Smart Balance, Inc.

(Exact name of registrant as specified in its charter)

 

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Delaware		20-2949397
(State of or other jurisdiction of incorporation)		(I.R.S. Employer Identification No.)

115 West Century Road, Suite 260, Paramus, New Jersey		07652
(Address of principal executive offices)		(Zip code)

Registrant’s telephone number, including area code: (201) 568-9300

 

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Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes x     No o.

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes o  No o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large Accelerated Filer      o	Accelerated Filer                        x
Non-Accelerated Filer        o  (Do not check if a smaller reporting company)	Smaller Reporting Company     o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes o No x.

 

As of November 4, 2010, the Registrant had 60,818,156 shares of common stock, par value $.0001 per share, outstanding.  

 

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SMART BALANCE, INC.

INDEX

		Page
Part I.	Financial Information	2
Item 1.	Financial Statements	2
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	20
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	30
Item 4.	Controls and Procedures	31
Part II.	Other Information	32
Item 1.	Legal Proceedings	32
Item 1A.	Risk Factors	32
Item 6.	Exhibits	32

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Cautionary Note Regarding Forward Looking Statements

 

This document contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). These statements may be identified by forward-looking words such as “may,” “expect,” “anticipate,” “contemplate,” “believe,” “estimate,” “intends,” and “continue” or similar words.  In addition, forward-looking statements are statements which

·

discuss future expectations or expansions of business lines;

 

·

contain projections of future results of operations or financial condition; or

 

·

state other “forward-looking” information.

We believe that communicating our expectations to our stockholders is important. However, there are always events in the future that we are not able to accurately predict or over which we have no control, and consequently, actual results may differ from those anticipated in the forward-looking statements.  Important factors that could cause actual results to differ from our expectations include, but are not limited to, the factors discussed in the section of this report entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” the “Risk Factors” section in our annual report on Form 10-K for the year ended December 31, 2009, as well as our ability to:

 

·

maintain margins during periods of commodity cost fluctuation;

·

introduce and expand our distribution of new products;

·

meet marketing and infrastructure needs;

·

respond to changes in consumer demand;

·

respond to adverse publicity affecting our Company or industry;

·

comply with regulatory requirements;

·

maintain existing relationships with and secure new customers;

	·	continue to rely on third party distributors, manufacturers and suppliers;
	·	sell our products in a competitive environment and with increasingly price sensitive consumers;
	·	continue to rely on the estimates or judgments related to our impairment analysis, which if changed could have a significant impact on recoverability of the Company’s goodwill and could have a material impact on its consolidated financial statements; and
	·	improve future operations in connection with our realignment program.

 

You are cautioned not to place undue reliance on our forward-looking statements, which speak only as of the date of this report.

  

All forward-looking statements included in this report attributable to us are expressly qualified in their entirety by the cautionary statements contained or referred to in this section. Except to the extent required by applicable laws and regulations, we undertake no obligation to update these forward-looking statements to reflect events or circumstances after the date of this report or to reflect the occurrence of unanticipated events.

 

1

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Part I.  Financial Information

 

Item 1. Financial Statements

 

SMART BALANCE, INC. AND SUBSIDIARY

Consolidated Balance Sheets

(In thousands, except share data)  

		September 30,				December 31,
		2010				2009
		(unaudited)
Assets
Current assets:
Cash and cash equivalents		$	8,553			$	7,538
Accounts receivable, net of allowance of: $274 (2010) and $345 (2009)			13,119				11,970
Accounts receivable - other			1,019				650
Income taxes receivable		-					1,131
Inventories			7,335				5,812
Prepaid taxes			-				405
Prepaid expenses and other assets			9,529				3,392
Deferred tax asset			1,656				462
Total current assets			41,211				31,360
Property and equipment, net			4,744				4,634
Other assets:
Goodwill			244,886				374,886
Intangible assets, net			148,140				151,089
Deferred costs, net			1,587				2,111
Other assets			2,093				985
Total other assets			396,706				529,071
Total assets		$	442,661			$	565,065
Liabilities and Stockholders' Equity
Current liabilities
Accounts payable and accrued expenses		$	23,956			$	22,626
Income taxes payable		891				-
Current portion of long term debt			3,350				5,500
Total current liabilities			28,197				28,126
Long term debt			54,650				51,143
Deferred tax liability			40,968				43,824
Other liabilities			2,088				965
Total liabilities			125,903				124,058
Commitment and contingencies
Stockholders' equity
Common stock, $.0001 par value, 250,000,000 shares authorized; 62,630,683 (2010 and 2009) issued and 60,818,156 and 62,630,683 outstanding in 2010 and 2009, respectively			6				6
Additional paid in capital			531,960				523,467
Retained deficit			(207,868	)			(82,466	)
Treasury stock at cost (2010 –1,812,527 shares)			(7,340	)		-
Total stockholders' equity			316,758				441,007
Total liabilities and stockholders' equity		$	442,661			$	565,065

 

See accompanying notes to the consolidated financial statements  

 

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SMART BALANCE, INC. AND SUBSIDIARY

Consolidated Statements of Operations

(Unaudited)

(In thousands, except share data)

 

		Three Months Ended September 30,								Nine Months Ended September 30,
		2010				2009				2010				2009
Net sales		$	59,939			$	59,806			$	179,207			$	180,590
Cost of goods sold			31,389				30,045				90,446				94,303
Gross profit			28,550				29,761				88,761				86,287
Operating expenses:
Marketing			9,754				9,952				30,252				27,573
Selling			4,994				4,225				14,614				13,012
General and administrative			10,401				12,126				33,528				36,518
Goodwill impairment			-				-				130,000				-
Total operating expenses			25,149				26,303				208,394				77,103
Operating income (loss)			3,401				3,458				(119,633	)			9,184
Other income (expense):
Interest income			-				1				-				3
Interest expense			(841	)			(1,237	)			(2,553	)			(3,573	)
Other income (expense), net			222				(135	)			(363	)			(588	)
Total other income (expense)			(619	)			(1,371	)			(2,916	)			(4,158	)
Income (loss) before income taxes			2,782				2,087				(122,549	)			5,026
Provision for income taxes			1,128				816				2,853				1,618
Net income (loss)		$	1,654			$	1,271			$	(125,402	)		$	3,408
Income (loss) per share:
Basic		$	0.03			$	0.02			$	(2.02	)		$	0.05
Diluted		$	0.03			$	0.02			$	(2.02	)		$	0.05
Weighted average shares outstanding:
Basic			61,154,018				62,630,683				62,076,439				62,630,683
Diluted			61,154,018				62,691,742				62,076,439				62,741,513

See accompanying notes to the consolidated financial statements

 

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SMART BALANCE, INC. AND SUBSIDIARY

Consolidated Statements of Cash Flows

(Unaudited)

(In thousands)

		Nine Months Ended September 30,
		2010				2009
Cash flows from operating activities
Net (loss) income		$	(125,402	)		$	3,408
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Depreciation and amortization of intangibles			3,908				3,663
Amortization of deferred financing costs			545				323
Deferred income taxes			(4,050	)			(3,141	)
Stock based compensation			8,492				12,092
Interest rate swaps			-				(1,532	)
Goodwill impairment			130,000				-
Changes in assets and liabilities:
Accounts receivable			(1,149	)			(197	)
Inventories			(1,523	)			5,251
Income taxes receivable			1,131				-
Prepaid expenses and other current assets			(6,101	)			(7,708	)
Accounts payable and accrued expenses			2,237				(3,532	)
Net cash provided by operating activities			8,088				8,627
Cash flows from investing activities
Purchase of property and equipment			(965	)			(749	)
Patent defense costs			(104	)			-
Net cash (used in) investing activities			(1,069	)			(749	)
Cash flows from financing activities
Proceeds from issuance of long term debt			9,000				-
Repayment of debt			(7,643	)			(5,000	)
Payments for loan costs			(21	)			-
Purchase of treasury stock			(7,340	)			-
Net cash (used in) financing activities			(6,004	)			(5,000	)
Net increase in cash for the period			1,015				2,878
Cash - Beginning of period			7,538				5,492
Cash - End of period		$	8,553			$	8,370
Cash paid during the period for:
Income taxes		$	4,897			$	5,203
Interest		$	2,210			$	4,806

See accompanying notes to the consolidated financial statements

 

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Property and Equipment

Property and equipment are stated at cost and depreciated using the straight-line method over the estimated useful lives of the assets ranging from 5 to 10 years. Leasehold improvements are amortized using the straight-line method over the shorter of the lease term or the estimated useful life of the improvement.  The Company continually evaluates whether events and circumstances have occurred that indicate the remaining estimated useful life of long lived assets may warrant revision, or that the remaining balance of these assets may not be recoverable.  When deemed necessary, the Company completes this evaluation by comparing the carrying amount of the assets against the estimated undiscounted future cash flows associated with them.  If such evaluations indicate that the future undiscounted cash flows of amortizable long-lived assets are not sufficient to recover the carrying value of such assets, the assets are adjusted to their estimated fair values.

 

Goodwill

 

Goodwill is tested annually for impairment or more frequently if events or changes in circumstances indicate that impairment may have occurred. The impairment analysis for goodwill includes a comparison of the Company’s carrying value (including goodwill) to the Company’s estimated fair value. If the fair value of the Company does not exceed its carrying value, then an additional analysis would be performed to allocate the fair value to all assets and liabilities of the Company as if the Company had been acquired in a business combination and the fair value was its purchase price. If the excess of the fair value of the Company over the fair value of its identifiable assets and liabilities is less than the carrying value of recorded goodwill, an impairment charge is recorded for the difference.  We completed our impairment analysis at June 30, 2010 and concluded that our estimated fair value was less than the carrying value of the recorded goodwill, and, accordingly, the Company recorded an impairment loss of $130,000 (see footnote 5 for further details).  At September 30, 2010, the Company reviewed its assessment of fair value and made a determination that no further impairment was warranted.

 

Intangible Assets

 

Other intangible assets are comprised of both definite and indefinite life intangible assets. Indefinite life intangible assets are not amortized but are tested annually for impairment, or more frequently if events or changes in circumstances indicate that the asset might be impaired. In assessing the recoverability of indefinite life intangible assets, the Company must make assumptions about the estimated future cash flows and other factors to determine the fair value of these assets.

 

6

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An intangible asset is determined to have an indefinite useful life when there are no legal, regulatory, contractual, competitive, economic, or any other factors that may limit the period over which the asset is expected to contribute directly or indirectly to the future cash flows of the Company. In each reporting period, the Company also evaluates the remaining useful life of an intangible asset that is not being amortized to determine whether events and circumstances continue to support an indefinite useful life. If an intangible asset that is not being amortized is determined to have a finite useful life, the asset will be amortized prospectively over the estimated remaining useful life and accounted for in the same manner as intangible assets subject to amortization.

 

The Company has determined that its Smart Balance ® and Earth Balance ® trademarks have indefinite lives and these assets are not being amortized. The Company has performed its annual assessment of its indefinite lived intangible assets for impairment at June 30, 2010 and determined there was no impairment.  Certain other assets acquired, primarily patent technology, have been determined to have definite lives ranging from 10 to 20 years and their costs are being amortized over their expected lives.

 

The Company generally expenses legal and related costs incurred in defending or protecting its intellectual property unless it can be established that such costs have added economic value to the business enterprise, in which case the Company capitalizes the costs incurred as part of intangible assets. The primary consideration in making the determination of whether to capitalize the costs is whether the Company can prove that it has been successful in defending itself against such intellectual property challenges.  The second consideration for capitalization is whether such costs have, in fact, increased the economic value of the Company’s intellectual property.  Legal defense costs that do not meet the considerations described above are expensed as incurred.  Recovery of legal expenses as part of a settlement agreement will be recorded as a reduction of capitalized legal fees if previously capitalized with any excess recorded as income.

  

Deferred Costs

 

Deferred loan costs associated with the Company’s secured debt financing are being amortized over the life of the loan, using the effective interest method.

 

Revenue Recognition

 

Revenue is recognized when the earnings process is complete and the risks and rewards of ownership have transferred to the customer, which is generally considered to have occurred upon the receipt of product by the customer. The earnings process is complete once the customer order has been placed and approved and the product shipped has been received by the customer. Product is sold to customers on credit terms established on an individual basis. The credit factors used include historical performance, current economic conditions and the nature and volume of the product.

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The Company offers its customers and consumers a variety of sales and incentive programs, including discounts, allowances, coupons, slotting fees, and co-op advertising; such amounts are estimated and recorded as a reduction in revenue. For interim reporting, the Company estimates the total annual sales incentives for most programs and records a pro rata share in proportion to forecasted annual revenue.  As a result, the Company has recorded a prepaid asset at September 30, 2010 of $8,560 which will be charged to expense over the remaining quarter.  The Company sells its products to customers without a right of return and is not obligated to accept any returns.

 

Earnings per Share of Common Stock

 

Basic earnings per share is computed by dividing net income applicable to common stockholders by the weighted-average number of shares of common stock outstanding for the period. Diluted earnings per share is computed by dividing net income by the number of weighted-average shares outstanding adjusted for any additional common shares that would have been outstanding if all of the potential dilutive common shares had been issued. Potential dilutive common shares outstanding would primarily include stock options.  For the three and nine months ended September 30, 2010, 11,265,375 and 11,225,375 stock options, respectively, were excluded from the dilutive EPS calculation because their exercise price was greater than the average market price.  Additionally, for the nine months ended September 30, 2010, 40,000 stock options were excluded from the dilutive EPS calculation because the result would be anti-dilutive.

 

The following table summarizes stock options not included in the computation of diluted earnings per share:

 

		Three Months Ended September 30,								Nine Months Ended September 30,
		2010				2009				2010				2009
Stock options excluded due to option price being greater than  market value			11,265,375				12,005,000				11,225,375				11,885,000
Stock options excluded due to anti-dilution			-				277,569				40,000				401,313

Segments

 

Authoritative accounting guidance requires segment information to be prepared using the “management” approach. The management approach is based on the method that management organizes the segments within the Company for making operating decisions and assessing performance. The Company evaluates all products, makes operating decisions and performance assessments based on a total company approach and therefore considers itself as having only one segment.  The Company’s buttery spreads business, marketed under Smart Balance®, Earth Balance®, Bestlife™, Smart Beat® and Nucoa®, is by far the most developed product segment and accounted for approximately 70% and 76% of  revenue for the three months ended September 30, 2010 and 2009, respectively, and 72% and 75% for the nine months ended September 30, 2010 and 2009, respectively.

 

Fair Value of Financial Instruments

 

The Company’s financial instruments consist of cash and cash equivalents, short term trade receivables, payables, note payables and accrued expenses. The carrying value of cash and cash equivalents, short term receivables and payables and accrued expenses approximate fair value because of their short maturities. The Company’s debt is determined by comparable quoted market prices and, therefore, approximates fair value.  The Company measures fair value based on authoritative accounting guidance for “Fair Value Measurements”, which requires a three-tier fair value hierarchy that prioritizes inputs to measure fair value.  These tiers include:  Level 1, defined as inputs, such as unadjusted quoted prices in an active market for identical assets or liabilities; Level 2, defined as inputs other than quoted market prices in active markets that are either directly or indirectly observable; or Level 3, defined as unobservable inputs for use when little or no market value exists therefore requiring an entity to develop its own assumptions.   When available, the Company uses quoted market prices to determine the fair value of an asset or liability. If quoted market prices are not available, the Company measures fair value using valuation techniques that use, when possible, current market-based or independently-sourced market parameters.

At September 30, 2010 and December 31, 2009, information about inputs into the fair value measurements of the Company’s assets and liabilities that are made on a recurring basis was as follows:

 

Income Taxes

 

Deferred income taxes are provided for the differences between the basis of assets and liabilities for financial reporting and income tax purposes. A valuation allowance is established when necessary to reduce deferred tax assets to the amount expected to be realized. As of September 30, 2010, no valuation allowances were recorded.

 

Advertising

 

Advertising costs are charged to operations (classified as marketing expenses) and amounted to $6,219 and $4,854 for the three months ended September 30, 2010 and 2009, respectively, and $19,480 and $15,465 for the nine months ended September 30, 2010 and 2009, respectively.

 

Use of Estimates

 

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates.

 

Concentration of Credit Risk

 

Financial instruments which potentially subject the Company to concentrations of credit risk consist principally of cash, cash equivalents, short term investments and trade receivables. The Company maintains the majority of its cash and cash equivalents in the form of demand deposits with financial institutions that management believes are creditworthy. At September 30, 2010, the cash balances in these institutions exceeded federally insured amounts. Concentrations of credit risk relative to trade receivables are limited due to our diverse client base. The Company does have one customer that accounted for approximately 17% of sales during the three and nine months ended September 30, 2010, respectively. The aggregate accounts receivable from this customer amounted to approximately 16% of the accounts receivable balance outstanding at September 30, 2010. The Company also has one product, “spreads,” which, accounted for approximately 70% and 72 % of total revenue for the three and nine months ended September 30, 2010, respectively.  Approximately 81% of the Company’s revenues during the three and nine months ended September 30, 2010, respectively, came from products utilizing licenses from Brandeis University.

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Recently Issued Accounting Pronouncements

 

There have been no significant developments to recently issued accounting standards, including the expected dates of adoption and estimated effects on the Company’s consolidated financial statements from those disclosed in our 2009 Annual Report on Form 10-K.

3.	Property and equipment

 

Property and equipment consist of the following:

 

		September 30, 2010				December 31, 2009
Software development costs		$	4,394			$	3,857
Equipment			1,154				771
Furniture and fixtures			1,021				976
Leasehold improvements			342				342
			6,911				5,946
Less: accumulated depreciation			(2,167	)			(1,312	)
Property and equipment, net		$	4,744			$	4,634

Depreciation expense was $269 for the three months ended September 30, 2010, compared to $215 for the three months ended September 30, 2009, and $856 for the nine months ended September 30, 2010, compared to $613 for the nine months ended September 30, 2009.

 

4.	Intangible assets

 

The following is a summary of intangible assets and goodwill as of September 30, 2010:

In conjunction with performing an impairment test of goodwill in connection with the preparation of the June 30, 2010 financial statements, the Company also performed an impairment test of its indefinite-lived intangible assets, namely, trade-names.  The Company used an income approach (relief-from-royalty method) to measure the fair value of these intangibles. The result of this assessment indicated that the fair value of these other intangible assets was not below their carrying values and therefore no impairment was recorded.  For other long-lived intangible assets, namely patents, the Company complied with the general valuation requirements set forth under ASC Topic 360 “Accounting for the Impairment of Long-Lived Assets.”  The result of this assessment indicated that no impairment existed.

6.	Realignment and Other Actions

In connection with the realignment of the Company to improve future operations, severance charges associated with workforce reductions and other facility closure and exit costs were recorded during the second quarter of 2010.  For the nine months ended September 30, 2010, the consolidated statement of operations includes realignment charges of $3,191 which are comprised of $2,736 of severance benefits, $401 for abandoned leased office space costs and $54 in other costs.  These costs were incurred during the second quarter and are included within operating expenses and classified as general and administrative charges on the consolidated income statement.

The consolidated balance sheet as of September 30, 2010 includes accruals relating to the realignment program of $2,628.  The following table sets forth the activity affecting the accrual during the nine months ended September 30, 2010:

		Severance				Other Closure and Exit Costs				Total
Balance as of December 31, 2009		$	-			$	-			$	-
Charges incurred			2,790				401				3,191
Cash payments			(481	)			(14	)			(495	)
Adjustments			(68	)			-				(68	)
Balance as of September 30, 2010		$	2,241			$	387			$	2,628

 

The Term Loan and the loans made pursuant to the Revolver will mature on November 3, 2013.  The Credit Agreement requires annual principal payments on the Term Loan of $5,500.

 

Loans outstanding under the Credit Agreement bear interest, at the Borrower’s option, at either a base rate (defined in the Credit Agreement as the greatest of (i) 2.5%, (ii) the Agent’s prime rate, (iii) the federal funds rate plus 0.50% and (iv) a reserve adjusted one-month LIBOR rate plus 1.0%) or a Eurodollar rate (of no less than 1.5%), in each case plus an applicable margin.  The applicable margin is determined under the Credit Agreement based on the ratio of the Company’s total funded debt to EBITDA for the prior four fiscal quarters (the “Leverage Ratio”), and may range from 2.25% to 3.25%, in the case of base rate loans, and 3.25% to 4.25%, in the case of Eurodollar rate loans.  The Borrower must also pay a commitment fee on the unused portion of the Revolver (determined under the Credit Agreement based on the ratio of the Company’s Leverage Ratio) which may range from 0.50% to 0.75%.

 

Subject to certain conditions, the Borrower may voluntarily prepay the loans under the Credit Agreement in whole or in part, without premium or penalty (other than customary breakage costs).  Mandatory prepayments that are required under the Credit Agreement include:

 

●

100% of the net cash proceeds (as defined in the Credit Agreement) upon certain dispositions of property or upon certain damages or seizures of property, subject to limited exceptions;

 

●

50% of all net cash proceeds from the issuance of additional equity securities of the Company, subject to limited exceptions, provided, however, if the Company’s Leverage Ratio is less than 2.0 as of the end of the most recently ended quarter, the prepayment is limited to 25% of such proceeds;

 

●

100% of the amount of net cash proceeds for certain issuances of additional indebtedness for borrowed money; and

 

●

beginning on December 31, 2010 and each fiscal year thereafter, an annual prepayment equal to 25% of excess cash flow of the Company (as defined in the Credit Agreement) for such fiscal year, provided such prepayment is not required if the Company has a Leverage Ratio of 2.0 or less, measured as of the end of such fiscal year.

 

The Credit Agreement contains covenants that are customary for agreements of this type.  These covenants include, among others: a limitation on the incurrence of additional indebtedness; a limitation on mergers, acquisitions, investments and dividend payments; and maintenance of specified financial ratios.  Under the Credit Agreement, the Company must maintain (1) a Leverage Ratio that is not greater than 2.75 to 1.0 until December 30, 2011 and not greater than 2.50 to 1.0 thereafter and (2) a ratio of EBITDA to Debt Service (as defined in the Credit Agreement), in each case for the prior four fiscal quarters, of not less than 2.00 to 1.00.  The Company is also limited to spending not more than $6,000 of capital expenditures per year with any unspent funds carried over to the next twelve months.  At September 30, 2010, the Company was in compliance with all of its covenants.

 

 

The failure to satisfy covenants under the Credit Agreement or the occurrence of other specified events that constitute an event of default could result in the acceleration of the repayment obligations of the Borrower.  The Credit Agreement contains customary provisions relating to events of default for agreements of this type. The events of default include, among others: the nonpayment of any outstanding principal, interest, fees or other amounts due under the Credit Agreement; certain bankruptcy events, judgments or decrees against the Company or the Borrower; cross defaults to other indebtedness exceeding $5,000; a change in control (as defined in the Credit Agreement) of the Company or the Borrower; and the failure to perform or observe covenants in the Credit Agreement.

 

The obligations under the Credit Agreement are guaranteed by the Company and all existing and future subsidiaries of the Borrower.  The Borrower, the Company and the other guarantors granted to the Agent, for the benefit of the Lenders, a security interest in substantially all of its respective assets, including, among other things, patents, patent licenses, trademarks and trademark licenses.

 

After the close of the transaction, total debt outstanding under the Credit Agreement totaled approximately $60,600 comprised of $55,000 of Term Loan debt and $5,600 of borrowings under the Revolver.  During the fourth quarter of 2009, the Company paid approximately $4,000 on its Revolver and during the first quarter of 2010 it paid $1,100 of its scheduled requirements.  During the second quarter of 2010, the Company paid $6,500 of which $1,600 reduced the Revolver to zero and $4,900 was applied against the Term Loan.  During the third quarter of 2010, the Company borrowed $9,000 under the Revolver bringing the total debt outstanding to $58,000 as of September 30, 2010.

 

The Company is required to pay the following amounts in each of the next four years:

 

2010		$	-
2011			5,000
2012			5,500
2013			47,500
Total		$	58,000

As of September 30, 2010, $3,350 is due in the next twelve months.  The interest rate under the Credit Agreement at September 30, 2010 was 4.75% while the interest rate on the unused line was 0.5%.  This amount does not take into account the amount, if any, of the requirement that, beginning on December 31, 2010, the Company make an annual payment equal to 25% of excess cash flow, as defined by the Credit Agreement, unless its leverage ratio is 2.0 or less.  The Company currently has a ratio of less than 2.0 and expects to remain at that level on December 31, 2010.

9.	Stock-based compensation

 

The Company and its stockholders have authorized the issuance of up to 12,150,000 stock options under its Stock and Awards Plan.  Through September 30, 2010, the Company had granted a total of 12,707,500 stock options under the Stock and Awards Plan, of which 2,817,125 have been forfeited.  This resulted in 9,890,375 shares issued and outstanding at September 30, 2010.

 

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In addition, during the first quarter of 2008, the compensation committee and sub-committee of the compensation committee approved the issuance of up to 1,375,000 inducement stock options grants to new employees outside of the Company’s stock plan pursuant to NASDAQ Marketplace Rule 4350.  During the twelve months ended December 31, 2008, the Company issued all of the 1,375,000 inducement grant stock options to new employees.

The Company utilizes two types of stock options, traditional service-based with a four year graded vesting (25% vest each year) and market condition-based stock options which vest when the underlying stock price reaches either $16.75 and $20.25, respectively, and remains there for 20 out of 30 consecutive trading days. Stock options are granted to recipients at exercise prices not less than the fair market value of the Company’s stock at the dates of grant and can consist solely of the service-based options or market conditions-based options or can consist of a combination of both types of options.  Stock options granted to employees have a term of 10 years.  The Company recognizes stock-based compensation expense over the requisite service period of the individual grants, which generally equals the vesting period, or as determined by the Monte Carlo valuation model.

 

As of September 30, 2010, the total compensation cost related to non-vested awards not yet recognized was $13,100 with a weighted average remaining period of 1.56 years over which it is expected to be expensed.

The Company accounts for its stock-based compensation awards in accordance with authoritative accounting guidance for share-based payment, which requires companies to recognize compensation expense for all equity-based compensation awards issued to employees that are expected to vest. Compensation cost is based on the fair value of awards as of the grant date.

Pre-tax stock-based compensation expense included in reported net income is as follows:

 

		Three Months Ended September 30,								Nine Months Ended September 30,
		2010				2009				2010				2009
Service period-based		$	1,949			$	1,911			$	4,497			$	5,670
Market price-based $16.75			300				1,230				1,627				3,686
Market price-based $20.25			703				914				2,369				2,736
Total		$	2,952			$	4,055			$	8,493			$	12,092

For the traditional service-based stock options, the Company estimated the fair value, as of the date of grant, using a Black-Scholes pricing model with the following assumptions: risk-free interest rate of 3.53% - 4.67%, expected life of 7 years for the service-based options and 10 years for the market price-based options, no dividends and volatility of 35.9% - 52.08%. The cost of the service-based stock options is being amortized over a four year vesting period. In the case of the market price-based stock options, the Company used the Monte Carlo valuation model.  The company has incorporated a forfeiture rate of 2.5% on all time vested options.  The Company recognizes compensation expense for the market price-based options over the estimated vesting period, which has been determined to be 2.75 – 4.82 years and 3.68 – 5.53 years for the $16.75 and $20.25 awards, respectively.

10.	Stock Repurchase Activities

 

 

12.

License

A substantial portion of the Company’s business is dependent on its exclusive worldwide license of certain technology from Brandeis University. This license agreement, dated September 1996, imposes certain obligations upon the Company, such as diligently pursuing the development of commercial products under the licensed technology. The agreement for each country expires at the end of the term of each patent in such country and contains no minimum commitments. The amount of royalties due is based on a formula of the percentage of oil and/or fat utilized in the licensed products. Should Brandeis believe that the Company has failed to meet its obligations under the license agreement, Brandeis could seek to limit or terminate the Company’s license rights. Royalties earned by Brandeis for the nine months ended September 30, 2010, were approximately $742.

 

13.	Income taxes

The Company’s effective tax rate for the year is dependent on many factors, including the impact of enacted tax laws in jurisdictions in which it operates and the amount of taxable income it earns. The effective tax rate for the third quarter was 40.6%.  The Company’s effective tax rate for the balance of 2010 is estimated to be 39%.  The deferred tax liability represents primarily the difference between the tax and accounting basis of intangible assets acquired in the GFA merger.

 

14.	Commitments and contingencies

As of September 30, 2010, the Company had the following commitments and contractual obligations:

 

●

An amended lease agreement for the lease of a corporate office facility located in Paramus, NJ.  The lease was effective as of September 1, 2008 and has a seven year life with the option to extend the lease for two additional five-year terms.  The annual rental expense is approximately $500 for each of the first five years.

●

Three lease agreements for the lease of a corporate office facility located in Niwot, Colorado.  The leases were effective as of August 1, 2007 and have a five-year life with the option to extend each lease for two 36 month terms.  The annual rental expense is approximately $100 for each of the first five years.

●

Forward purchase commitments for a portion of the Company's projected requirement for peanuts and for palm, soy and canola oil.  These commitments may be stated at a firm price, or as a discount or premium from a future commodity market price. These commitments total approximately $28.6 million as of September 30, 2010.  The majority of these commitments are expected to be liquidated by the second quarter of 2011.

 

15.	Legal Proceedings

The Company is currently involved in the following legal proceedings:

 

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On February 8, 2010 a lawsuit was filed against Smart Balance, Inc. in the Federal District Court for the Central District in California in Santa Ana, California.  The complaint alleges, among other things, violations of California’s unfair competition law, false advertising, and consumer remedies act and seeks to identify all similarly situated plaintiffs and certify them in a class action.  The Company has not yet answered the complaint, and intends to vigorously defend itself.  The Company does not expect that the resolution of this matter will have a material adverse effect on its business.

In 2007, three parties filed Oppositions to European Patent No. 0820307 relating to increasing the HDL level and the HDL/LDL ratio in Human Serum by Balancing Saturated and Polyunsaturated Dietary Fatty Acids.  In July 2010, a hearing was held on this matter in Munich, Germany and the patent panel ruled against the Company.  The Company is awaiting the panel’s written decision and then will make a determination on whether to appeal the ruling.  The Company believes that neither this proceeding, nor its ultimate outcome, will have any material adverse effect on its business.

The Company is not a party to any other legal proceeding that it believes would have a material adverse effect on its business, results of operations or financial condition.

 

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Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

This Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the September 30, 2010 Condensed Consolidated Financial Statements and the related Notes contained in this quarterly report on Form 10-Q and our annual report on Form 10-K for the year ended December 31, 2009. Forward-looking statements in this section are qualified by the cautionary statements included under the heading “Cautionary Note Regarding Forward Looking Information,” above.

Company Overview

We are a consumer food products company that competes primarily in the retail branded food products industry and focuses on providing value-added, functional food products to consumers. Functional food is defined as a food or a food ingredient that has been shown to affect specific functions or systems in the body and may play an important role in disease prevention. We market buttery spreads, popcorn, peanut butter, cooking oil, mayonnaise, milk, sour cream and other products primarily under the Smart Balance® trademark. In the natural food channel, we sell similar natural and organic products under the Earth Balance® trademark. Our trademarks are of material importance to our business and are protected by registration or other means in the United States and a number of international markets.  Our buttery spreads business, marketed under Smart Balance®, Earth Balance®, SmartBeat®, Bestlife™ and Nucoa®, is by far our most developed product group and accounted for approximately 71.5% of sales for the nine months ended September 30, 2010.  Our products are sold throughout the U.S.  A majority of our products are sold through supermarket chains and food wholesalers.

We outsource production of finished goods to third-party manufacturers.  We do not own or operate any manufacturing facilities.  Outsourcing allows us to focus our energy and resources on marketing and sales, while substantially reducing capital expenditures and avoiding the complication of managing a production work force.  Our manufacturers supply our products at a price equal to the cost of ingredients and certain packaging plus a contracted toll charge.  We use third party distributors and a network of public warehouses to deliver products from our manufacturers to our customers.

Our goal is to become a recognized leader in providing nutritious and good tasting products for a wide variety of consumer needs.  We believe the Smart Balance® brand has the potential to become a broad functional foods platform across multiple food categories.  Our primary growth strategy is two-fold: (1) to drive consumer and trade awareness of our brands and (2) to increase purchase frequency by expanding product offerings and distribution in our core category of spreads and into other dairy categories.  In order to drive consumer and trade awareness of our brands and add more households that prefer our products, we will continue to use marketing and promotional programs to drive trial and encourage brand loyalty. We spent over $50 million in 2009 for consumer marketing and promotion.  In order to increase purchase frequency and expand our product offerings and distribution, during 2008 we launched a successful distribution initiative to increase shelf presence in retailers.  The effort substantially increased the average number of our products that retailers have on the shelf, especially in the spreads category.

 

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2009 was an important year in creating a foundation necessary to support growth over the next several years.  We increased our market share and profitability in the core spreads category, established our dairy initiative, lead by our enhanced milk products, and refinanced our credit facility with a strategically flexible capital structure.  In 2010, we launched our 3-tier spreads initiative, with products in all segments of the category.  We also began expansion of milk distribution in 2010.

In our core spreads category, for the year ended December 31, 2009 our dollar market share was up 1.1 points to 15.2% according to Nielsen data for the food channel.  Accordingly, we were first among competitors in dollar share growth in 2009 and second behind private label in unit share growth, an accomplishment for a premium priced product in this economy.  We are now the number two marketer of spreads in the U.S. on a dollar basis. In the first nine months of 2010, our market share was 15.7%, up .02 points, from the same period in the prior year.  Our strategy has always been to maintain price and product positioning as a premium brand.  As a result, we lost some volume opportunities over the last twelve months as consumers continued to be price sensitive and competitors sought to increase unit share through price promotion.

Our current dairy aisle initiative is the critical part of our growth plan.  Centered on the high purchase frequency of the milk category, we believe success in expanding in the dairy aisle will be the driver toward our growth goals.  In 2010, we expanded milk nationally and are using advertising and other marketing to drive trial.  However, our ability to build trial for milk continues to be slowed by the current economic environment.  For our dairy initiative in 2009, we expanded distribution of milks to the Northeast, beyond the initial Florida market.  We launched sour cream products later in the year.   In 2010, we continued our expansion of the distribution of milk across the U.S.  Market share of our milks is .35% of the total milk category for the food channel, twelve weeks ended October 2, 2010, according to Nielsen data.

We restructured our long-term debt in November 2009 to give the Company greater flexibility in strategic areas such as acquisitions and capital structure with higher available credit and less restrictive financial covenants than our previous facility.  At the end of September 2010 our debt was $58.0 million.  Our board authorized a two-year, $25 million stock repurchase program, which became effective starting in March 2010.  As of September 30, 2010, approximately $7.3 million was used to repurchase the Company’s shares.

In 2009, we signed an exclusive license agreement to use the Bestlife™ brand across virtually all food and beverage categories.  The Best Life® program was developed by Bob Greene, Oprah’s trainer and nutritional advisor.  We believe that this relationship provides us with a significant opportunity to use a targeted marketing approach to penetrate the value segment of the spreads category and other categories where the Smart Balance® brand does not participate.  We began distribution of Bestlife™ spreads in March 2010.  In the third quarter of 2010, we announced the launch of Earth Balance® organic soymilk into Whole Foods markets nationwide.   We plan to expand Earth Balance® organic soymilk to other natural food customers in 2011.

 

Subject to certain conditions, the Borrower may voluntarily prepay the loans under the Credit Agreement in whole or in part, without premium or penalty (other than customary breakage costs).  Mandatory prepayments that are required under the Credit Agreement include:

 

●

100% of the net cash proceeds (as defined in the Credit Agreement) upon certain dispositions of property or upon certain damages or seizures of property, subject to limited exceptions;

●

50% of all net cash proceeds from issuance of additional equity securities of the Company, subject to limited exceptions, provided, however, if the Company’s Leverage Ratio is less than 2.0 as of the end of the most recently ended quarter, the prepayment is limited to 25% of such proceeds;

●

100% of the amount of net cash proceeds for certain issuances of additional indebtedness for borrowed money; and

●

Beginning on December 31, 2010 and each fiscal year thereafter, an annual prepayment equal to 25% of excess cash flow of the Company (as defined in the Credit Agreement) for such fiscal year, provided such prepayment is not required if the Company has a Leverage Ratio of 2.0 or less, measured as of the end of such fiscal year.

The Credit Agreement contains covenants that are customary for agreements of this type.  These covenants include, among others: a limitation on the incurrence of additional indebtedness; a limitation on mergers, acquisitions, investments and dividend payments; and maintenance of specified financial ratios.  Under the Credit Agreement, the Company must maintain (1) a Leverage Ratio that is not greater than 2.75 to 1.0 until December 30, 2011 and not greater than 2.50 to 1.0 thereafter and (2) a ratio of EBITDA to Debt Service (as defined in the Credit Agreement), in each case for the prior four fiscal quarters, of not less than 2.00 to 1.00.  The Company is also limited to spending not more than $6 million of capital expenditures per year with any unspent funds carried over to the next twelve months.  At September 30, 2010, the Company was in compliance with all of its covenants.

The failure to satisfy covenants under the Credit Agreement or the occurrence of other specified events that constitute an event of default could result in the acceleration of the repayment obligations of the Borrower.  The Credit Agreement contains customary provisions relating to events of default for agreements of this type. The events of default include, among others: the nonpayment of any outstanding principal, interest, fees or other amounts due under the Credit Agreement; certain bankruptcy events, judgments or decrees against the Company or the Borrower; cross defaults to other indebtedness exceeding $5.0 million; a change in control (as defined in the Credit Agreement) of the Company or the Borrower; and the failure to perform or observe covenants in the Credit Agreement.

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The obligations under the Credit Agreement are guaranteed by the Company and all existing and future subsidiaries of the Borrower.  The Borrower, the Company and the other guarantors granted to the Agent, for the benefit of the Lenders, a security interest in substantially all of its respective assets, including, among other things, patents, patent licenses, trademarks and trademark licenses.

After the close of the transaction, total debt outstanding under the Credit Agreement totaled approximately $60.6 million comprised of $55 million of Term Loan debt and $5.6 million of borrowings under the Revolver.  During the fourth quarter of 2009, the Company paid approximately $4.0 million on its Revolver and during the first quarter of 2010 it paid $1.1 million of its scheduled requirements.  During the second quarter of 2010, the Company paid $6.5 million of which $1.6 million reduced the Revolver to zero and $4.9 million was applied against the Term Loan.  During the third quarter of 2010, the Company borrowed $9 million under the Revolver bringing the total debt outstanding to $58 million as of September 30, 2010.

The Company is required to pay the following amounts in each of the next four years:

 

2010		$	-
2011			5.0
2012			5.5
2013			47.5
Total		$	58.0

The interest rate under the Credit Agreement at September 30, 2010 was 4.75% while the interest rate on the unused line was 0.5%. This amount does not take into account the amount, if any, of the requirement that, beginning on December 31, 2010, the Company make an annual payment equal to 25% of excess cash flow, as defined by the Credit Agreement, unless its leverage ratio is 2.0 or less.  The Company currently has a ratio of less than 2.0 and expects to remain at that level on December 31, 2010.

 Contractual Obligations

There has been no material change to our contractual obligations as disclosed in the fiscal year 2009 Form 10-K filed with the SEC on March 10, 2010.

Off Balance Sheet Arrangements

We do not have off-balance sheet arrangements, financings, or other relationships with unconsolidated entities or other persons, also known as “variable interest entities.”

We are exposed to market risk from changes in interest rates charged on our debt. The impact on earnings is subject to change as a result of movements in market rates. A hypothetical increase in interest rates of 100 basis points would result in potential reduction of future pre-tax earnings of approximately $0.6 million per year.  Our ability to meet our debt service obligations will be dependent upon our future performance which, in turn, is subject to future economic conditions and to financial, business and other factors.