UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
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FORM 10-Q
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(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934.
For the quarterly period ended September 30, 2004
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934.
For the transition period from to
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Commission File Number 333-39373
SOVEREIGN SPECIALTY CHEMICALS, INC.
(Exact Name of Registrant as Specified in Its Charter)
---------------
Delaware
36-4176637
(State or Other Jurisdiction of Incorporation or Organization)
(IRS Employer Identification No.)
225 W. Washington St. -- Ste. 1450, Chicago, IL 60606
(Address of Principal Executive Offices)
(Zip Code)
Registrant's Telephone Number, Including Area Code: (312) 223-7970
Registrant's Web Address: sovereignsc.com
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 [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X]
On November 9, 2004, the registrant had 2,162,876 shares of voting common
stock outstanding and no shares of non-voting common stock outstanding.
SOVEREIGN SPECIALTY CHEMICALS, INC.
FORM 10-Q
TABLE OF CONTENTS
Page Number
PART I. Financial Information
Item 1. Financial Statements:
Consolidated Balance Sheets at September 30, 2004 (Unaudited)
and December 31, 2003......................................... 1
Consolidated Statements of Operations for the three and nine
months ended September 30, 2004 and 2003 (Unaudited)............ 2
Consolidated Statements of Cash Flows for the nine months ended
September 30, 2004 and 2003 (Unaudited)......................... 3
Notes to Consolidated Financial Statements...................... 4
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations................. 9
Item 3. Quantitative and Qualitative Disclosures about
Market Risk................................................... 18
Item 4. Controls and Procedures................................. 19
PART II. Other Information
Item 1. Legal Proceedings....................................... 20
Item 2. Unregistered Sales of Equity Securities and Use of
Proceeds........................................................ 20
Item 3. Defaults Upon Senior Securities......................... 20
Item 4. Submission of Matters to a Vote of Security
Holders....................................................... 20
Item 5. Other Information....................................... 20
Item 6. Exhibits................................................ 20
Signatures...................................................... 21
SOVEREIGN SPECIALTY CHEMICALS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Dollars in Thousands, Except Share Amounts)
September 30, December 31,
2004 2003
------------- -------------
(Unaudited)
Assets
Current assets:
Cash and cash equivalents $11,481 $8,454
Accounts receivable, net 64,109 51,205
Inventories 31,748 26,574
Other current assets 3,909 3,785
------------- -------------
Total current assets 111,247 90,018
Property, plant, and equipment, net 64,899 67,877
Goodwill 124,388 124,388
Deferred financing costs, net 5,698 7,274
Other assets 173 187
------------- -------------
Total assets $306,405 $289,744
============= =============
Liabilities and stockholders' equity
Current liabilities:
Accounts payable $39,503 31,327
Accrued expenses 21,251 22,758
Current portion of long-term debt 3,328 2,122
Current portion of capital lease obligations 394 429
------------- -------------
Total current liabilities 64,476 56,635
Long-term debt, less current portion 202,500 206,108
Capital lease obligations, less current portion 1,852 2,118
Other long-term liabilities 2,301 2,319
Stockholders' equity:
Common stock, $0.01 par value, 2,700,000 shares authorized,
2,162,876 and 1,441,189 issued and outstanding 15 15
Common stock, non-voting, $0.01 par value, 2,100,000 shares
authorized, none and 730,182 issued and outstanding 7 7
Additional paid-in capital 63,227 64,073
Accumulated deficit (26,503) (40,488)
Accumulated other comprehensive loss (1,470) (1,043)
------------- -------------
Total stockholders' equity 35,276 22,564
------------- -------------
Total liabilities and stockholders' equity $306,405 $289,744
============= =============
See accompanying notes to consolidated financial statements.
1
SOVEREIGN SPECIALTY CHEMICALS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(Dollars in Thousands)
Three months ended Nine months ended
September 30, September 30,
--------------------- ---------------------
2004 2003 2004 2003
---------- --------- --------- ----------
(Unaudited) (Unaudited)
Net sales $106,607 $98,747 $308,757 $281,128
Cost of goods sold 75,541 70,446 218,443 202,657
---------- --------- --------- ----------
Gross profit 31,066 28,301 90,314 78,471
Selling, general and administrative expenses 19,007 18,235 56,096 52,515
---------- --------- --------- ----------
Operating income 12,059 10,066 34,218 25,956
Interest expense, net 5,966 6,306 18,456 19,111
---------- --------- --------- ----------
Income before income taxes 6,093 3,760 15,762 6,845
Income tax expense 339 1,494 1,777 3,112
---------- --------- --------- ----------
Net income $5,754 $2,266 $13,985 $3,733
========== ========= ========= ==========
See accompanying notes to consolidated financial statements
2
SOVEREIGN SPECIALTY CHEMICALS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in Thousands)
Nine months ended
--------------------------------------
September 30, 2004 September 30, 2003
------------------- ------------------
(Unaudited) (Unaudited)
Operating Activities
Net income $13,985 $3,733
Adjustments to reconcile net income to net cash provided by
(used in) operating activities:
Depreciation and amortization 6,969 6,642
Amortization of deferred financing costs 1,576 1,518
Amortization of debt discounts 436 442
Foreign exchange gains (95) (1,036)
Deferred income taxes - 2,214
Changes in operating assets and liabilities:
Accounts receivable (12,619) (10,878)
Inventories (5,135) (2,692)
Prepaid expenses and other assets 93 (1,149)
Accounts payable and other liabilities 6,505 116
------------------- ------------------
Net cash provided by (used in) operating activities 11,415 (1,090)
Investing Activities
Purchase of property, plant and equipment (3,885) (6,789)
------------------- ------------------
Net cash used in investing activities (3,385) (6,789)
Financing Activities
Payments on long-term debt (855) (1,158)
Payments for deferred financing costs - (34)
Payments on capital lease obligations (300) (160)
Repurchase of common stock (846) -
Proceeds from revolving credit facilities 13,000 25,000
Payments on revolving credit facilities (14,986) (23,307)
------------------- ------------------
Net cash (used in) provided by financing activities (3,987) 341
Effect of exchange rate changes on cash (516) 111
------------------- ------------------
Net increase (decrease) in cash and cash equivalents 3,027 (7,427)
Cash and cash equivalents at beginning of period 8,454 14,124
------------------- ------------------
Cash and cash equivalents at end of period $11,481 $6,697
=================== ==================
See accompanying notes to consolidated financial statements.
3
SOVEREIGN SPECIALTY CHEMICALS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2004
(Dollars in Thousands)
1. Summary of Significant Accounting Policies
Basis of Presentation and Principles of Consolidation
The consolidated financial statements as of and for the periods ended
September 30, 2004 and 2003, respectively, include the accounts of Sovereign
Specialty Chemicals, Inc. and its wholly owned subsidiaries (the "Company"). All
intercompany balances and transactions have been eliminated.
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 amounts reported in the financial
statements and accompanying notes. Actual results could differ from those
estimates.
Interim Financial Information
The unaudited interim consolidated financial statements of the Company, in
the opinion of management, reflect all necessary adjustments, consisting only of
normal recurring adjustments, for a fair presentation of results as of the dates
and for the interim periods covered by the financial statements. The results for
the interim periods are not necessarily indicative of the results of operations
to be expected for the entire year or any other interim period
The unaudited interim consolidated financial statements of the Company have
been prepared in conformity with generally accepted accounting principles and
reporting practices. Certain information in footnote disclosures normally
included in financial statements prepared in accordance with generally accepted
accounting principles has been condensed or omitted pursuant to the rules and
regulations of the Securities and Exchange Commission; however, the Company
believes the disclosures are adequate to make the information not misleading.
The unaudited interim consolidated financial statements contained herein should
be read in conjunction with the audited consolidated financial statements and
notes thereto included in the Company's Annual Report on Form 10-K for the year
ended December 31, 2003.
Reclassifications
Certain prior year amounts have been reclassified to conform to current year
presentation.
2. Subsequent Event
On October 6, 2004, the Company entered into a definitive agreement for its sale
to Henkel Corporation for a transaction value of approximately $575 million. The
acquisition, which has been approved by the boards of both companies, is subject
to regulatory approvals and is expected to close in the fourth quarter of 2004.
Following the closing of the transaction, the Company will become a wholly-owned
subsidiary of Henkel.
3. Plant Closure Costs
In November 2002, the Company announced the closure of its Cincinnati, Ohio
and Kapellen, Belgium manufacturing plants in 2003. At the time of the
announcement, the Cincinnati, Ohio plant employed 118 people, and primarily
produced water-borne adhesives sold to the industrial market. Substantially all
production from this plant was transferred to the Company's plants in
Greenville, South Carolina, and Carol Stream and Plainfield, Illinois in the
first nine months of 2003. Production related to the final product line to be
transferred was completed in the first quarter of 2004. Some of the technical,
sales support, customer service, and administrative functions have been
transitioned to other Company locations. Approximately 88 employees, in both
manufacturing and support functions were terminated as part of the closure.
4
At the time of the November 2002 announcement, the Kapellen, Belgium plant
employed 24 people and produced water-borne and hot-melt adhesives for the
European packaging and converting market. This production was shifted to the
Newark, United Kingdom plant during the first nine months of 2003. Approximately
16 employees primarily in manufacturing functions have been terminated as part
of the plant closure. A separate Kapellen office continues to provide sales,
technical and distribution support to continental Europe.
These closures include the termination of certain existing employees, the
abandonment or sale at a loss of certain fixed assets, the disposal of certain
inventory and the sale of certain buildings. As a result of the announced
closures, the Company recorded a charge of $4.1 million in the fourth quarter of
2002 and an additional charge of $0.4 million in the first half of 2003,
included in selling, general and administrative expense, relative to the
following costs: termination benefits of $2.0 million, loss on fixed assets of
$1.3 million and other exit costs of $1.2 million. Approximately $1.5 million of
termination benefits, $0.3 million of fixed asset write offs, and $0.7 million
of other exits costs have been incurred through September 30, 2004. The Company
expects approximately $0.1 million in termination benefits in Belgium, $0.8
million write off of fixed assets in Cincinnati and $0.2 million of other exit
costs will be incurred in 2004 and are recorded in accrued liabilities on the
balance sheet. Approximately $0.7 million of termination benefits in Belgium are
long term and this obligation and $0.2 million in other exit costs in Cincinnati
are recorded in other long term liabilities at September 30, 2004.
The following provides an analysis of the changes in the plant closure
liability for the nine months ended September 30, 2004:
Liability for plant closures, balance at January 1, 2004 $2,854
Less: costs incurred nine months ended September 30, 2004 (889)
--------
Liability for plant closures, balance at September 30, 2004 $1,965
========
4. Inventories
Inventories are summarized as follows:
September 30, December 31,
2004 2003
---------- ---------
Raw materials $ 11,198 $ 9,235
Work in process 310 478
Finished goods 20,240 16,861
---------- ---------
$ 31,748 $ 26,574
========== =========
5. Comprehensive Loss
For the three and nine months ended September 30, 2004 and 2003,
respectively, the calculation of comprehensive loss is as follows:
September 30, 2004 September 30, 2003
--------------------------- --------------------------
Three Months Nine Months Three Months Nine Months
Ended Ended Ended Ended
------------- ----------- ------------ ------------
Net income as Reported $5,754 $13,985 $2,266 $3,733
Foreign currency translation
Adjustments (564) (427) (17) (47)
------------- ----------- ------------ ------------
Comprehensive income $5,190 $13,558 $2,249 $3,686
============= =========== ============ ============
6. Segment Reporting
The Company has two reportable segments: the commercial segment and the
construction segment. Applications sold by the commercial segment consist
primarily of flexible packaging adhesives and coatings for a number of
applications, high performance, specialty adhesives and coatings for automotive,
aerospace, manufactured housing and textile applications. Through the
construction segment, the Company manufactures and sells housing repair,
remodeling and construction sealants and adhesives used in exterior and interior
applications.
5
The Company evaluates performance and defines segment profit based upon
operating income. The reportable segments' accounting policies are the same as
those of the Company as a whole. Segment profit is calculated as a reportable
segment's operating income. Total segment profits exceed consolidated operating
profits because of unallocated corporate expenses included in selling, general
and administrative expenses.
The reportable segments are each managed and measured separately primarily
due to the differing customers, products sold and distribution channels. The
reportable segments are as follows:
Commercial Construction Totals
---------- ------------ ---------
For the three months ended September 30, 2004:
Revenues from external customers $62,729 $43,879 $106,608
Segment profit 7,831 6,921 14,752
For the three months ended September 30, 2003:
Revenues from external customers $60,009 $38,738 $98,747
Segment profit 6,132 6,111 12,243
For the nine months ended September 30, 2004:
Revenues from external customers $188,805 $119,952 $308,757
Segment profit 23,263 18,494 41,757
For the nine months ended September 30, 2003:
Revenues from external customers $177,062 $104,066 $281,128
Segment profit 17,508 15,209 32,717
A reconciliation of the reportable segments to consolidated operating income is
as follows:
For the For the
three months ended Nine months ended
September 30, September 30,
2004 2003 2004 2003
Profit:
Total profit for reportable segments... $ 14,752 $ 12,243 $ 41,757 $ 32,717
Unallocated corporate expense.......... (2,693) (2,177) (7,539) (6,761)
---------- ---------- ----------- ----------
Income from operations............ $ 12,059 $ 10,066 $ 34,218 $ 25,956
========== ========== ========= ==========
7. Defined Benefit Pension Plans
The Company sponsors two defined benefit pension plan covering certain salaried
and union employees of certain subsidiaries of the Company. The salaried plan is
not open to new participants. The Company's funding policy has been to
contribute annually at least the minimum required by ERISA. The plans provide
monthly benefits under a benefit formula. The number of plan participants total
112 in aggregate at September 30, 2004, 88 of which are active or terminated and
fully vested and 24 of which are retired and receiving benefits. None of the
plan assets of either pension plan are invested in equity of the Company or
equity investments in any related party.
September 30, 2004 September 30, 2003
-------------------------- ----------------------
Components of net periodic benefit cost: Three Months Nine Months Three Months Nine Months
Ended Ended Ended Ended
Service cost............................. $15 $45 $17 $51
Interest cost............................ 39 117 39 117
Recognized loss.......................... 10 30 19 57
Expected return on plan assets........... (23) (69) (31) (93)
---- ---- ---- ----
Net periodic benefit cost ............... $41 $123 $44 $132
=== ==== ==== ====
6
8. Income Taxes
Income tax expense was $0.3 million and $1.8 million for the three and nine
months ended September 30, 2004. Income tax expense was $1.5 million and $3.1
million for the same periods in 2003, respectively. Income tax expense in 2004
represents U.S. state and international income taxes. We did not record any U.S.
federal income tax expense for the first nine months of 2004 because we expect
that existing net operating loss carry forwards will be used to offset such
income in 2004. A valuation allowance had been previously provided against the
tax benefit of these net operating loss carry forwards in the prior year. In
addition, we continue to provide a full valuation allowance against our net
deferred tax assets.
9. Other Financial Information
The Company is a holding company with no independent assets or operations.
Certain of the Company's subsidiaries (Guarantor Subsidiaries) have guaranteed
the Company's 11 7/8% Senior Subordinated Notes. Full separate financial
statements of the Guarantor Subsidiaries have not been presented as the
guarantors are wholly owned subsidiaries of the Company and the guarantees are
full, unconditional and joint and several. Management does not believe that
inclusion of such financial statements would be material to investors. The
unaudited condensed financial statement data as of September 30, 2004 and 2003
of the Guarantor Subsidiaries and the non-guarantor subsidiaries are below.
The following sets forth the unaudited financial data at September 30, 2004 and
for the three and nine months then ended.
Guarantor Non-Guarantor
Subsidiaries Subsidiaries Parent Eliminations Total
------------ ------------- ----------- ------------ ------------
(Unaudited) (Unaudited) (Unaudited) (Unaudited) (Unaudited)
Statement of operations data for
the nine months ended September 30,
2004:
Net sales $272,182 $36,575 $- $- $308,757
Cost of goods sold 191,309 27,133 -- -- 218,442
------------ ------------- ----------- ------------ ------------
Gross profit 80,873 9,442 - - 90,315
Selling, general and administrative
Expense 41,599 6,958 7,539 -- 56,096
------------ ------------- ----------- ------------ ------------
Operating income(loss) 39,274 2,484 (7,539) - 34,219
Interest expense (15,852) (202) (2,403) -- (18,457)
------------ ------------- ----------- ------------ ------------
Income (loss) before income taxes $23,422 $2,282 $(9,942) $- $15,762
============ ============= =========== ============ ============
Statement of operations data for
the three months ended September 30,
2004:
Net sales $94,290 $12,317 $- $- $106,607
Cost of goods sold 66,492 9,049 -- -- 75,541
------------ ------------- ----------- ------------ ------------
Gross profit 27,796 3,268 - - 31,066
Selling, general and administrative
Expense 14,022 2,292 2,693 - 19,007
------------ ------------- ----------- ------------ ------------
Operating income(loss) 13,776 976 (2,693) - 12,059
Interest expense (5,174) (29) (763) -- (5,966)
------------ ------------- ----------- ------------ ------------
Income (loss) before income taxes $8,602 $947 $(3,456) $ $6,093
============ ============= =========== ============ ============
Balance sheet data:
Current assets $96,437 $21,694 $22,243 $(29,127) $111,247
Property plant and equipment, net 51,729 12,266 904 - 64,899
Goodwill, net 121,353 3,035 - - 124,388
Deferred financing costs, net 4,432 - 1,266 - 5,698
Deferred tax assets (802) 863 (61) - -
Other assets 4,613 1 282,633 (287,074) 173
------------ ------------- ----------- ------------ ------------
Total assets $277,762 $37,859 $306,985 $(316,201) $306,405
============ ============= =========== ============ ============
Liabilities and stockholders' equity:
Current liabilities $73,973 $13,433 $6,086 $(29,016) $64,476
Long-term liabilities 200,179 9,028 210,400 (212,953) 206,654
Total stockholders' equity 3,610 15,398 90,499 (74,232) 35,275
------------ ------------- ----------- ------------ ------------
Total liabilities and stockholders'
equity $277,762 $37,859 $306,985 $(316,201) $306,405
============ ============= =========== ============ ============
7
Guarantor Non-Guarantor
Subsidiaries Subsidiaries Parent Eliminations Total
------------ ------------- ----------- ------------ ------------
(Unaudited) (Unaudited) (Unaudited) (Unaudited) (Unaudited)
Statement of cash flows data for
the nine months ended September 30,
2004:
Operating activities:
Net income (loss) $21,043 $925 $(7,983) $- $13,985
Depreciation and amortization 5,954 690 325 - 6,969
Foreign exchange gains (83) (12) - - (95)
Deferred income taxes - - - - -
Amortization of deferred financing
Costs 1,170 - 406 - 1,576
Amortization of bond discount - - 436 - 436
Changes in operating assets and
Liabilities (7,305) (678) (18,083) - (11,456)
------------ ------------- ----------- ------------ ------------
Net cash provided by (used in)
operating activities 35,389 925 (24,899) - 11,415
Investing activities:
Purchase of property, plant and
Equipment (3,425) (194) (266) - (3,885)
------------ ------------- ----------- ------------ ------------
Net cash used in investing
Activities (3,425) (194) (266) - (3,885)
Financing activities:
Intercompany financing (13,993) 627 13,366 - -
Payments on long-term debt - (500) (355) - (855)
Repurchase of common stock - - (846) - (846)
Payments on capital lease
Obligations (300) - - - (300)
Net proceeds from revolving credit
Facilities (14,671) (315) 13,000 -- (1,986)
------------ ------------- ----------- ------------ ------------
Net cash provided by (used in) financing
Activities (28,964) (188) 25,165 - (3,987)
Effect of foreign currency changes on
Cash (653) 137 -- -- (516)
------------ ------------- ----------- ------------ ------------
Net decrease in cash and cash
Equivalents 2,347 680 - - 3,027
Cash and cash equivalents, beginning
of period 11,378 2,746 -- -- 8,454
------------ ------------- ----------- ------------ ------------
Cash and cash equivalents, end of
Period $13,725 $3,426 $- $- $11,481
============ ============= =========== ============ ============
The following sets forth the unaudited financial data at September 30, 2003 and
for the three and nine months then ended.
Guarantor Non-Guarantor
Subsidiaries Subsidiaries Parent Eliminations Total
------------ ------------- ----------- ------------ ------------
(Unaudited) (Unaudited) (Unaudited) (Unaudited) (Unaudited)
Statement of operations data for
the nine months ended September 30,
2003:
Net sales $246,266 $34,862 $-- $-- $281,128
Cost of goods sold 176,601 26,056 -- -- 202,657
------------ ------------- ----------- ------------ ------------
Gross profit 69,665 8,806 -- -- 78,471
Selling, general and administrative
Expense 38,494 7,260 6,761 -- 52,515
------------ ------------- ----------- ------------ ------------
Operating income (loss) 31,171 1,546 (6,761) -- 25,956
Interest expense 15,967 591 2,553 -- 19,111
------------ ------------- ----------- ------------ ------------
Income (loss) before income taxes $15,204 $955 $(9,314) $-- $6,845
============ ============= =========== ============ ============
Statement of operations data for
the three months ended September 30,
2003:
Net sales $87,354 $11,393 $-- $-- $98,747
Cost of goods sold 61,873 8,573 -- -- 70,446
------------ ------------- ----------- ------------ ------------
Gross profit 25,481 2,820 -- -- 28,301
Selling, general and administrative
expense 13,598 2,460 2,177 -- 18,235
------------ ------------- ----------- ------------ ------------
Operating income (loss) 11,883 360 (2,177) -- 10,066
Interest expense 4,938 487 881 -- 6,306
------------ ------------- ----------- ------------ ------------
Income (loss) before income taxes $6,945 $(127) $(3,058) $-- $3,760
============ ============= =========== ============ ============
Balance sheet data:
Current assets $86,975 $22,037 $20,633 $(20,664) $108,981
Property plant and equipment, net 55,334 12,393 1,050 -- 68,777
Goodwill, net 121,353 3,035 -- -- 124,388
Deferred financing costs, net 6,059 -- 1,807 -- 7,866
Deferred tax assets 5,307 863 (2,471) -- 3,699
Other assets 10,853 28 282,633 (293,321) 193
------------ ------------- ----------- ------------ ------------
Total assets $285,881 $38,356 $303,652 $(313,985) $313,904
============ ============= =========== ============ ============
Liabilities and stockholders' equity:
Current liabilities $60,690 $16,605 $2,681 $(20,664) $59,312
Long-term liabilities 210,370 18,124 219,432 (222,873) 225,053
Total stockholders' equity 14,821 3,627 81,539 (70,448) 29,539
------------ ------------- ----------- ------------ ------------
Total liabilities and stockholders'
equity $285,881 $38,356 $303,652 $(313,985) $313,904
============ ============= =========== ============ ============
8
Guarantor Non-Guarantor
Subsidiaries Subsidiaries Parent Eliminations Total
------------ ------------- ----------- ------------ ------------
(Unaudited) (Unaudited) (Unaudited) (Unaudited) (Unaudited)
Statement of cash flows data for
the nine months ended September 30,
2003:
Operating activities:
Net income (loss) $9,505 $(132) $(5,640) $-- $3,733
Depreciation and amortization 5,456 986 200 -- 6,642
Foreign exchange (gains) losses (62) (974) -- -- (1,036)
Deferred income taxes -- -- 2,214 2,214
Cumulative effect of change in
accounting principle
Amortization of deferred financing
costs 1,112 -- 406 -- 1,518
Amortization of bond discount -- -- 442 -- 442
Changes in operating assets and
liabilities (4,302) (2,169) (8,132) -- (14,603)
------------ ------------- ----------- ------------ ------------
Net cash provided by (used in)
operating activities 11,709 (2,289) (10,510) -- (1,090)
Investing activities:
Sale of property, plant and
equipment -- -- -- --
Purchase of property, plant and
equipment, net (5,782) (513) (494) -- (6,789)
------------ ------------- ----------- ------------ ------------
Net cash used in investing
activities (5,782) (513) (494) -- (6,789)
Financing activities:
Intercompany financing (12,681) 2,289 10,392 -- --
Payments on long-term debt (300) (503) (355) -- (1,158)
Payments for deferred financing
costs -- -- (34) -- (34)
Payments on capital lease
obligations (203) 43 -- -- (160)
Net proceeds on revolving credit
facilities -- 692 1,001 -- 1,693
------------ ------------- ----------- ------------ ------------
Net cash provided by (used in) financing
activities (13,184) 2,521 11,004 -- 341
Effect of foreign currency changes on
cash (15) 126 -- -- 111
------------ ------------- ----------- ------------ ------------
Net increase (decrease)
in cash (7,272) (155) -- -- (7,427)
Cash and cash equivalents, beginning
of period 11,378 2,746 -- -- 14,124
------------ ------------- ----------- ------------ ------------
Cash and cash equivalents, end of period $4,106 $2,591 $-- $-- $6,697
============ ============= =========== ============ ============
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
The following discussion and analysis is provided to increase the
understanding of, and should be read in conjunction with, the unaudited interim
consolidated financial statements and accompanying notes included herein.
9
General
We are a leading developer and supplier of high performance specialty
adhesives, sealants and coatings for use in three primary end markets: packaging
and converting; industrial; and construction. We operate in the highly
fragmented adhesives, sealants and coatings segment of the specialty chemicals
industry. We focus on select value-added market niches in which we have
established leadership positions and competitive advantages in product
development, manufacturing and distribution. Our strategy includes swiftly
responding to emerging customer needs and leveraging the depth and breath of our
operations, technologies, best practices and expertise. We frequently design our
products in cooperation with our customers to meet their unique specifications
and to provide critical performance attributes to their products, resulting in a
significant number of long-lived primary supplier relationships.
We are headquartered in Chicago, Illinois, and supported by operations
worldwide. We were founded as a partnership in 1995, were incorporated in 1997,
and in 1999, 75% of our common stock was acquired by SSCI Investors LLC. We have
successfully expanded our business through the integration of ten strategic
acquisitions. Currently, our business is comprised of a Commercial segment and a
Construction segment. Our Commercial segment (approximately 62% of net sales for
the nine months ended September 30, 2004) serves a range of industrial end
markets, including high-performance specialty adhesives and coatings for
transportation, furniture and product assembly applications, flame retardant
specialties and specialty polymers. Our Commercial segment also manufactures
coating and adhesive products for packaging, paper converting and graphic arts
applications. Our Construction segment (approximately 38% of net sales for the
nine months ended September 30, 2004) manufactures branded caulk, sealants and
adhesives which serve the following end markets: distributors for professional
contractors, original equipment manufacturers (OEM's), Co-Op distributors and
do-it-yourself retailers. We plan to continue our growth through a combination
of strong customer focus and focus on key product areas, new product
development, leveraging technology across business units, continued market
penetration and international expansion.
On October 6, 2004 we entered into a definitive agreement for the sale of
the Company to Henkel Corporation for a transaction value of approximately $575
million. The acquisition, which has been approved by the boards of both
companies, is subject to regulatory approvals and is expected to close in the
fourth quarter of 2004. Following the closing of the transaction, we will become
a wholly-owned subsidiary of Henkel.
Summary of Critical Accounting Policies
The discussion and analysis of our financial condition and results of
operations are based upon our consolidated financial statements, which have been
prepared in accordance with accounting principles generally accepted in the
United States. The preparation of these financial statements requires us to make
estimates and judgments that affect the reported amounts of assets, liabilities,
revenues and expenses, and related disclosure of contingent assets and
liabilities. On an ongoing basis, we continually evaluate our estimates. We base
our estimates on historical experience and on various other assumptions that are
believed to be reasonable under the circumstances, the results of which form the
basis for making judgments about the carrying values of assets and liabilities
that are not readily apparent from other sources. Actual results may differ from
these estimates.
We believe the following critical accounting policies affect our more
significant judgments and estimates used in the preparation of our consolidated
financial statements.
Revenue Recognition. Revenue from the sale of products is recognized at the
point of passage of title, which is typically at the time of shipment. Before
recognizing passage of title, we require that persuasive evidence of a revenue
arrangement exists, delivery of product has occurred or services have been
rendered, the price to the customer is fixed and determinable and collectibility
is reasonably assured. Rebates, discounts, returns and other allowances are
reflected as reductions from gross sales in determining net sales. Rebates are
accrued based on contractual relationships with customers as shipments are made.
Customer returns and allowances and discounts are accrued based on our history
of sales returns and allowances.
Cost of Goods Sold. Cost of goods sold represents the actual cost of
purchased raw materials, direct and indirect labor, warehousing and
manufacturing overhead costs, including depreciation, utilized directly in the
production of products for which revenue has been recognized.
Selling, General & Administrative Expenses. Selling, general &
administrative expenses generally are those costs not directly related to the
production process and include all selling, marketing, research and development
and customer service expenses as well as expenses related to general management,
finance and accounting, information services, human resources, legal and
corporate overhead.
Goodwill. Goodwill represents the excess of acquisition cost over the fair
value of net assets acquired and is tested for impairment at least annually.
This impairment test involves various assumptions related to future cash flows,
termination values and discount rates for each reporting unit. These assumptions
are subjective and based on many different quantitative and qualitative factors
that, when revised, can significantly affect the overall evaluation of goodwill
impairment.
10
Reserve for Inventory Obsolescence. Our estimated reserves for obsolescence
or unmarketable inventory is equal to the difference between the cost of the
inventory and the estimated market value based upon assumptions about market
conditions, future demand and expected usage rates. We periodically review
inventory and if applicable, record additional inventory write-downs. If actual
market conditions are less favorable than those projected by management and
cause usage rates to vary from those estimated, additional inventory write-downs
may be required, however these would not be expected to have a material adverse
impact on our financial statements.
Allowance for Doubtful Accounts. We maintain allowances for doubtful
accounts for estimated losses resulting from the failure of our customers to
make required payments. We evaluate the adequacy of our allowance for doubtful
accounts and make judgments and estimates in determining the appropriate
allowance at each reporting period. If a customer's financial condition were to
deteriorate, additional allowances may be required.
Deferred Tax Asset Valuation Allowance. Pursuant to the provisions of SFAS
No. 109, Accounting for Income Taxes, we evaluate the need for a valuation on
our net deferred tax asset, including an estimation of our future taxable income
to determine an allowance adequate to reduce the total deferred tax asset to an
amount that will more likely than not be realized.
Segment Reporting
We have two reportable segments: the Commercial segment and the Construction
segment. Our Commercial segment serves a range of industrial end markets,
including high-performance specialty adhesives and coatings for transportation,
furniture and product assembly applications, flame retardant specialties and
specialty polymers. Our Commercial segment also manufactures coating and
adhesive products for packaging, paper converting and graphic arts applications.
Our Construction segment manufactures branded caulk, sealants and adhesives
which serve the following end markets: distributors for professional
contractors, OEM's, Co-Op distributors and do-it-yourself retailers.
We evaluate the performance of each segment based on operating income.
Segment profit is calculated as a reportable segment's operating income. Total
segment profits exceed consolidated operating profits to the extent of
unallocated corporate expenses included in selling, general and administrative
expenses. Unallocated corporate expenses were $2.7 million and $7.5 million for
the three and nine months ended September 30, 2004, respectively; and $2.2
million and $6.8 million for the three and nine months ended September 30, 2003.
Results of Operations
Three months ended September 30, 2004 compared to three months ended September
30, 2003
Net Sales. Net sales were $106.6 million and $98.7 million for the three
months ended September 30, 2004 and 2003, respectively. The third quarter 2004
net sales level represents an increase of $7.9 million or 7.4% over the prior
year. The increase resulted from gains in both the Construction and the
Commercial segments. Construction segment sales were $43.9 million in the third
quarter of 2004, up $5.1 million, or 13.3% from the prior year reflecting sales
increases in building material applications and increased sales to the retail
do-it-yourself market. Commercial segment sales were $62.7 million in the third
quarter of 2004, up $2.7 million, or 4.5% from the prior year due to sales
increases in a number of domestic end markets, with the largest year over year
gains recognized in product assembly and flexible packaging end markets.
Cost of Goods Sold. Cost of goods sold was $75.5 million for the three
months ended September 30, 2004, an increase of $5.1 million, or 6.7% over third
quarter 2003 cost of sales of $70.4 million. Gross profit as a percentage of net
sales increased for the third quarter of 2004 to 29.1% from 28.7% for the third
quarter of 2003. We experienced increased raw material costs year over year
measured as a percentage of net sales. As a result of completed plant closures
and lean manufacturing initiatives, we were able to control manufacturing costs
year over year, while increasing net sales by $7.9 million. Manufacturing cost
improvements year over year more than offset the negative impact of increased
raw material costs and resulted in improved gross margin percentage for the
quarter.
11
Selling, General and Administrative Expenses. Selling, general and
administrative expenses (SG&A) were $19.0 million for the three months ended
September 30, 2004, an increase of $0.8 million, or 4.1% from the third quarter
2003 expenses of $18.2 million. This increase was primarily due to increased
volume-related selling and marketing costs incurred in the Construction segment
and normal wage increases. As a percentage of net sales, SG&A decreased to 17.8%
of net sales for the third quarter of 2004 from 18.5% in the third quarter of
2003. Management remains focused on reducing SG&A as a percent of net sales and
on containing costs where possible.
Operating Income. Operating income was $12.1 million and $10.1 million for
the three months ended September 30, 2004 and 2003, respectively. Operating
income as a percentage of net sales was 11.1% and 9.2% for the three months
ended September 30, 2004 and 2003, respectively, and is reflective of strong
sales growth, improved gross margins, and control of selling, general and
administrative expenses.
Interest Expense. Net interest expense was $6.0 million and $6.3 million for
the three months ended September 30, 2004 and 2003, respectively. The 5.7%
decrease in interest expense was due primarily to the decrease in our average
outstanding level of variable rate debt year over year.
Income Tax Expense. Income tax expense was $0.3 million for the three months
ended September 30, 2004 and represents U.S. state and international income
taxes. We did not record any U.S. federal income tax expense for the third
quarter of 2004 because we expect that existing net operating loss carry
forwards will be used to offset such income in 2004. A valuation allowance had
been previously provided against the tax benefit of these net operating loss
carry forwards in the prior year. In addition, we continue to provide a full
valuation allowance against our net deferred tax assets. Income tax expense was
$1.5 million for the same period in 2003.
Net income. Net income for the three months ended September 30, 2004 and
2003 was $5.7 million and $2.3 million, respectively. The increase in income
from the prior year is reflective of strong sales growth, improved gross margins
and control of selling, general and administrative expenses.
Commercial Segment
The following table presents net sales and segment profit expressed in
millions of dollars and segment profit margin, which is segment profit expressed
as a percentage of net sales:
For the
Quarter Ended
September 30,
------------------
Dollar Percentage
2004 2003 Change Change
------- --------- ------- ----------
Net sales $62.7 $60.0 $2.7 4.5%
======= =========
Segment profit $7.8 $6.1 $1.7 27.7%
======= =========
Segment profit margin 12.5% 10.2%
======= =========
Net sales were $62.7 million for the three months ended September 30, 2004,
representing a $2.7 million increase from third quarter 2003. This increase was
due primarily to increased sales of product assembly, transportation and
flexible packaging applications end markets. Segment profit was $7.8 and $6.1
million for the quarters ended September 30, 2004 and 2003, respectively.
Segment profit increased as a result of net sales increases, reductions in
manufacturing costs and constant SG&A.
12
Construction Segment
The following table presents net sales and segment profit expressed in
millions of dollars and segment profit margin, which is segment profit expressed
as a percentage of net sales:
For the
Quarter Ended
September 30,
------------------
Dollar Percentage
2004 2003 Change Change
--------- ------- ------- -----------
Net sales $43.9 $38.7 $5.2 13.3%
========= =======
Segment profit $6.9 $6.1 $0.8 13.3%
========= =======
Segment profit margin 15.8% 15.8%
========= =======
Net sales for the Construction segment were $43.9 million for the quarter
ended September 30, 2004 and $38.7 million for the quarter ended September 30,
2003. The $5.2 million and 13.3% increase in sales in 2004 over the prior year
was primarily due to the sustained strength of its building materials
applications and strength at major retail accounts. Segment profit increased by
$0.8 million, or 13.3%, primarily as a result of higher sales volume and
management focus on reduction of selling, general and administrative costs that
offset higher year over year raw material costs.
Nine months ended September 30, 2004 compared to nine months ended September 30,
2003
Net Sales. Net sales were $308.8 million and $281.1 million for the nine
months ended September 30, 2004 and 2003, respectively. The third quarter 2004
net sales level represents an increase of $27.6 million or 8.9% over the prior
year. The increase resulted from gains in both the Construction and Commercial
segments. Construction segment sales were $120.0 million in the first nine
months of 2004, up $15.9 million, or 15.3% from the prior year reflecting sales
increases in building material applications due to the continued strength in the
housing market and increased sales to the retail do-it-yourself market.
Commercial segment sales were $188.8 million in the first nine months of 2004,
up $11.7 million, or 6.6% from the prior year due primarily to increased sales
of product assembly, transportation, industrial specialties and flexible
packaging applications and moderate increases in nearly all other end markets
Cost of Goods Sold. Cost of goods sold was $218.4 million for the nine
months ended September 30, 2004, an increase of $15.7 million, or 7.2% over the
prior year cost of sales of $202.7 million. Gross profit as a percentage of net
sales increased in 2004 to 29.3% from 27.9% in the first nine months of 2003.
This increase is reflective of maintaining raw material margins year over year
despite increased raw material costs and significant reductions in manufacturing
expense as a percentage of sales year over year.
Selling, General and Administrative Expenses. Selling, general and
administrative expenses were $56.1 million for the nine months ended September
30, 2004, an increase of $3.6 million, or 6.4% over prior year expenses of $52.5
million. This increase was due to increased selling and marketing costs incurred
in the construction segment, normal wage increases and a $0.9 million decrease
in foreign exchange gain/loss year over year. As a percentage of net sales,
selling, general and administrative expenses decreased to 18.2% for the nine
months ended September 30, 2004 from 18.7% for the nine months ended September
30, 2003. This decrease is reflective of a management focus on cost containment.
Operating Income. Operating income was $34.2 million and $26.0 million for
the nine months ended September 30, 2004 and 2003, respectively. Operating
income as a percentage of net sales was 11.1% and 9.2% for the nine months ended
September 30, 2004 and 2003, respectively, and is reflective of strong sales
growth, maintenance of raw material margins, reductions in manufacturing costs,
and control of selling, general and administrative expenses.
Interest Expense. Net interest expense was $18.5 million and $19.1 million
for the nine months ended September 30, 2004 and 2003, respectively. The 3.5%
decrease in interest expense was due primarily to a decrease in our average
outstanding level of variable rate debt year over year.
Income tax expense (benefit). Income tax expense was $1.8 million for the
nine months ended September 30, 2004. Income tax expense was $3.1 million for
the same period in 2003. Income tax expense in 2004 represents U.S. state and
international income taxes. We did not record any U.S. federal income tax
expense for the first nine months of 2004 because we expect that existing net
operating loss carry forwards will be used to offset such income in 2004. A
valuation allowance had been previously provided against the tax benefit of
these net operating loss carry forwards in the prior year.
Net income. Net income for the nine months ended September 30, 2004 and 2003
was $14.0 million and $3.7 million, respectively. The increase in income from
the prior year is reflective of strong sales growth, maintenance of raw material
margins, reductions in manufacturing costs, and control of selling, general and
administrative expenses.
13
Commercial Segment
The following table presents net sales and segment profit expressed in
millions of dollars and segment profit margin, which is segment profit expressed
as a percentage of net sales:
For the
Nine Months Ended
September 30,
------------------
Dollar Percentage
2004 2003 Change Change
-------- -------- ------- ----------
Net sales $188.8 $177.1 $11.7 6.6%
======== ========
Segment profit $23.3 $17.5 $5.8 32.9%
======== ========
Segment profit margin 12.3% 9.9%
======== ========
Net sales were $188.8 million for the nine months ended September 30, 2004,
representing a $11.7 million increase from the first nine months of 2003. This
increase was due primarily to increased sales of product assembly,
transportation, industrial specialties and flexible packaging applications and
moderate increases in nearly all other end markets. Segment profit was $23.3
million for nine months ended September 30, 2004 and $17.5 million for the same
period in 2003. Segment profit increased as a result of net sales increases,
reductions in manufacturing costs and constant SG&A.
Substantially all production from our Cincinnati, Ohio plant, which
primarily produced water borne adhesives, was transferred to our plants in
Greenville, South Carolina, and Carol Stream and Plainfield, Illinois in the
first nine months of 2003. Production relative to an insignificant product line
that had not been transferred at December 31, 2003 was transferred in the first
quarter of 2004. Some of the technical, sales support, customer service, and
administrative functions have been transitioned to our other locations.
Approximately 88 employees, in both manufacturing and support functions were
terminated as part of the closure.
Our Kapellen, Belgium plant which employed 24 people and produced
water-borne and hot-melt adhesives for the European packaging and converting
market was closed and the production was shifted to our Newark, United Kingdom
plant during the first nine months of 2003. Approximately 16 employees,
primarily in manufacturing functions, have been terminated as part of the plant
closure. A separate Kapellen office continues to provide sales, technical and
distribution support to continental Europe.
These closures include the termination of certain existing employees, the
abandonment or sale at a loss of certain fixed assets, the disposal of certain
inventory and the sale of certain buildings. As a result of the announced
closures we recorded a charge of $4.1 million in the fourth quarter of 2002 and
an additional charge of $0.4 million in the first half of 2003, included in
selling, general and administrative expense, relative to the following costs:
termination benefits of $2.0 million, loss on fixed assets of $1.3 million and
other exit costs of $1.2 million. Approximately $1.5 million of termination
benefits, $0.3 million of fixed asset write offs, and $0.7 million of other
exits costs have been incurred through September 30, 2004. We expect
approximately $0.1 million in termination benefits in Belgium, $0.8 million
write off of fixed assets in Cincinnati and $0.2 million of other exit costs
will be incurred in 2004 and are recorded in accrued liabilities on the balance
sheet. Approximately $0.7 million of termination benefits in Belgium are long
term and this obligation and $0.2 million in other exit costs in Cincinnati are
recorded in other long term liabilities at September 30, 2004.
Construction Segment
The following table presents net sales and segment profit expressed in
millions of dollars and segment profit margin, which is segment profit expressed
as a percentage of net sales:
For the
Nine Months Ended
September 30,
------------------
Dollar Percentage
2004 2003 Change Change
--------- -------- ------- -----------
Net sales $120.0 $104.1 $15.9 15.3%
========= ========
Segment profit $18.5 $15.2 $3.3 21.6%
========= ========
Segment profit margin 15.4% 14.6%
========= ========
14
Net sales for the Construction segment were $120.0 million for the nine months
ended September 30, 2004 and $104.1 million for the nine months ended September
30, 2003. The $15.9 million or 15.3% increase in sales in 2004 was primarily due
to the sustained strength of its building materials end markets and strength at
major retail accounts. Segment profit increased by $3.3 million, or 21.6%,
primarily as a result of higher sales volume, management focus on reduction of
selling, general and administrative costs and pricing increases that offset
higher year over year raw material costs.
Liquidity and Capital Resources
Net cash provided in operating activities was $11.4 million for the nine
months ended September 30, 2004. Net cash used in operations was $1.1 million
for the nine months ended September 30, 2003. During the first nine months of
2004, we increased inventory levels by $5.1 million and accounts receivable
balances by $12.6 million to support and as a result of increased sales volume
we have experienced since the fourth quarter of 2003. At September 30, 2003,
accounts receivable and inventory balances were $60.9 million and $31.2 million,
respectively. Accounts receivable at September 30, 2004 is approximately $3.2
million higher than at September 30, 2003; sales for the quarter ended September
30, 2004 were approximately $7.9 million higher than sales for the corresponding
prior year quarters'. As a percentage of net sales, receivables decreased as we
continue to shorten the time frame in which we collect on our receivables. We
have maintained inventory balances consistent with September 30, 2003 levels
while supporting sales increases year over year. Consolidated operating working
capital (receivables plus inventory less payables) continues to decline as a
percentage of net sales due to continued management focus in this area.
Operating working capital in dollars and as a percentage of net sales was $56.4
million and 14.1%, $46.5 million and 12.5% and $54.2 million and 14.8% at
September 30, 2004, December 31, 2003 and September 30, 2003, respectively. This
is a point in time comparison but we manage this measure on a monthly basis by
looking at a rolling twelve month average operating working capital percentage.
We have experienced significant declines in our average working capital
throughout the last 26 months as a result of management focus in this area.
Accounts payable increased by $8.2 million and accrued expenses decreased by
$1.5 million during the nine months ended September 30, 2004.
Net cash used in investing activities was $3.9 million and $6.7 million in
the nine months ended September 30, 2004 and 2003, respectively, and resulted
from additions to property, plant and equipment.
Net cash used in financing activities was $4.0 million for the nine months
ended September 30, 2004. We have lowered our total debt balance by
approximately $2.8 million in the first nine months of 2004 and approximately
$16.6 million below the September 30, 2003 balance. Net debt, defined as total
debt less cash, was $196.6 million and $217.9 million at September 30, 2004 and
September 30, 2003, respectively.
Credit Facilities
Our credit agreement, as amended (Credit Agreement), provides for aggregate
borrowings of $107.8 million. The Credit Agreement includes (1) a $50.0 million
revolving credit facility (Credit Facility) (including letters of credit of up
to $20 million), (2) Term Loan A with an aggregate principal balance of $11.1
million at September 30, 2004 and no capacity to borrow additional funds under
that facility and (3) Term Loan B with an aggregate principal balance of $46.7
million at September 30, 2004 and no additional capacity to borrow additional
funds under that facility.
The Credit Facility matures December 30, 2005. Commitment fees on the unused
portion of the Credit Facility of 0.375% to 0.050% are payable quarterly in
arrears. At September 30, 2004, we had no borrowings outstanding and $48.0
million in available borrowings under the Credit Facility (net of approximately
$2.0 million outstanding letters of credit). Our effective interest rate for our
borrowings under the Credit Agreement was 5.6% and 5.9%, for the three months
ended September 30, 2004 and 2003, respectively.
Borrowings under the Credit Facility are available on a revolving basis and
may be used for general corporate purposes, excluding, however, loans, advances
and investments, including acquisitions, by the Company other than specified
exceptions.
The Term Loan B includes a $2.4 million discount which is being amortized
through interest expense over the life of the facility ($0.8 million through
September 30, 2004). The Term Loan B will mature December 30, 2007. Scheduled
principal repayment under the Term Loan B facility for the years ending December
31, 2003 through 2006 will be $0.5 million per year payable quarterly. The
remaining balance under Term Loan B, will be repaid in 2007. We have three
scheduled quarterly payments in 2007 at the same rate of $0.5 million per year
and a final payment due for the balance outstanding at December 30, 2007. There
is no scheduled amortization for the $11.1 million outstanding under the Term
Loan A for the years ending December 31, 2003 and 2004. The remaining $11.1
million drawn under Term Loan A will be repaid quarterly from the second quarter
2005 through the first quarter 2006.
15
Borrowings under the Credit Agreement bear interest at our option at a rate
per annum equal to either (1) the higher of (a) the current base rate as offered
by JPMorgan Chase or (b) 1/2 of 1% per annum above the federal funds rate plus,
in either case, an applicable margin or (2) a Eurodollar rate plus an applicable
margin. The applicable margin varies by facility. For amounts drawn under the
Term Loan A and the Credit Facility the Eurodollar margin is 3.75% and the base
rate margin is 2.75%. For amounts drawn under the Term Loan B facility, the
Eurodollar margin is 4.50% and the base rate margin is 3.50%. Amounts
outstanding under the Credit Facility, Term Loan A and Term Loan B bear
interest, payable quarterly in the case of base rate advances and payable at the
end of the relevant interest period of one, two, three or six months (or
quarterly in certain cases) for all Eurodollar advances. Our credit ratings do
not affect the interest rates for our borrowings under our Credit Agreement.
We have a Singapore credit facility providing for borrowings up to
approximately $1.4 million in U.S. dollars which is secured by a letter of
credit. Interest is payable at United States prime plus 1.0%. At September 30,
2004, approximately $0.2 million was drawn on the facility.
Our Credit Agreement obligates us to make mandatory prepayments in certain
circumstances with the proceeds of asset sales or issuance of capital stocks or
indebtedness and with certain excess cash flow (no mandatory payments are
pending at September 30, 2004). Our Credit Agreement contains covenants that
restrict our and our subsidiaries' ability to incur additional indebtedness,
incur liens, dispose of assets, prepay or amend other indebtedness, pay
dividends or purchase our stock, and change the business conducted by us or our
subsidiaries. In addition, we must also comply with specified financial ratios
and tests including maintenance of maximum total debt to EBITDA, maximum senior
debt to EBITDA, minimum EBITDA to interest expense, and minimum asset coverage
ratios (in each case, as defined in our credit agreement) and other covenants at
the end of each fiscal quarter. The covenant ratio calculations in our credit
agreement utilize non GAAP financial measures that are specifically defined in
the Credit Agreement. At September 30, 2004, we were in compliance with all
financial and other covenants as prescribed by the Credit Agreement.
Each of these covenants continues for the term of the Credit Agreement
either at the latest level, or a more restrictive level. Deterioration in our
current operating performance could result in our failure to satisfy our
financial covenants. A failure by us to satisfy the covenants under the Credit
Agreement would trigger the lenders' right to require immediate repayment of all
or part of the indebtedness; such acceleration, in turn, would also give rise to
a right to require immediate repayment by holders of our subordinated notes. The
Credit Facility, Term Loan A and Term Loan B are secured by a security interest
in substantially all of our subsidiaries' assets, including pledges of the
common stock of our domestic and first tier foreign subsidiaries. In addition,
the Credit Facility, Term Loan A and Term Loan B are guaranteed by our
subsidiaries. Some of our guarantees and pledges are in support of only offshore
advances, if any, under the Credit Facility.
Senior Subordinated Notes
In March 2000, we completed a private placement of $150.0 million in
principal amount of 11 7/8% Senior Subordinated Notes (the Notes) due 2010. The
Notes were subsequently exchanged for notes with substantially identical terms
that were registered with the Securities and Exchange Commission. The Notes were
issued at a discount of $1.1 million which is being amortized to interest
expense over the life of the Notes. At September 30, 2004, the unamortized
discount is $0.6 million.
The Notes mature on March 15, 2010. Interest is payable semi-annually in
arrears each March 15 and September 15. On or after March 15, 2005, the Notes
may be redeemed at our option, in whole or in part, at specified redemption
prices plus accrued and unpaid interest:
Year Redemption Price
---------------------- ----------------
2005 105.938%
2006 103.958%
2007 101.979%
2008 and thereafter 100.000%
In the event of a change in control, we would be required to offer to
repurchase the Notes at a price equal to 101.0% of the principal amount plus
accrued and unpaid interest.
The Notes are our general obligations, subordinated in right of payment to
all existing and future senior debt and are guaranteed by our wholly-owned
domestic subsidiaries -- (the Guarantor Subsidiaries). Each of the Guarantor
Subsidiaries' guarantees of the Notes are full, unconditional, and joint and
several.
16
The indenture under which the Notes were issued contains certain covenants
that, among other things, limit us from incurring other indebtedness, engaging
in transactions with affiliates, incurring liens, making certain restricted
payments (including dividends), and making certain asset sales.
Related Parties
We have a management agreement with AEA Investors Inc. under which we
receive advisory and consulting services provided by AEA Investors LLC, the
successor company to AEA Investors Inc. and sometimes referred to in this report
collectively with its successor as AEA Investors. The management agreement
provides for an annual aggregate fee of $1.0 million plus reasonable
out-of-pocket costs and expenses.
Liquidity and Capital Requirements
Interest payments on the amounts drawn under the Credit Agreement, as well
as other indebtedness and obligations, represent significant obligations for us.
Our remaining liquidity demands relate to capital expenditures and working
capital needs. Our capital expenditures were approximately $8.2 million in 2003
and management currently anticipates capital expenditures will be approximately
$6.0 million in 2004 and $8.0 million in 2005, respectively. While we engage in
ongoing evaluations of and discussions with, third parties regarding possible
acquisitions, as of the date of this report, we have no current expectations
with respect to any acquisitions. Exclusive of the impact of any future
acquisitions, joint venture arrangements or similar transactions, our management
does not expect capital expenditure requirements to increase materially in the
foreseeable future.
Our primary sources of liquidity are cash flows from operations and
borrowings under our Credit Agreement. Based on current and anticipated
financial performance, we expect that cash flow from operations and borrowings
under our Credit Agreement will be adequate to meet anticipated requirements for
capital expenditures, working capital and scheduled interest payments, including
interest payments on the amounts outstanding under the 11 7/8% Senior
Subordinated Notes, the Credit Agreement and other indebtedness through
September 30, 2005. Our ability to satisfy capital requirements will be
dependent upon our future financial performance. Additionally our ability to
repay or refinance our debt obligations will also be subject to economic
conditions and to financial, business and other factors, many of which are
beyond our control.
Forward-looking Statements
Some of the information presented in, or connection with, this report
include "forward-looking statements" based on our current expectations and
projections about future events and involve potential risks and uncertainties.
Our future results could differ materially from those discussed in this report.
Some of the factors that could cause or contribute to such differences include:
-- changes in economic and market conditions that impact the demand for
our products and services;
-- risks inherent in international operations, including possible
economic, political or monetary instability;
-- uncertainties relating to our ability to consummate our business
strategy, including realizing synergies and cost savings from the
integration of acquired businesses or from plant closures;
-- the impact of new technologies and the potential effect of delays in
the development or deployment of such technologies; and,
-- changes in raw material costs and our ability to adjust selling
prices.
You should not place undue reliance on our forward-looking statements, which
are applicable only as of November 10, 2004. All written and oral
forward-looking statements attributable to us are expressly qualified in their
entirety by the foregoing factors and those identified in Exhibit 99.1
incorporated by reference into this report. We undertake no obligation to revise
or update these forward-looking statements to reflect events or circumstances
that arise after November 10, 2004 or to reflect the occurrence of unanticipated
events. New risks emerge from time to time and it is not possible for us to
predict all such risks, nor can we assess the impact of all such risks on our
business or the extent to which any risks, or combination of risks, may cause
actual results to differ materially from those contained in any forward-looking
statement.
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Item 3. Quantitative and Qualitative Disclosures about Market Risk
The principal market risks, which are potential losses in fair values, cash
flows or earnings due to adverse changes in market rates and prices, to which we
are exposed, as a result of our holdings of financial instrument and commodity
positions, are:
-- interest rates on debt;
-- foreign exchange rates; and
-- commodity prices, which affect the cost of raw materials.
Our financial instruments include short-term debt and long-term debt. Trade
accounts payable and trade accounts receivable are not considered financial
instruments for purposes of this item because their carrying amount approximate
fair value. We do not maintain a trading portfolio and do not utilize derivative
financial instruments to manage our market risks. In the future, we may enter
into foreign exchange currency hedging agreements in connection with our
international operations.
Market Risk Management
We have measured our market risk related to our financial instruments based
on changes in interest rates and foreign currency rates utilizing a sensitivity
analysis. The sensitivity analysis measures the potential loss in fair values,
cash flows and earnings based on a hypothetical change (increase and decrease)
in interest rates and a decline in the U.K. pound/dollar exchange rate. We used
market rates as of September 30, 2004 on our financial instruments to perform
the sensitivity analysis. We believe that these potential changes in market
rates are reasonably possible in the near-term (one year or less). We have
conducted an analysis of the impact of a 100 basis point change in interest
rates and a 10% decline in the U.K. pound/dollar exchange rate as discussed
below.
Interest Rate Exposure
Our primary interest rate exposure relates to our variable rate debt. We
utilize a combination of variable rate debt, primarily under our Credit
Agreement, and fixed rate debt, primarily under our 11 7/8% Senior Subordinated
Notes. Our Credit Agreement requires that, at least 45% of our funded
indebtedness be fixed-rate or subject to interest rate hedging agreements to
reduce the risk associated with variable-rate debt. At September 30, 2004
approximately 73.0% of our funded indebtedness was fixed-rate. The variable rate
debt is primarily exposed to changes in interest expense from changes in the
U.S. prime rate, the federal funds effective rate and the Eurodollar borrowing
rate, while the fixed rate debt is primarily exposed to changes in fair value
from changes in medium term interest rates. Based on our indebtedness at
September 30, 2004, we estimate that an immediate 100 basis point rise in
interest rates would result in $0.6 million increase in interest expense for the
period October 1, 2004 to September 30, 2005. For purposes of this estimate, we
have assumed a constant level of variable rate debt and a constant interest rate
over the period equal to those levels existing on September 30, 2004.
Currency Rate Exposure
Our primary foreign currency exchange rate exposure relates to the U.K.
pound which results in our exposure to changes in the dollar exchange rate. Our
exposure to changes in U.S. dollar exchange rates with currencies other than the
U.K. pound are not currently material. Changes in translation risk are reported
as adjustments to stockholders' equity. We estimate that the impact of a 10%
decline in the dollar/U.K. pound exchange rate from $1.82/(pound)1.00 to
$1.64/(pound)1.00 at September 30, 2004 would result in a decrease in our
earnings before taxes of $0.4 million for the period from October 1, 2004 to
September 30, 2005.
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Commodities Risk
We are subject to market risk with respect to commodities because our
ability to recover increased raw materials costs through higher pricing may be
limited by the competitive environment in which we operate.
We use a broad variety of specialty and some commodity raw materials in our
manufacturing processes. In 2003, we purchased about $201 million of raw
materials including acrylic monomers and polymers, resins, natural and synthetic
rubbers, solvents, and urethanes. Although these raw materials are derived from
crude oil or natural gas, the raw materials are several manufacturing steps
removed (downstream) from these basic feed stocks. As a result, the price of oil
and gas will affect our costs for these raw materials both upward and downward,
but the magnitude of change is diluted.
We typically purchase strategic raw materials on a contract basis to
moderate price changes during the contract period. However, prices can change
significantly at the end of contract periods if supply shortages, feedstock cost
pressures, or other unforeseen market conditions arise. Commodity raw materials
are available from numerous independent suppliers, and specialty raw materials
are usually available from several suppliers.
We expect the cost of many raw materials to increase over the long term. In
aggregate, we have had some success historically in passing on raw material cost
increases through price increases to our customers over time under certain
competitive market conditions, although not always in levels adequate to
maintain margins. We may not achieve historical levels of success in the future.
The sensitivity analyses above are estimates and are based on certain
simplifying assumptions. These analyses should not be viewed as predictive of
our future financial performance. Additionally, we cannot provide any assurance
that the actual impact in any particular year will not materially exceed the
amounts indicated above.
Item 4. Controls and Procedures
We carried out an evaluation, under the supervision and with the
participation of our management, including our Chief Executive Officer and Chief
Financial Officer, of the effectiveness of the design and operation of our
disclosure controls and procedures as of the end of the period covered by this
report. Based upon that evaluation, our Chief Executive Officer and Chief
Financial Officer concluded that our disclosure controls and procedures are
effective in timely alerting them to material information relating to us
(including our consolidated subsidiaries) required to be included in our
periodic SEC filings.
There were no changes in our internal controls over financial reporting that
occurred during the most recent fiscal quarter 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
Item 1. Legal Proceedings
None
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
None
Item 3. Defaults Upon Senior Securities
None
Item 4. Submission of Matters to a Vote of Security Holders
On September 30, 2004, holders of approximately 94% of the outstanding
shares of our voting common stock, par value $0.01 per share, executed and
delivered written consents approving the entering into of an agreement and plan
of merger with Henkel Corporation pursuant to which we would be come a wholly
owned subsidiary of Henkel Corporation. The agreement and plan of merger was
signed on October 6, 2004.
Item 5. Other Information
None
Item 6. Exhibits
Exhibits
31.1 -- Certifications as required by Section 302(a) of the
Sarbanes-Oxley Act of 2002
31.2 -- Certifications as required by Section 302(a) of the
Sarbanes-Oxley Act of 2002
99.1 -- Cautionary Statements for Regarding Forward Looking
Statements incorporated by reference to Exhibit 99.1 to the
Company's Form 10-K dated February 27, 2004.
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SOVEREIGN SPECIALTY CHEMICALS, INC.
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.
SOVEREIGN SPECIALTY CHEMICALS, INC.
/s/ NORMAN E. WELLS JR.
------------------------------------------------------
Norman E. Wells Jr., Chairman, Chief Executive Officer
(Principal Executive Officer)
/s/ TERRY D. SMITH
------------------------------------------------------
Terry D. Smith, Vice President, Chief Financial Officer
(Principal Financial Officer)
Date: November 10, 2004
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