenditure term loan of $1,000,000 by six months to December
31, 2004. The Credit Facility is secured by substantially all assets of the
Company and enables the Company to borrow below prime, using a LIBOR rate
option.
The Company could not operate its business without the Credit Facility with
Comerica or one similar to it. The Credit Facility calls for continued
satisfaction of various financial covenants for 2004 and beyond related to
profitability levels, debt service coverage, and the ratio of total liabilities
to tangible net worth. As of September 30, 2004 the Company was in compliance
with all requirements under the Credit Facility.
At September 30, 2004 the Company had working capital of $1,531,400 which
reflected an improvement of $242,200 versus September 30, 2003. The increase was
primarily attributable to higher inventories as a result of the sales growth and
the reinstatement of $739,500 of net short-term deferred tax assets, partially
offset by increased borrowings outstanding under the line of credit to finance
the higher level of operations in general.
23
During 2004 the Company used $769,100 in cash from operating activities,
compared to using $1,692,900 in cash in 2003. The decrease in cash used in 2004
was primarily due to reductions in the cash used for working capital items,
partially offset by the lower profitability levels in 2004. During 2003 the
Company was required to hold significant quantities of flaxseed in inventory
prior to production, which was less prevalent in 2004.
Cash used in investing activities was $962,100 in 2004 compared to $1,427,200 in
2003. In 2004 the cash was primarily invested in the new production facility in
Iowa. In 2003 the cash was invested in the purchase of the SpectraVac
intellectual property and in machinery and equipment, primarily a new rotary
labeler and six used expeller presses which were subsequently installed in the
new Iowa facility.
Cash provided by financing activities was $1,731,400 in 2004 compared to cash
provided of $3,202,300 in 2003. The cash provided in 2004 was primarily from
proceeds under the revolving line of credit and the capital expenditures term
note. The cash provided in 2003 was primarily increased borrowing under the
revolving line of credit and the refinancing of the Company's bank term debt to
finance the equipment purchases and the cash used for operating activities.
Management believes that future cash flows from operations and available
borrowing capacity under the revolving line of credit should provide adequate
funds to meet the Company's estimated cash requirements for the foreseeable
future. Excess borrowing capacity under the revolving line of credit was
$900,300 and $1,515,200 at September 30, 2004 and 2003, respectively.
The Company does not utilize off-balance sheet financing arrangements. There
were no transactions with special purpose entities that give the Company access
to assets or additional financing or carry debt that is secured by the Company.
Related Party Transactions and Other Relationships:
There was one significant transaction with a related party during the nine
months ended September 30, 2004. The Company paid consulting fees of $33,000,
plus expenses incurred, to Running Stream Food and Beverage, Inc. ("RSFB"). RSFB
provided private label consulting and management services to the Company until
April 16, 2004 and is owned and operated by John R. Battendieri, a non-executive
Director of the Company until his resignation from the Board of Directors
effective April 1, 2004. The Company elected to terminate the consulting
services agreement with RSFB at the end of its two-year term on April 16 in
order to focus on its core business in healthy oils and nutritional supplements.
In the opinion of Management, the consulting fees paid to RSFB were fair,
reasonable and consistent with terms the Company could have obtained from an
unaffiliated third party.
Mr. Thomas Simone is one of the Company's external Directors and also sits on
the Board of United Natural Foods, Inc. ("UNFI"). UNFI is the Company's largest
customer, representing approximately 36% of the Company's net sales for the year
ended December 31, 2003.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
- ------------------------------------------------------------------
The Company does not hold market risk sensitive trading instruments, nor does it
use financial instruments for trading purposes. All sales, operating items and
balance sheet data are denominated in U.S. dollars; therefore, the Company has
no foreign currency exchange rate risk. The Company will occasionally purchase
24
inventories in foreign currencies; however, in most cases payment is made at the
time title to the inventory passes to the Company. Therefore, any foreign
currency gain or loss has been immaterial to date.
The book value of all financial instruments approximates fair value. For trade
accounts receivable and trade accounts payable, the book value approximates fair
value due to the short-term maturity of these items. The Company's
interest-bearing term notes payable and capital lease obligations approximate
fair value based on rates currently available for debt with similar terms and
maturities. The fair value of the line of credit approximates book value because
the interest rate fluctuates with changes in the LIBOR or prime rate.
Throughout the course of its fiscal year, the Company utilizes a variable
interest rate line of credit at various borrowing levels. For the nine months
ended September 30, 2004 the average outstanding balance under the line of
credit was $5,641,500 with a weighted average effective interest rate of 3.8%
per annum. For the nine months ended September 30, 2003 the average outstanding
balance under the line of credit was $4,504,400 with a weighted average
effective interest rate of 4.8% per annum. Effective July 11, 2003 with the
change in the primary banking relationship to Comerica Bank, the line of credit
agreement called for the interest rate to float at the prime rate or LIBOR plus
2.25%, at the Company's option. The previous line of credit agreement called for
the interest rate to float at the prime rate plus 1.0%.
Certain other debt items are also sensitive to changes in interest rates. The
following table summarizes estimated fair values, future principal payments and
related weighted average interest rates by expected maturity date for long-term
debt, excluding capital leases, as of September 30, 2004 ($ thousands):
Expected Future Principal Payments
(Years Ended December 31)
2004 2005 2006 2007 2008 2010 Total Fair Value
---- ---- ---- ---- ---- ---- ----- ------
Long Term Debt:
Fixed Rate $ 78.5 $228.2 -- -- -- -- $ 306.7 $ 306.7
Avg. Int. Rate 9.2% 9.2% -- -- -- -- 9.2%
Variable Rate $ 62.5 $450.0 $450.0 $450.0 $324.3 -- $1,736.8 $1,736.8
Avg. Int. Rate Var. Var. Var. Var. Var. -- Var.
Imputed Rate -- -- -- -- -- $513.3 $ 513.3 $ 320.6
Avg. Int. Rate -- -- -- -- -- 7.6% 7.6%
The fair value of all long-term debt is equal to the sum of the expected future
principal payments with the exception of the non-interest bearing note payable
due in one lump sum of $513,300 on December 31, 2010. Interest has been imputed
on that note at an effective rate of 7.6% per annum, leaving a fair value at
September 30, 2004 of $320,600.
In the ordinary course of its business the Company enters into commitments to
purchase raw materials over a period of time, generally six months to one year,
at contracted prices. At September 30, 2004 these future commitments
approximated fair value because they were not at prices in excess of current
market, nor in quantities in excess of normal requirements. The Company does not
utilize derivative contracts either to hedge existing risks or for speculative
purposes.
The Company is subject to a wide variety of risks in the ordinary course of its
business. Some of the more significant risks include heavy concentrations of
sales with a few key customers; heavy concentrations of raw material supply with
a few key suppliers; heavy reliance on several key processors for its dressings,
25
condiments and butter substitutes; reliance on one processor for bottling of its
oils as well as warehousing and distribution of its finished case goods;
regulation by various federal, state and local agencies with regards to the
manufacture, handling, storage and safety of food products; regulation of its
manufacturing facilities for cleanliness and employee safety; and regulation by
various agencies with regards to the labeling and certification of organic and
kosher foods. The Company is also subject to competition from other food
companies, the risk of crop shortages due to weather or other factors, and is
dependant on the continued demand for healthy oils and nutritional supplements
by consumers.
Item 4. DISCLOSURE CONTROLS AND PROCEDURES
- -------------------------------------------
The Company's Chief Executive Officer and Chief Financial Officer have evaluated
the effectiveness of both the design and the operation of its disclosure
controls and procedures and have found them to be adequate. The Company has
formed a Disclosure Review Committee (the "DRC") which consists of various
senior managers from each functional area of the Company. The DRC considers the
materiality of new information and reports to the Company's Chief Financial
Officer.
There were no material changes in the Company's internal control system during
the nine months ended September 30, 2004. Management is not aware of any
significant deficiencies in the design or operation of internal controls.
26
PART II - OTHER INFORMATION
Item 1. Legal Proceedings
- --------------------------
Industrial Accident
On February 4, 2004 the Company pleaded no contest to two misdemeanor counts of
violations under CLCS 6425, violation of a regulation issued by the California
Occupational Health and Safety Administration ("CAL-OSHA"), requiring employers
to provide, maintain and ensure employees use required confined space equipment.
The plea arose in connection with a tragic production accident on April 25, 2002
that resulted in the death of two of the Company's employees. Under the Terms of
Settlement and Probation entered into with the plea, the Company agreed to pay a
fine of $150,000 in three annual installments of $50,000 each on June 1, 2004,
2005 and 2006. In addition the Company paid $150,000 in restitution to the
California District Attorneys Association Workers Safety Training Account to
assist in the prosecution of worker safety cases in the State of California. The
Company also reimbursed costs of $25,000 each to the Petaluma Police Department,
the Petaluma Fire Dept. and the Sonoma County District Attorney's Office.
Finally, an additional fine of $250,000 under CLCS 6425 was suspended
conditioned upon the Company's compliance with the terms of court supervised
probation for three years. Accordingly, the Company accrued an expense of
$375,000 against the year ended December 31, 2003 to cover the net present value
of the above payments, plus estimated attorney's fees to reach agreement on the
plea with the District Attorney's Office. Total payments made in connection with
the plea during the nine months ended September 30, 2004 were $275,000.
At September 30, 2004 the remaining unsettled issues in connection with the
industrial accident were the CAL-OSHA proposed penalties of $137,900 which have
been appealed by the Company, and one remaining appeal filed with the Workers'
Compensation Appeals Board of California for serious and willful misconduct
penalties. The Company intends to defend itself and believes it has meritorious
defenses, since the CAL-OSHA citations did not include any willful penalties. If
actually litigated, the workers compensation appeal is an all-or-nothing
proposition under which the Company will either be liable for an amount equal to
50% of the eventual death benefit to be paid by the Company's worker's
compensation insurance carrier at the time of the accident, or nothing. Based on
the advice of counsel, the Company expects the workers compensation appeal to be
settled rather than litigated. The Company had a reserve of $196,500 at
September 30, 2004 to cover the anticipated settlement of these outstanding
issues and the two remaining installments of $50,000 each under the CLCS 6425
fine, which Management believes will be approximately adequate.
Proposition 65 Complaint
On November 26, 2003 the Company was notified by attorneys for the Environmental
Law Foundation (the "ELF") that the Spectrum Naturals(R) Organic Balsamic
Vinegar contains lead in excess of the allowable quantities under the Safe
Drinking Water and Toxic Enforcement Act of 1986, also known as Proposition 65.
The ELF is a California non-profit organization that represents itself as
dedicated to the preservation of human health and the environment.
ELF's attorneys filed a Complaint for Civil Penalties, Statutory, Equitable and
Injunctive Relief (the "Complaint") against Cost Plus, Inc., Safeway, Inc.,
Trader Joe's Company, Williams-Sonoma, Inc., Whole Foods, Inc. and unspecified
defendants one through 100 in the Superior Court of the State of California on
May 20, 2003 alleging violation of Proposition 65 for the sale of various
products that contain lead in excess of the allowable limits without the
required warning label. ELF's attorneys later notified Spectrum and dozens of
other retailers, importers and manufacturers of vinegar that they would be
included as one of the 100 unspecified defendants included in the Complaint.
27
While lead has been shown to cause cancer and reproductive toxicity in humans,
the Proposition 65 consumption quantity defined as no significant risk level for
cancer was set at 15 micrograms per day. Lead is a naturally occurring element
in all vinegars. Based on the Company's tests, a person would need to consume
somewhere between 1.3-2.6 cups (270-630ml) daily of the Company's various
vinegar products to reach the Proposition 65 lead level. The small lead content
in vinegar occurs naturally in the soil and is absorbed by the grapes used to
make vinegar. The level of lead in vinegar is not affected by the manufacturing
process and, therefore, is not subject to regulation under Proposition 65.
The Spectrum Naturals(R) brand was built on the premise of providing consumers
with organic healthy oils and condiments. Management does not believe the
consumption of its various vinegar products as condiments or salad dressings
poses any increased risk for cancer or reproductive toxicity.
The Company has joined a Joint Defense Group established by attorneys
representing several of the defendants in the Complaint. Total attorney's fees
incurred by the Company as a member of the Joint Defense Group for the nine
months ended September 30, 2004 were $11,000. Management believes the Complaint
will eventually be shown to be without merit. Accordingly, no provision for loss
or future attorney's fees has been recorded at September 30, 2004.
Patent Infringement Complaint
The Company was previously involved in a dispute with GFA Brands, Inc. ("GFA")
that the Spectrum Naturals(R) Organic Margarine was infringing upon two patents
issued in the United States that pertain to particular oil compositions suitable
for human consumption. The patents were granted to Brandeis University, which
exclusively licensed them to GFA. The Company withdrew the margarine from the
market and began to evaluate reformulating the product while pursuing its rights
against GFA. On August 28, 2001 the Company filed a complaint against GFA for
declaratory judgment of non-infringement and invalidity of the patents.
On August 30, 2004 the case was settled via a joint stipulation to dismiss all
claims without prejudice to either party since the Spectrum Naturals(R) Organic
Margarine remains off the market while the Company and its copacker evaluate the
reformulated product. Management continues to believe that the original formula
for the margarine fell outside the claims made in the Brandeis University
patents and that the patents should be declared invalid. However, the Company
cannot justify the excessive legal expenses associated with patent infringement
litigation.
Item 2. Changes in Securities and Use of Proceeds
- --------------------------------------------------
During the nine months ended September 30, 2004 the Company issued 132,166
shares of its common stock for the exercise of stock options. Total proceeds
received by the Company were $45,900.
The Company has not in the past nor does it intend to pay cash dividends on its
common stock in the future. The Company intends to retain earnings, if any, for
use in the operation and expansion of its business.
28
Item 3. Defaults Upon Senior Securities
- ----------------------------------------
None.
Item 4. Submission of Matters to a Vote of Security Holders
- ------------------------------------------------------------
None.
Item 5. Other Information
- --------------------------
None.
Item 6. Exhibits and Reports on Form 8-K
- -----------------------------------------
(a) Exhibits:
31.08 Certification of Chief Executive Officer pursuant to Section 302 of
the Sarbanes-Oxley Act of 2002.
31.09 Certification of Chief Financial Officer pursuant to Section 302 of
the Sarbanes-Oxley Act of 2002.
32.08 Certification of Chief Executive Officer pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002.
32.09 Certification of Chief Financial Officer pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002.
(b) Reports on Form 8-K during the quarter ended September 30, 2004:
The Company filed a Current Report on Form 8-K on August 5, 2004 disclosing
the Company's unaudited financial position and results of operations as of
and for the three months ended June 30, 2004.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
Date: November 8, 2004 SPECTRUM ORGANIC PRODUCTS, INC.
By: /s/ Robert B. Fowles
-------------------------------
Robert B. Fowles
Duly Authorized Officer &
Chief Financial Officer