UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

(Mark One)

For the quarterly period ended June 30, 2017

or

For the transition period from                      to                    

Commission File Number: 0-10653

 

ESSENDANT INC.

(Exact Name of Registrant as Specified in its Charter)

 

 

One Parkway North Boulevard

Suite 100

Deerfield, Illinois 60015-2559

(847) 627-7000

(Address, Including Zip Code, and Telephone Number, Including Area Code, of Registrant’s Principal Executive Offices)

 

Indicate by check mark whether 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 registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  ☒    No  ☐

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 and 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  ☒    No   ☐

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

 

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 7(a)(2)(B) of the Securities Act.

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ☐    No  ☒

On July 21, 2017, the registrant had outstanding 37,529,402 shares of common stock, par value $0.10 per share.

 

 

 

 

 

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ESSENDANT INC.

FORM 10-Q

For the Quarterly Period Ended June 30, 2017

TABLE OF CONTENTS

 

 

 

 

 

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PART I – FINANCIAL INFORMATION

 

ESSENDANT INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)

 

 

See notes to condensed consolidated financial statements.

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ESSENDANT INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF INCOME (LOSS)

(in thousands, except per share data)

(Unaudited)

 

 

 

See notes to condensed consolidated financial statements.

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ESSENDANT INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(in thousands)

(Unaudited)

 

 

See notes to condensed consolidated financial statements.

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ESSENDANT INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(dollars in thousands)

(Unaudited)

 

 

 

See notes to condensed consolidated financial statements.

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ESSENDANT INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

1. Basis of Presentation

The accompanying Condensed Consolidated Financial Statements represent Essendant Inc. (“ESND”) with its wholly owned subsidiary Essendant Co. (“ECO”), and ECO’s subsidiaries (collectively, “Essendant” or the “Company”). The Condensed Consolidated Financial Statements have been prepared in accordance with accounting principles generally accepted in the United States and include the accounts of ESND and its subsidiaries. All intercompany transactions and balances have been eliminated. The Company operates in a single reportable segment as a leading national wholesale distributor of workplace items.

The accompanying Condensed Consolidated Financial Statements are unaudited. The Condensed Consolidated Balance Sheet as of December 31, 2016, was derived from the December 31, 2016 audited financial statements. The Condensed Consolidated Financial Statements have been prepared in accordance with the rules and regulations of the United States Securities and Exchange Commission (“SEC”). Certain information and footnote disclosures normally included in financial statements, prepared in accordance with accounting principles generally accepted in the United States, have been condensed or omitted pursuant to such rules and regulations. Accordingly, the reader of this Quarterly Report on Form 10-Q should refer to the Company’s Annual Report on Form 10-K for the year ended December 31, 2016 (the “2016 Form 10-K”) for further information.

In the opinion of management, the accompanying unaudited Condensed Consolidated Financial Statements reflect all adjustments, consisting only of normal recurring adjustments, necessary to present fairly the financial position of Essendant at June 30, 2017 and the results of operations for the three and six months ended June 30, 2017 and 2016, and cash flows for the six months ended June 30, 2017 and 2016. The results of operations for the three and six months ended June 30, 2017 should not necessarily be taken as indicative of the results of operations that may be expected for the entire year.

New Accounting Pronouncements

In March 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2016-09, Compensation – Stock Compensation (Topic 718), Improvements to Employee Share-Based Payment Accounting. Under the new guidance, when awards vest or are settled, companies are required to record excess tax benefits and tax deficiencies as income tax expense or benefit in the income statement instead of in additional paid-in capital. Furthermore, excess tax benefits are presented as an operating activity on the statement of cash flows rather than as a financing activity. In the six months ended June 30, 2017, the Company adopted the standard which resulted in $0.8 million of incremental tax expense that was recognized due to excess tax deficiencies of vested or settled awards in the first six months of 2017. Furthermore, the Company notes certain other changes resulting from adoption including changes in the calculation of the effect of dilutive securities for purposes of calculating diluted net income per share which was immaterial in the period and Condensed Consolidated Statement of Cash Flows presentation changes. The Company has elected to apply guidance concerning cash flow presentation on a prospective basis and to continue to estimate the number of awards expected to be forfeited.

 

In January 2017, the FASB issued ASU No. 2017-04, “Intangibles—Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment,” which eliminates the second step of the two-step goodwill impairment test. Specifically, the standard requires an entity to perform its interim or annual goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount. An impairment charge is recognized for the amount by which the carrying amount exceeds the reporting unit's fair value; however, the loss recognized could not exceed the total amount of goodwill allocated to that reporting unit. An entity still has the option to perform a qualitative assessment to determine if the quantitative impairment test is necessary. The Company early adopted the standard in the quarter ended March 31, 2017 when an interim impairment test was conducted as further discussed in Note 4 – “Goodwill and Intangible Assets”.

In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers, that outlines a single comprehensive model for entities to use in accounting for revenue arising from contracts with customers and supersedes most current revenue recognition guidance, including industry-specific guidance. The ASU is based on the principle that an entity should recognize revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The ASU also requires additional disclosure about the nature, amount, timing and uncertainty of revenue and cash flows arising from customer contracts, including significant judgments and changes in judgments and assets recognized from costs incurred to fulfill a contract. In August 2015, the FASB issued ASU No. 2015-14, Revenue from Contracts with Customers, which deferred the effective date of ASU No. 2014-09. This standard is effective for fiscal years beginning after December 15, 2017, including interim periods within that reporting period.

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Entities have the option of using either a full retrospective or a modified retrospective approach for the adoption of the new standard. The Company plans to adopt the standard using the modified retrospective approach, which will require the Company to recognize the cumulative effect of initial adoption of the standard for all contracts as of, and new contracts after, the date of initial application.

Based on the Company’s current assessment and detailed review of the revenue transactions of the organization with its customers, the impact of the application of the new standard is expected to be immaterial. The Company expects that revenue recognition related to the processing, fulfillment and shipment of various warehoused goods to remain substantially unchanged. The Company also expects disclosure changes resulting from certain policy elections and practical expedient uses of, or allowable divergences from, authoritative guidance. The Company will continue to monitor for modifications to the standards throughout the year ended December 31, 2017.

 

In February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842), that requires lessees to recognize right-of-use assets and lease liabilities for all leases other than those that meet the definition of short-term leases. For short-term leases, lessees may elect an accounting policy by class of underlying asset under which these assets and liabilities are not recognized and lease payments are generally recognized over the lease term on a straight-line basis. This standard will be effective for annual periods beginning after December 15, 2018, including interim periods within that reporting period, and early application is permitted. The Company is currently evaluating the new guidance to determine the impact it will have on its consolidated financial statements.

 

In June 2016, the FASB issued ASU No. 2016-13, Financial Instruments – Credit Losses (Topic 326) Measurement of Credit Losses on Financial Instruments. This standard replaces the incurred loss methodology previously employed to measure credit losses for most financial assets and requires the use of a forward-looking expected loss model. Current accounting delays the recognition of credit losses until it is probable a loss has been incurred, while the update will require financial assets to be measured at amortized costs less a reserve and equal to the net amount expected to be collected. This standard will be effective for annual periods beginning after December 15, 2019, including interim periods within that reporting period, and early application is permitted. The Company is currently evaluating the new guidance to determine the impact it will have on its consolidated financial statements.

 

In August 2016, the FASB issued ASU No. 2016-15, Statement of Cash Flows (Topic 230), Classification of Certain Cash Receipts and Cash Payments. This standard amends and adjusts how cash receipts and cash payments are presented and classified in the statement of cash flows and is effective for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years and will require adoption on a retrospective basis unless impracticable. If impracticable the Company would be required to apply the amendments prospectively as of the earliest date possible. The Company is currently evaluating the impact the new guidance will have on its statement of cash flows or financial statement disclosures.

 

In March 2017, the FASB issued ASU No. 2017-07, “Compensation – Retirement Benefits (Topic 715): Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost.” The standard requires registrants that include a measure of operating income to include the service cost component in the same financial statement line item as other compensation costs and to report other pension-related costs, including amortization of prior service cost/credit, and settlement and curtailment effects, etc. separately, excluding them from operating expenses and income. The ASU also stipulates that only the service cost component of net benefit cost is eligible for capitalization. Application of the standard is required to be made on a retrospective basis for the presentation of the service cost component and the other components of net periodic pension cost and net periodic postretirement benefit cost in the income statement while the change in capitalized benefit cost is to be applied prospectively. This standard will be effective for annual periods beginning after December 15, 2017, including interim periods within that reporting period, and early application is permitted as of the beginning of an annual period. The Company is currently evaluating the new guidance to determine the impact it will have on the presentation of its consolidated financial statements, but does not expect any impact on the Company’s net income.

 

 

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Inventory

Approximately 98.3% of total inventory as of June 30, 2017 and December 31, 2016, respectively, has been valued under the Last-In-First-Out (“LIFO”) method. An actual valuation of inventory under the LIFO method can be made only at the end of each fiscal year based on the inventory levels and costs at that time. Interim LIFO calculations are based on management’s estimates of expected year-end inventory levels and costs, and are subject to the final year-end LIFO inventory valuation. Inventory valued under the LIFO accounting method is recorded at the lower of cost or market. If the Company had valued its entire inventory under the lower of First-In-First-Out (“FIFO”) cost or market, inventory values would have been $158.1 million and $147.9 million higher than reported as of June 30, 2017 and December 31, 2016, respectively.

For the three months ended June 30, 2017, there was a $0.3 million reduction in LIFO liquidations as compared to the $1.6 million reported in the first quarter. For the six months ended June 30, 2017, LIFO liquidations resulted in LIFO income of $1.3 million, which was more than offset by LIFO expense of $11.5 million related to current inflation, for an overall net increase in cost of sales of $10.2 million. LIFO liquidations occur when there are decrements of LIFO inventory quantities carried at lower costs in prior years as compared with the cost of current year purchases. 

 

2. Share-Based Compensation

As of June 30, 2017, the Company has two active equity compensation plans. Under the 2015 Long-Term Incentive Plan (as amended and restated), award instruments include, but are not limited to, stock options, restricted stock awards, restricted stock units (“RSUs”), and performance-based awards. Associates and non-employee directors of the Company are eligible to become participants in the plan. The Nonemployee Directors’ Deferred Stock Compensation Plan allows non-employee directors to elect to defer receipt of all or a portion of their annual retainer in deferred stock units.

 

The Company granted 58,962 shares of restricted stock and 221,365 RSUs during the first six months of 2017, compared to 129,059 shares of restricted stock and 247,656 RSUs during the first six months of 2016.

 

3. Severance and Restructuring Charges

 

Commencing in 2015, the Company began certain restructuring actions which included workforce reductions, facility closures, and actions to reduce costs through management delayering in order to achieve broader functional alignment of the organization. The charges associated with these actions were included in “warehousing, marketing and administrative expenses.” These actions were substantially completed in 2016. No expenses have been recorded in the three and six months ended June 30, 2017 and the three months ended June 30, 2016.

 

The expenses, cash flows, and accrued liabilities associated with the restructuring actions described above are noted in the following table (in thousands):

 

    

 

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4. Goodwill and Intangible Assets

The Company tests goodwill for impairment annually as of October 1 and whenever triggering events or circumstances indicate that an impairment may have occurred, such as a significant adverse change in the business climate, loss of key personnel or a decision to sell or dispose of a reporting unit, among others. Determining whether an impairment has occurred requires a comparison of the carrying value of the net assets of the reporting unit to the fair value of the respective reporting unit.

 

In the quarter ended March 31, 2017, given a sustained decrease in the Company’s share price and related market capitalization, the Company determined that a triggering event had occurred for all of its reporting units, requiring an interim impairment test of goodwill. During this assessment, the Company determined that the carrying value of net assets for three of the four reporting units of the Company exceeded fair value. In consideration of the Company’s adoption of ASU 2017-04 (refer to Note 1 – “Basis of Presentation”) the Company recognized a goodwill impairment of $198.8 million in aggregate based on the difference between the carrying value of net assets and fair value as determined based on the combination of market prices and merger and acquisitions (“M&A”) transactions of comparable businesses and forecasted future discounted cash flows.

 

The carrying amount of goodwill by reporting unit and impairment recognized is noted in the table below (in thousands):

 

 

Acquired intangible assets are initially recorded at their fair market values determined based on quoted market prices in active markets, if available, or recognized valuation models. The Company’s intangible assets have finite useful lives and are amortized on a straight-line basis over their useful lives.  

The following table summarizes the intangible assets of the Company by major class of intangible assets and the cost, accumulated amortization, net carrying amount, and weighted average life, if applicable (in thousands):

 

 

The following table summarizes the amortization expense to be incurred in 2017 through 2021 on intangible assets (in thousands):

 

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5. Accumulated Other Comprehensive Income (Loss)

The change in Accumulated Other Comprehensive Income (Loss) (“AOCI”) by component, net of tax, for the period ended June 30, 2017 was as follows (amounts in thousands):

 

 

The following table details the amounts reclassified out of AOCI into the income statement during the three and six months ended June 30, 2017  (in thousands):

 

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6. Earnings Per Share

Basic earnings per share (“EPS”) is computed by dividing net income by the weighted-average number of common shares outstanding during the period. Diluted EPS reflects the potential dilution that could occur if dilutive securities were exercised into common stock. Stock options, restricted stock, restricted stock units and deferred stock units are considered dilutive securities. For the three- and six- month periods ended June 30, 2017 and 2016, 0.2 million shares of such securities, respectively, were outstanding but were not included in the computation of diluted earnings per share because the options’ exercise prices were greater than the average market price of the common shares and, therefore, the effect would be antidilutive. An additional 0.2 million shares of common stock outstanding for the six months ended June 30, 2017 were excluded from the computation of diluted earnings per share due to the net loss. The following table sets forth the computation of basic and diluted earnings per share (in thousands, except per share data):  

 

 

 

Common Stock Repurchases

As of June 30, 2017 , the Company had Board authorization to repurchase $68.2 million of common stock. During the three and six months ended June 30, 2017, the Company did not repurchase any shares of its common stock. During the three months ended June 30, 2016, the Company did not repurchase any shares of its common stock. For the six months ended June 30, 2016, the Company repurchased 241,270 shares at an aggregate cost of $6.8 million. Depending on the market and business conditions and other factors, the Company may continue or suspend purchasing its common stock at any time without notice. Acquired shares are included in the issued shares of the Company and treasury stock, but are not included in average shares outstanding when calculating earnings per share data.

 

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7. Debt

ESND is a holding company and, as a result, its primary sources of funds are cash generated from operating activities of its direct operating subsidiary, ECO, and from borrowings by ECO. The 2017 Credit Agreement and the 2013 Note Purchase Agreement (each as defined below and each a “Lending Agreement”) contain restrictions on the use of cash transferred from ECO to ESND.

 

On February 22, 2017, ESND, ECO, ECO’s United States subsidiaries (ESND, ECO and the subsidiaries collectively referred to as the “Loan Parties”), JPMorgan Chase Bank, National Association, as Administrative Agent, and certain lenders entered into a Fifth Amended and Restated Revolving Credit Agreement (the “2017 Credit Agreement”). The 2017 Credit Agreement amended and restated the Fourth Amended and Restated Five-Year Revolving Credit Agreement dated as of July 9, 2013 (as amended prior to February 22, 2017, the “2013 Credit Agreement”). Also on February 22, 2017, ESND, ECO and the holders of ECO’s 3.75% senior secured notes due January 15, 2021, (the “Notes”) entered into Amendment No. 4 (“Amendment No. 4”) to the Note Purchase Agreement dated as of November 25, 2013, (as amended prior to February 22, 2017, the “2013 Note Purchase Agreement”).

 

The 2017 Credit Agreement and Amendment No. 4 eliminated certain covenants in the 2013 Credit Agreement and the 2013 Note Purchase Agreement that prohibited the Company from exceeding a debt-to-EBITDA ratio of 3.5 to 1.0 (or 4.0 to 1.0 following certain permitted acquisitions) and restricted the Company’s ability to pay dividends and repurchase stock when the ratio was 3.0 to 1.0 or more. As a result, the Company is no longer subject to a debt-to-EBITDA ratio covenant.

 

Proceeds from the 2017 Credit Facility were used to repay the balances of the 2013 Credit Agreement and the Receivables Securitization Program (as defined below).

 

The 2017 Credit Agreement provides for a revolving credit facility (with an aggregated committed principal amount of $1.0 billion), a first-in-last-out (“FILO”) revolving credit facility (with an aggregated committed principal amount of $100 million) and a term loan (with an initial aggregated committed principal amount of $77.6 million). The term loan was funded in a single funding on March 24, 2017. Loans under the 2017 Credit Agreement must be extended to the Company first through the FILO facility.

 

Borrowings under the 2017 Credit Agreement bear interest at LIBOR for specified interest periods, at the REVLIBOR30 Rate (as defined in the 2017 Credit Agreement) or at the Alternate Base Rate (as defined in the 2017 Credit Agreement), plus, in each case, a margin determined based on the Company’s average quarterly revolving availability. Depending on the Company’s average quarterly revolving availability, the margin on LIBOR-based loans and REVLIBOR30 Rate-based loans ranges from 1.25% to 1.75% for revolving and term loans and 2.00% to 2.50% for FILO loans, and on Alternate Base Rate loans ranges from 0.25% to 0.75% for revolving and term loans and 1.00% to 1.50% for FILO loans. From February 22, 2017 (the date of the 2017 Credit Agreement) to June 30, 2017, the applicable margin for LIBOR-based loans and REVLIBOR30 Rate-based loans is 1.50% for revolving and term loans and 2.25% for FILO loans, and for Alternate Base Rate loans is 0.50% for revolving and term loans and 1.25% for FILO loans. In addition, ECO is required to pay the lenders a commitment fee on the unutilized portion of the revolving and FILO commitments under the 2017 Credit Agreement at a rate per annum equal to 0.25%. Letters of credit issued pursuant to the 2017 Credit Agreement incur interest based on the applicable margin rate for LIBOR-based Loans, plus 0.125%. Unamortized deferred financing fees of $7.0 million are included within “Current maturities of long-term debt” and “Long-term debt” on the Condensed Consolidated Balance Sheets and will be amortized over the life of the agreements.

 

Obligations of ECO under the 2017 Credit Agreement are guaranteed by ESND and ECO’s domestic subsidiaries. ECO’s obligations under these agreements and the guarantors’ obligations under the guaranty are secured by liens on substantially all Company assets. Availability of credit under the revolving facility will be subject to a revolving borrowing base calculation comprised of a certain percentage of the eligible accounts receivable, plus a certain percentage of the inventory, less reserves. Similarly, availability under the FILO revolving credit facility is subject to a FILO borrowing base comprised primarily of 10% of the eligible accounts receivable, plus 10% multiplied by the net orderly liquidation value percentages of the eligible inventory, less reserves. The amount of the remaining term loan of $76.1 million, is based on the value of the Company’s owned real estate and certain equipment. Beginning in April 2017, the Company began repayment of nominal principal amounts pursuant to the terms and conditions of the term loan, and these payments may be subject to acceleration under certain dispositions of the underlying collateral.

 

The 2017 Credit Agreement contains representations and warranties, covenants and events of default that are customary for facilities of this type, including covenants to deliver periodic certifications setting forth the revolving borrowing base and FILO borrowing base. As long as the Payment Conditions (as defined in the 2017 Credit Agreement) are satisfied, the Loan Parties may pay dividends, repurchase stock and engage in certain permitted acquisitions, investments and dispositions, in each case subject to the other terms and conditions of the Credit Agreement and the other loan documents.

 

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If ECO elects to prepay some or all of the Notes prior to January 15, 2021, and in some circumstances if ECO is required to prepay the Notes, ECO will be obligated to pay a make-whole amount as set forth in the Agreement and Amendment No. 4. The Company’s obligations under the 2013 Note Purchase Agreement and Amendment No. 4 are secured by a $165.0 million letter of credit issued under the 2017 Credit Agreement.

 

The Company’s accounts receivable securitization program (“Receivables Securitization Program” or the “Program”) was terminated when the Company entered into the 2017 Credit Agreement. The Program provided maximum financing of up to $200 million secured by all the customer accounts receivable and related rights originated by ECO.

 

Debt consisted of the following amounts (in millions):

 

 

The 2017 Credit Agreement provides for the issuance of letters of credit up to $25.0 million, plus up to $165.0 million to be used as collateral for obligations under the 2013 Note Purchase Agreement. Letters of credit totaling approximately $177.5 million were utilized as of June 30, 2017.

 

Interest under the 2013 Note Purchase Agreement is payable semi-annually at a rate per annum equal to 3.75% (3.66% after the effect of terminating an interest rate swap).

 

For additional information about the 2017 Credit Agreement and the 2013 Note Purchase Agreement, see Note 11 – “Debt” to the Company’s Consolidated Financial Statements in the 2016 Form 10-K.

 

8. Pension and Post-Retirement Benefit Plans

The Company maintains pension plans covering union and certain non-union employees. For more information on the Company’s retirement plans, see Note 13 – “Pension Plans and Defined Contribution Plan” to the Company’s Consolidated Financial Statements in the 2016 Form 10-K. A summary of net periodic pension cost related to the Company’s pension plans for the three and six months ended June 30, 2017 and 2016 was as follows (dollars in thousands):

 

 

The Company made cash contributions to its pension plans of $10.0 million in the three and six months ended June 30, 2017 and $10.0 million during the six months ended June 30, 2016. Additional contributions, if any, for 2017 have not yet been determined. As of June 30, 2017 and December 31, 2016, the Company had accrued $30.0 million and $40.2 million, respectively, of pension liability within “Other long-term liabilities” on the Condensed Consolidated Balance Sheets.

 

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Defined Contribution Plan

 

The Company has defined contribution plans covering certain salaried associates and non-union hourly paid associates (the “Plan”). The Plan permits associates to defer a portion of their pre-tax and after-tax salary as contributions to the Plan. The Plan also provides for Company-funded discretionary contributions as well as matching associates’ salary deferral contributions, at the discretion of the Board of Directors. The Company recorded expense of $1.9 million and $3.7 million for the Company match of employee contributions to the Plan for the three and six months ended June 30, 2017, respectively and the three and six months ended June 30, 2016, respectively.

 

9. Fair Value Measurements

The Company measures certain financial assets and liabilities, including an interest rate swap and foreign currency derivatives, at fair value on a recurring basis, based on market rates of the Company’s positions and other observable interest rates. The fair value of the interest rate swaps is determined by using quoted market forward rates (level 2 inputs) and reflects the present value of the amount the Company would pay for contracts involving the same notional amount and maturity date. The fair value of the foreign exchange hedge is determined by using quoted market spot rates (level 2 inputs).

Accounting guidance on fair value establishes a hierarchy for those instruments measured at fair value which distinguishes between assumptions based on market data (observable inputs) and the Company’s own assumptions (unobservable inputs). The hierarchy consists of three levels:

Determining which level to apply to an asset or liability requires significant judgment. The Company evaluates its hierarchy disclosures each quarter. The following table summarizes the financial instruments measured at fair value in the accompanying Condensed Consolidated Balance Sheets as of June 30, 2017 and December 31, 2016 (in thousands):

 

The carrying amount of accounts receivable at June 30, 2017, approximates fair value because of the short-term nature of this item. As of June 30, 2017, no assets or liabilities were measured at fair value on a nonrecurring basis.

 

 

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10. Other Assets and Liabilities

Receivables related to supplier allowances totaling $87.8 million and $86.9 million were included in “Accounts receivable” in the Condensed Consolidated Balance Sheets as of June 30, 2017 and December 31, 2016, respectively.

Current and non-current prepaid customer rebates, net of allowances, were $50.6 million and $47.9 million as of June 30, 2017 and December 31, 2016, respectively, and are included as a component of “Other current assets” and “Other assets”. Accrued customer rebates of $47.2 million and $65.3 million as of June 30, 2017 and December 31, 2016, respectively, were included in “Accrued liabilities” in the Condensed Consolidated Balance Sheets.

 

11. Income Taxes

The Company's tax provision for interim periods is determined using an estimate of its annual effective tax rate, adjusted for discrete items.

 

For the three and six months ended June 30, 2017, the Company recorded income tax expense of $4.5 million and $0.1 million on pre-tax income of $9.6 million and pre-tax loss of $183.4 million, for an effective tax rate of 46.8% and (0.1%), respectively. For the three and six months ended June 30, 2016, the Company recorded income tax expense of $7.8 million and $17.8 million on pre-tax income of $20.8 million and $47.3 million, for an effective tax rate of 37.8% and 37.7%, respectively. In the three and six months ended June 30, 2017, the Company adopted ASU 2016-09 which resulted in $0.5 million and $0.8 million, respectively, of incremental tax expense recognized due to excess tax deficiencies of vested or settled awards in the period. The adoption of the standard was applied prospectively in accordance with guidance.

 

The Company’s U.S. statutory rate is 35.0%. The most significant factor impacting the effective tax rate for the six months ended June 30, 2017 was the discrete impact of the goodwill impairment charges. There were no significant discrete items impacting the effective tax rate for the six months ended June 30, 2016.

 

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12. Legal Matters

 

The Company has been named as a defendant in two lawsuits alleging that the Company sent unsolicited fax advertisements to the named plaintiffs, as well as other persons and entities, in violation of the Telephone Consumer Protection Act of 1991, as amended by the Junk Fax Prevention Act of 2005 ("TCPA"). One lawsuit was initially filed in the United States District Court for the Central District of California on May 1, 2015, and subsequently refiled in the United States District Court for the Northern District of Illinois. The other lawsuit was filed in the United States District Court for the Northern District of Illinois on January 14, 2016. The two lawsuits have been consolidated for pre-trial proceedings, and assigned to the same judge. Plaintiffs in both lawsuits seek certification of a class of plaintiffs comprised of persons and entities who allegedly received fax advertisements from the Company. Under the TCPA, recipients of unsolicited fax advertisements can seek damages of $500 per fax for inadvertent violations and up to $1,500 per fax for knowing and willful violations. Other reported TCPA lawsuits have resulted in a broad range of outcomes, with each case being dependent on its own unique set of facts and circumstances. In each lawsuit, the Company is vigorously contesting class certification and denies that any violations occurred.  

 

Litigation of this kind is likely to lead to settlement negotiations, including negotiations prompted by pre-trial civil court procedures. Regardless of whether the lawsuits are resolved at trial or through settlement, the Company believes that a loss associated with resolution of the pending claims is probable. As of the year ended December 31, 2016, the Company recorded a $4.0 million, pre-tax reserve within “warehousing, marketing and administrative expenses” in the consolidated statement of operations. During the six months ended June 30, 2017, the Company recorded an additional $6.0 million, pre-tax reserve to reflect events concerning mediation activities and settlement negotiations between the Company and the plaintiffs for a total reserve at June 30, 2017 of $10.0 million. The Company continues to evaluate its defenses based on its internal review and investigation of prior events, new information and future circumstances. Final disposition of the lawsuits, whether through settlement or through trial, may result in a loss materially in excess of the aggregate recorded amount. However, a range of reasonably possible excess losses is not estimable at this time. 

 

As disclosed in the first quarter of 2017, the Company was named in a lawsuit filed by a former employee in the Los Angeles Superior Court. During the second quarter of 2017, the Company reached an agreement on the general terms of a settlement to resolve this litigation. The parties are in the process of finalizing a settlement agreement, which will be subject to court approval. In consideration of the settlement, the Company recorded a $3.0 million pre-tax reserve within the warehousing, marketing and administrative expenses line item in the consolidated statement of operations for the three and six months ended June 30, 2017. 

 

The Company is also involved in other legal proceedings arising in the ordinary course of, or incidental to its business. The Company has established reserves, which are not material, for potential losses that are probable and reasonably estimable that may result from those proceedings. In many cases, however, it is difficult to determine whether a loss is probable or even possible or to estimate the amount or range of potential loss, particularly where proceedings may be in relatively early stages or where plaintiffs are seeking substantial or indeterminate damages. Matters frequently need to be more developed before a loss or range of loss can reasonably be estimated. The Company believes that such ordinary course legal proceedings will be resolved with no material adverse effect upon its financial condition, results of operations or cash flows.

 

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This Quarterly Report on Form 10-Q contains “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Exchange Act. Forward-looking statements often contain words such as “expects,” “anticipates,” “estimates,” “intends,” “plans,” “believes,” “seeks,” “will,” “is likely,” “scheduled,” “positioned to,” “continue,” “forecast,” “predicting,” “projection,” “potential” or similar expressions. Forward-looking statements include references to goals, plans, strategies, objectives, projected costs or savings, anticipated future performance, results or events and other statements that are not strictly historical in nature. These forward-looking statements are based on management’s current expectations, forecasts and assumptions. This means they involve a number of risks and uncertainties that could cause actual results to differ materially from those expressed or implied here. These risks and uncertainties include, without limitation, those set forth in Item 1A. “Risk Factors” in the Company’s Annual Report on Form 10-K for the year-ended December 31, 2016 (the “2016 Form 10-K”).

 

Readers should not place undue reliance on forward-looking statements contained in this Quarterly Report on Form 10-Q. The forward-looking information herein is given as of this date only, and the Company undertakes no obligation to revise or update it.

 

Company Overview

 

Essendant Inc. is a leading national wholesale distributor of workplace items, with 2016 net sales of approximately $5.4 billion. Essendant Inc. sells over 190,000 items including janitorial, foodservice and breakroom supplies (“JanSan”), technology products, traditional office products, industrial supplies, cut sheet paper products, automotive products and office furniture. These items include a broad spectrum of brand-name and Essendant private label brand products. Essendant sells through a network of 70 distribution centers to approximately 29,000 reseller customers. Customers include office and workplace dealers; facilities and maintenance distributors, technology, military, automotive aftermarket customers, national retailers and healthcare and vertical suppliers; industrial distributors and internet retailers. The Company also operates CPO Commerce which sells tools, do-it-yourself equipment and other items online to the consumer market.

 

The Company has begun implementing six actions to improve the performance of our business, which include:

 

Key Trends and Recent Results

 

Net sales in the second quarter of 2017 declined by 6.9% compared to the second quarter of 2016. The decline was primarily due to lower sales to large customers in the national retail and independent dealer channels. Profitability in the quarter was adversely impacted by lower sales volume and lower supplier allowances. We are implementing strategies to address these market trends, but we expect them to continue and to continue to impact our business. As a result, our outlook is for 2017 net sales to be down 6% to 9% compared to 2016, which will result in additional margin pressure.

 

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Actions impacting comparability of results (the “Actions”)

 

Second Quarter Results

 

For a further discussion of selected trends, events or uncertainties the Company believes may have a significant impact on its future performance, readers should refer to “Key Trends and Recent Results” under Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in the 2016 Form 10-K.

 

Critical Accounting Policies, Judgments and Estimates

In the second quarter of 2017, there were no significant changes to the Company’s critical accounting policies, judgments or estimates from those disclosed in the 2016 Form 10-K.

 

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Results of Operations—Three Months Ended June 30, 2017 Compared with the Three Months Ended June 30, 2016 

The following table presents the Condensed Consolidated Statements of Income results (in thousands):

 

 

 

Net Sales. Net sales for the quarter ended June 30, 2017 were $1.3 billion, a 6.9% decrease from $1.4 billion in sales during the quarter ended June 30, 2016. In light of the first half sales results, full year 2017 net sales are expected to be down 6% to 9% as compared to 2016. Net sales by key product category for the quarters included the following:

 

JanSan product sales decreased $32.0 million or 8.6% in the second quarter of 2017 compared to the second quarter of 2016. Sales decreased due to declines in the national retail channel of $27.2 million and the independent distributor channel of $3.5 million. As a percentage of total sales, JanSan represented 26.9% in the second quarter of 2017, a decrease from the prior year quarter percentage of total sales of 27.4%.

 

Technology product (primarily ink and toner) sales decreased $42.6 million or 12.4% from the second quarter of 2016. Sales in this category decreased primarily as a result of reduced supplier promotions and declines in the independent dealer channel of $31.0 million as well as declines in the national retail channel of $12.0 million, partially offset by internet retailers sales growth of $2.1 million. As a percentage of total sales, technology products represented 23.8% in the second quarter of 2017, a decrease from the prior year quarter percentage of total sales of 25.3%.

 

Traditional office product sales decreased $21.2 million or 10.5% in the second quarter of 2017 compared to the second quarter of 2016. Sales in this category decreased due to reductions in the independent dealers channel of $10.4 million and sales to the national retail channel of $10.2 million, partially offset by internet retailers sales growth of $0.5 million. As a percentage of total sales, traditional office products represented 14.4% in the second quarter of 2017, a decrease from the prior year quarter percentage of total sales of 15.0%.

 

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Industrial product sales increased $2.4 million or 1.7% in the second quarter of 2017 compared to the second quarter of 2016. This increase was driven by growth in the general industrial channel of $3.2 million and the energy channel of $2.0 million, partially offset by a decline in the retail channel of $4.0 million. As a percentage of total sales, industrial supplies represented 11.5% in the second quarter of 2017, an increase from the prior year quarter percentage of total sales of 10.6%.

 

Cut sheet paper product sales increased $4.8 million or 4.7% in the second quarter of 2017 compared to the second quarter of 2016. The increase in this category was primarily driven by increased sales to independent dealers of $5.3 million and internet retailers sales growth of $0.8 million, partially offset by declines in the national retail channel of $0.6 million. As a percentage of total sales, cut sheet paper represented 8.4% in the second quarter of 2017, which increased from the prior year quarter percentage of total sales of 7.5%.

 

Automotive product sales increased $1.6 million or 2.0% in the second quarter of 2017 compared to the second quarter of 2016. The increase in this category was primarily driven by growth initiatives. As a percentage of total sales, automotive products represented 6.5% in the second quarter of 2017, which increased from the prior year quarter percentage of total sales of 5.9%.

 

Office furniture sales decreased $6.7 million or 9.0% in the second quarter of 2017 compared to the second quarter of 2016. This decrease was primarily the result of declines in sales to independent dealer channels of $5.7 million and internet retailers of $0.8 million. As a percentage of total sales, office furniture represented 5.4% in the second quarter of 2017, which decreased from prior year quarter percentage of total sales of 5.5%.

 

The remainder of the Company’s second quarter 2017 net sales were composed of freight and other revenues.

 

Gross Profit and Gross Margin Rate. Gross profit for the second quarter of 2017 was $177.6 million, compared to $195.8 million in the second quarter of 2016. Gross profit as a percentage of net sales (the gross margin rate) of 14.1% decreased from the prior-year quarter gross margin rate of 14.5%. The gross margin decline of $18.3 million was principally the result of lower sales volume impacting margin by $12.3 million, with the remainder of the decline primarily driven by lower supplier allowances. Sales volume and supplier allowance declines more than offset the benefits of merchandising and pricing actions related to our transformative initiatives. The gross margin rate was negatively impacted as revenue declines outpaced cost reductions. Our sales to larger resellers are generally at lower margins than sales to our smaller resellers. Sales to new customers tend to be lower margin but improve over time. Lower margin category sales include cut-sheet paper products and technology products, while JanSan, traditional office products, furniture and industrial supplies are higher margin categories.

 

Operating Expenses. Operating expenses for the second quarter of 2017 were $161.7 million or 12.8% of net sales, compared to $169.4 million or 12.5% of net sales in the prior year. The $7.7 million decrease was primarily driven by the decrease from the prior year pension settlement charge of $11.7 million, partially offset by increased transformational expenses of $5.4 million and litigation expenses of $3.0 million. Adjusted operating expenses were $153.3 million or 12.2% of net sales compared with $157.6 million or 11.6% of net sales in the same period last year, which was primarily driven by overall cost containment actions including decreased variable labor expenses of $2.3 million, partially offset by a reset of management incentives of $4.2 million.

 

Interest Expense, net. Interest expense, net for the second quarter of 2017 was $6.3 million compared to $5.7 million in the second quarter of 2016. This increase was primarily driven by higher interest rates on outstanding debt.

 

Income Taxes. Income tax expense was $4.5 million for the second quarter of 2017, compared to $7.8 million for the same period in 2016. The Company’s effective tax rate was 46.8% for the current-year quarter as compared to 37.8% for the same period in 2016. The most significant factor impacting the effective tax rate for the three months ended June 30, 2017 was the impact of the adoption of new accounting guidance related to share based compensation.

 

Net Income. Net income for the second quarter of 2017 decreased to $5.1 million or $0.14 per diluted share, compared to $12.9 million or $0.35 per diluted share in the prior year quarter. Adjusted net income was $10.3 million, or $0.28 per diluted share, compared with adjusted net income of $20.3 million or $0.55 per diluted share for the prior year quarter.

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Results of Operations—Six Months Ended June 30, 2017 Compared with the Six Months Ended June 30, 2016

The following table presents the Condensed Consolidated Statements of Income results (in thousands):

 

 

 

Net Sales. Net sales for the six-month period ended June 30, 2017 were $2.5 billion, a 6.5% decrease from $2.7 billion in sales during the six-month period ended June 30, 2016. Net sales by key product category for the periods included the following:

 

JanSan product sales decreased $62.7 million or 8.5% in the first six months of 2017 compared to the first six months of 2016. Sales decreased due to declines in the national retail channel of $47.5 million, independent distributor channel of $13.4 million and internet retailers sales of $1.3 million. As a percentage of total sales, JanSan represented 26.6% in the first six months of 2017, a decrease from the prior year quarter percentage of total sales of 27.2%.

 

Technology products (primarily ink and toner) sales decreased $87.4 million or 12.6% from the first six months of 2016. Sales in this category decreased primarily as a result of reduced supplier promotions and declines in the independent dealer channel of $74.8 million as well as declines in the national retail channel of $16.1 million, partially offset by internet retailers sales growth of $4.7 million. As a percentage of total sales, technology products represented 24.0% in the first six months of 2017, a decrease from the same prior year period of 25.7%.

 

Traditional office product sales decreased $41.4 million or 10.0% in the first six months of 2017 compared to the first six months of 2016. Sales in this category decreased due to reductions in the independent dealers channel of $26.0 million and declines in sales to the national retail channel of $17.7 million, partially offset by internet retailers sales growth of $3.2 million. As a percentage of total sales, traditional office products represented 14.8% in the first six months of 2017, a decrease from the same prior year period percentage of total sales of 15.3%.

 

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Industrial product sales increased $9.6 million or 3.4% in the first six months of 2017 compared to the first six months of 2016. This increase was driven by growth in the general industrial channel of $5.9 million and the energy channel of $4.1 million, partially offset by a decline in the retail channel of $2.9 million. As a percentage of total sales, industrial supplies represented 11.6% in the first six months of 2017, an increase from the same prior year period percentage of total sales of 10.4%.

 

Cut sheet paper product sales increased $16.2 million or 8.4% in the first six months of 2017 compared to the first six months of 2016. The increase in this category was primarily driven by increased sales to independent dealers of $14.9 million and internet retailers sales growth of $2.5 million. As a percentage of total sales, cut sheet paper represented 8.3% in the first six months of 2017, which increased from the same prior year period percentage of total sales of 7.1% due to continued product category market-share growth.

 

Automotive product sales increased $1.0 million or 0.6% in the first six months of 2017 compared to the first six months of 2016. The increase in this category was primarily driven by growth initiatives. As a percentage of total sales, automotive products represented 6.4% in the first six months of 2017, which increased from the same prior year period percentage of total sales of 5.9%.

 

Office furniture sales decreased $11.5 million or 7.7% in the first six months of 2017 compared to the first six months of 2016. This decrease was primarily the result of declines in sales to independent dealer channels of $9.0 million, national retail channel of $1.4 million and internet retailers of $0.8 million. As a percentage of total sales, office furniture represented 5.4% in the first six months of 2017, which decreased from the same prior year period percentage of total sales of 5.5%.

 

The remainder of the Company’s second quarter 2017 net sales were composed of freight and other revenues.

 

Gross Profit and Gross Margin Rate. Gross profit for the first six months of 2017 was $363.2 million, compared to $395.9 million in the first six months of 2016. Gross profit as a percentage of net sales (the gross margin rate) of 14.4% decreased from the prior-year six month period gross margin rate of 14.6%. The gross margin decline of $32.7 million was principally the result of lower sales volume, impacting margin by $22.8 million, lower supplier allowances of $10.1 million and higher freight costs of $3.3 million. Sales volume and supplier allowance declines and higher freight costs more than offset the benefits of merchandising and pricing actions related to our transformative initiatives. The gross margin rate was negatively impacted as revenue declines outpaced cost reductions.

 

Operating Expenses. Operating expenses for the first six months of 2017 were $533.5 million or 21.1% of net sales, compared to $337.0 million or 12.4% of net sales in the prior year. The $196.5 million increase was primarily driven by goodwill impairment of $198.8 million, increased litigation expenses of $9.0 million and transformational expenses of $8.4 million, partially offset by reductions from the prior year pension settlement charge of $11.7 million and reductions in occupancy expenses of $2.2 million. Adjusted operating expenses were $317.3 million or 12.5% of net sales compared with $325.0 million or 12.0% of net sales in the same period last year, primarily as a result of overall cost containment actions including decreased variable labor expenses of $3.0 million, partially offset by a reset of management incentives of $5.6 million.

 

Interest Expense, net. Interest expense, net for the first six months of 2017 was $13.0 million compared to $11.6 million in the first six months of 2016. This increase was primarily driven by higher interest rates on outstanding debt.

 

Income Taxes. Income tax expense was $0.1 million for the first six months of 2017, compared to $17.8 million for the same period in 2016. The Company’s effective tax rate was (0.1%) for the first six months of 2017, compared to 37.7% for the same period in 2016. The most significant factor impacting the effective tax rate for the six months ended June 30, 2017 was the discrete impact of the goodwill impairment charges in the period.

 

Net (Loss) Income. Net loss for the first six months of 2017 decreased to $183.5 million or $(5.01) per diluted share, compared to net income of $29.5 million or $0.80 per diluted share in the prior year. Adjusted net income was $19.5 million, or $0.53 per diluted share, compared with adjusted net income of $36.9 million or $1.00 per diluted share for the same prior year period.

 

 

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Cash Flows

 

Cash flows for the Company for the six-month periods ended June 30, 2017 and 2016 are summarized below (in thousands):

 

Operating Activities

 

For the six-month period ended June 30, 2017, the increase in net cash provided by operating activities was principally the result of decreased inventories and accounts receivable, partially offset by decreased accrued liabilities.

 

Investing Activities

 

Gross capital spending for the six-month period ended June 30, 2017 and 2016 was $13.7 million and $19.3 million, respectively, which was used for various investments in fleet equipment, information technology systems, technology hardware, and distribution center equipment including facility projects.

 

Financing Activities

 

The Company’s cash flow from financing activities is largely dependent on levels of borrowing under the Company’s credit agreement, the acquisition or issuance of treasury stock, and quarterly dividend payments.

 

Cash outflows from financing activities in the six-months ended June 30, 2017 included the repayment of the asset securitization program and payment of debt issuance costs incurred in connection with the 2017 Credit Agreement, partially offset by incremental borrowings under the 2017 Credit Agreement and term loan as compared to net borrowings and repurchases of shares in the six months ended June 30, 2016.

 

In May 2017, the Board of Directors approved a dividend of $0.14 that was paid on July 14, 2017 to shareholders of record as of June 15, 2017. In July 2017, the Board of Directors approved a dividend of $0.14 payable on October 13, 2017 to shareholders of record as of September 15, 2017.

 

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Liquidity and Capital Resources

 

Essendant’s growth has historically been funded by a combination of cash provided by operating activities and debt financing. The Company believes that its cash from operations and collections of receivables, coupled with its sources of borrowings and available cash on hand, are sufficient to fund its currently anticipated requirements. These requirements include payments of interest and dividends, scheduled debt repayments, capital expenditures, working capital needs, the funding of pension plans, and funding for additional share repurchases and acquisitions, if any. The Company believes that its sources of borrowings are sound and that the strength of its balance sheet affords the financial flexibility to respond to both internal growth opportunities and those available through acquisitions.

 

Availability of financing as of June 30, 2017, is summarized below (in millions):

 

 

 

The Company’s total debt and debt-to-total capitalization ratio consisted of the following amounts (in millions):

 

 

Refer to Note 7 - “Debt”, for further descriptions of the provisions of our financing facilities as well as Note 11 - “Debt”, in our 2016 Form 10-K.

 

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Adjusted Operating Expenses, Adjusted Operating Income, Adjusted Net Income, Adjusted Diluted Earnings Per Share, Adjusted EBITDA and Free Cash Flow (the “Non-GAAP table”)

 

The Non-GAAP table below presents Adjusted Operating Expenses, Adjusted Operating Income, Adjusted Net Income, Adjusted Diluted Earnings per Share, Adjusted EBITDA and Free Cash Flow for the three and six months ended June 30, 2017 and 2016 (in thousands, except per share data). These non-GAAP measures exclude certain non-recurring items and exclude other items that do not reflect the Company’s ongoing operations and are included to provide investors with useful information about the financial performance of our business. The presented non-GAAP financial measures should not be considered in isolation or as substitutes for the comparable GAAP financial measures. The non-GAAP financial measures do not reflect all of the amounts associated with our results of operations as determined in accordance with GAAP, and these non-GAAP financial measures should only be used to evaluate our results of operations in conjunction with the corresponding GAAP financial measures.

 

In order to calculate the non-GAAP measures, management excludes the following items to the extent they occur in the reporting period, to facilitate the comparison of current and prior year results and ongoing operations, as management believes these items do not reflect the underlying cost structure of our business. These items can vary significantly in amount and frequency.

 

 

Restructuring actions were taken in 2015 to improve our operational utilization, labor spend, inventory performance and functional alignment of the organization. This included workforce reductions and facility consolidations with an expense impact of $0.3 million in the six months ended June 30, 2016 (refer to Note 3 – “Severance & Restructuring Charges”).

 

 

 

 

In the six months ended June 30, 2017, the Company recorded an impairment of goodwill of $198.8 million, based on a decline in market capitalization (refer to Note 4 – “Goodwill and Intangible Assets”).

 

 

Adjusted operating expenses and adjusted operating income. Adjusted operating expenses and adjusted operating income provide management and our investors with an understanding of the results from the primary operations of our business by excluding the effects of items described above that do not reflect the ordinary expenses and earnings of our operations. Adjusted operating expenses and adjusted operating income are used to evaluate our period-over-period operating performance as they are more comparable measures of our continuing business. These measures may be useful to an investor in evaluating the underlying operating performance of our business.

 

Adjusted net income and adjusted diluted earnings per share. Adjusted net income and adjusted diluted earnings per share provide a more comparable view of our Company’s underlying performance and trends than the comparable GAAP measures. Net income and diluted earnings per share are adjusted for the effect of items described above that do not reflect the ordinary earnings of our operations.

 

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Adjusted earnings before interest, taxes, depreciation and amortization (EBITDA). Adjusted EBITDA is helpful in evaluating our operating performance and is used by management for various purposes, including as a measure of performance and as a basis for strategic planning and forecasting. Net income is adjusted for the effect of interest, taxes, depreciation and amortization and stock-based compensation expense. Management believes that adjusted EBITDA is also commonly used by investors to evaluate operating performance between competitors because it helps reduce variability caused by differences in capital structures, income taxes, stock-based compensation accounting policies, and depreciation and amortization policies.  

 

Free cash flow. Free cash flow is useful to management and our investors as it is a measure of the Company’s liquidity. It provides a more complete understanding of factors and trends affecting our cash flows than the comparable GAAP measure. Net cash provided by (used in) operating activities and net cash provided by (used in) investing activities are aggregated and adjusted to exclude acquisitions, net of cash acquired and divestitures.

 

 

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The Company is subject to market risk associated principally with changes in interest rates and foreign currency exchange rates. There were no material changes to the Company’s exposures to market risk during the quarter ended June 30, 2017, from those disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2016.

 

Evaluation of Disclosure Controls and Procedures

 

We maintain disclosure controls and procedures as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934. Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report. Based upon this evaluation, the principal executive officer and the principal financial officer concluded that our disclosure controls and procedures are effective in providing reasonable assurance that material information required to be disclosed in our reports filed with or submitted to the Securities and Exchange Commission under the Securities Exchange Act is made known to management, including the principal executive officer and the principal financial officer, as appropriate to allow timely decisions regarding required disclosure.

 

Changes in Internal Control over Financial Reporting

During the quarter ended June 30, 2017, there have been no changes in our internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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PART II – OTHER INFORMATION

 

 

For information regarding legal proceedings, see Note 12 - “Legal Matters.”

 

For information regarding risk factors, see “Risk Factors” in Item 1A of Part I of the 2016 Form 10-K. There have been no material changes to the risk factors described in such Form 10-K, except for the following three revised risk factors.

The loss of one or more significant customers could significantly reduce Essendant’s revenues and profitability.

In 2016, Essendant’s largest customer accounted for approximately 11% of net sales and Essendant’s five largest customers accounted for approximately 25% of net sales. Several of Essendant’s current and potential customers were involved in business combinations in 2016 and 2015 and the Company expects increased customer consolidation in the future. Following business combinations, the surviving companies often review their supply chain and sourcing options, which can result in the companies altering their sourcing relationships. The Company generally does not have long-term contracts with its customers, which are typically free to reduce or terminate their purchases from the Company on little or no notice. Increasing direct purchases by major customers from manufacturers, as well as the loss of one or more key customers, changes in the sales mix or sales volume to key customers, or a significant downturn in the business or financial condition of any of them could significantly reduce Essendant’s sales and profitability.

For example, Essendant’s revenue and profitability declined as sales, including sales to several large customers, declined in the first half of 2017.

 

Essendant relies on independent resellers for a significant percentage of its net sales.

Sales to independent resellers account for a significant portion of Essendant’s net sales. Independent resellers compete with national distributors and retailers that have substantially greater financial resources and technical and marketing capabilities. Financial, technical, and commercial constraints are challenging as business increasingly shifts online. Over the years, several of the Company’s independent reseller customers have been acquired by competitors or have ceased operation, and the Company expects independent reseller customers to continue to consolidate. If Essendant’s customer base of independent resellers declines and the Company is not able to replace resulting sales declines, the Company’s business and results of operations will be adversely affected.

In the first half of 2017, sales to independent dealers declined, which the Company believes is due in part to independent dealers losing market share to larger competitors with greater resources. Sales in the first half of 2017 were also adversely affected by the previously disclosed acquisition of a large regional independent dealer customer by Staples.

 

Essendant’s reliance on supplier allowances and promotional incentives could impact profitability.

Supplier allowances and promotional incentives that are often based on the volume of Company product purchases contribute significantly to Essendant’s profitability. If Essendant does not comply with suppliers’ terms and conditions, or does not make requisite purchases to achieve certain volume hurdles, Essendant may not earn certain allowances and promotional incentives. For example, in 2016, as the Company executed its strategy to improve cash flow in part through lower inventory balances, a reduction in purchases from suppliers resulted in lower supplier allowances and promotional incentives, which contributed to unfavorable gross margin changes. Additionally, suppliers may reduce the allowances they pay Essendant if they conclude the value Essendant creates does not justify the allowances. If Essendant’s suppliers reduce or otherwise alter their allowances or promotional incentives, Essendant’s profit margin for the sale of the products it purchases from those suppliers may decline. The loss or diminution of supplier allowances and promotional support could have an adverse effect on the Company’s results of operations. As part of the Company’s multi-year transformation program, the Company has undertaken merchandising and sourcing initiatives to more effectively leverage supply relationships and enhance profitability. Failure to complete the process, incomplete attainment or ineffective management of the initiatives could cause declines in profitability and results of operations.

For example, we earned lower supplier allowances in the first half of 2017, which resulted primarily from lower sales and ongoing inventory rationalization efforts.

 

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The Company did not repurchase any shares of common stock in the six months ended June 30, 2017 while during the six months ended June 30, 2016, the Company repurchased 241,270 of common stock at an aggregate cost of $6.8 million. The Company did not repurchase any additional shares through July 21, 2017. As of that date, the Company had approximately $68.2 million remaining of existing share repurchase authorization from the Board of Directors.  

 

 

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This Quarterly Report on Form 10-Q includes as exhibits certain documents that the Company has previously filed with the SEC. Such previously filed documents are incorporated herein by reference from the respective filings indicated in parentheses at the end of the exhibit descriptions (all made under the Company’s file number of 0-10653). Each of the management contracts and compensatory plans or arrangements included below as an exhibit is identified as such by a double asterisk at the end of the related exhibit description.

 

 

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

 

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