Form 10-K/A Darling International YE Dec 31, 2005

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

______________________________________

 

FORM 10-K/A
Amendment No. 2

 

(Mark One)


X

 

ANNUAL REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES

EXCHANGE ACT OF 1934

 

 

For the fiscal year ended December 31, 2005

OR

 

 

TRANSITION REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES

EXCHANGE ACT OF 1934

 

 

For the transition period from _______________ to _______________

 

 

Commission File Number

0-24620

 

DARLING INTERNATIONAL INC.

(Exact name of registrant as specified in its charter)

 

Delaware

36-2495346

(State or other jurisdiction

(I.R.S. Employer

of incorporation or organization)

Identification Number)

251 O'Connor Ridge Blvd., Suite 300

 

Irving, Texas

75038

(Address of principal executive offices)

(Zip Code)

 

Registrant's telephone number, including area code: (972) 717-0300

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

Title of Each Class

Name of Exchange on Which Registered

Common Stock $0.01 par value per share

American Stock Exchange (“AMEX”)

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

 

 

          Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

 

Yes      X         No         

 

  

 

 

          Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.

 

Yes               No      X   

 

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 report(s)), and    (2) has been subject to such filing requirements for the past 90 days.      Yes      X         No         

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

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act (check one):       Large accelerated filer             Accelerated filer    X         Non-accelerated filer      

 

 

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

Yes    ____     No      X   

  

 

 

 

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As of the last day of the Registrant’s most recently completed second fiscal quarter, the aggregate market value of the shares of common stock held by nonaffiliates of the Registrant was approximately $204,191,000 based upon the closing price of the common stock as reported on the American Stock Exchange (“AMEX”) on that day. (In determining the market value of the Registrant’s common stock held by non-affiliates, shares of common stock beneficially owned by directors, officers and holders of more than 10% of the Registrant’s common stock have been excluded. This determination of affiliate status is not necessarily a conclusive determination for other purposes.)

There were 64,445,430 shares of common stock, $0.01 par value, outstanding at March 7, 2006.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Selected designated portions of the Registrant’s definitive Proxy Statement in connection with the Registrant’s 2006 Annual Meeting of stockholders are incorporated by reference into Part III of this Annual Report.

 

Explanatory Note

Darling International Inc. (the "Company") is filing this Amendment No. 2 on Form 10-K/A ("Amendment No. 2") to amend the Company's previously filed Annual Report on Form 10-K for the fiscal year ended December 31, 2005 (the "Original Form 10-K"), as filed with the Securities and Exchange Commission ("SEC") on March 14, 2006 and as amended by Amendment No. 1 on Form 10-K/A filed with the SEC on August 18, 2006 (as so amended, the "Form 10-K"). The purpose of this Amendment No. 2 is to respond to a comment letter received from the staff of the SEC and to amend our disclosures in Item 7 and Item 8 for the reasons set forth below.

Except as described in this explanatory note, no other changes have been made to the Form 10-K, and this Amendment No. 2 does not amend, update or change any other information contained in the Form 10-K. Information not affected by the changes described in this explanatory note is unchanged and reflects the disclosures made previously in the Form 10-K. Accordingly, this Amendment No. 2 should be read in conjunction with the Company's filings made with the SEC subsequent to the filing of the Form 10-K, including any amendments to those filings.

In accordance with Rule 12b-15 promulgated under the Securities Exchange Act of 1934, as amended, the complete text of Item 7 and Item 8 is set forth herein, including those portions of the text that have not been amended from that set forth in the Form 10-K.

The only changes to the text in Item 7 of the Form 10-K are as follows:

The first paragraph under Income Taxes (page 30 of the Original Form 10-K) was amended to discuss the impact of the reduction in the Company's effective tax rate (as disclosed in Note 10 to the Company's financial statements) on its results of operations for fiscal 2005.

Accounts Receivable and Allowance for Doubtful Accounts and Accrued Medical Claims Liability were removed from the Company's discussion of critical accounting policies (pages 38 and 40, respectively, of the Original Form 10-K) as the Company has determined that these policies are not critical accounting policies.

The only changes to the text in Item 8 of the Form 10-K are as follows:

The second paragraph under Note 1(b)(12)-Use of Estimates (page 57 of the Original Form 10-K) was added to address the Company's policy with regard to its disclosure of reasonably possible loss contingencies in accordance with Statement of Financial Accounting Standards 5, as well as certain other standards.

The first paragraph under Note 1(b)(13)-Impairment of Long-Lived Assets and Long-Lived Assets to be Disposed of (page 57 of the Original Form 10-K) was amended to provide the Company's disclosure policy with respect to complying with FASB Statement No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets."

The last sentence of the third paragraph of Note 14-Contingencies (page 72 of the Original Form 10-K) was revised to make it clear that the likelihood is remote that any additional liability from the lawsuits and claims mentioned in such Note 14 that may not be covered by insurance would have a material effect on the Company's financial statements.

 

 

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PART II

 

 

 

ITEM 7.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

 

The following Management’s Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements that involve risks and uncertainties. The Company’s actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors, including those set forth in Item 1A of this report, under the heading “Risk Factors.”

 

The following discussion should be read in conjunction with the historical consolidated financial statements and notes thereto included in Item 8 of this report. The Company is organized along two operating business segments, Rendering and Restaurant Services. See Note 15 of Notes to Consolidated Financial Statements.

 

Overview

 

Darling International Inc. is a recycler of food and animal by-products and provides grease trap services to food service establishments. The Company collects and recycles animal by-products and used cooking oil from food service establishments. The Company processes these raw materials at 24 facilities located throughout the United States into finished products such as protein (primarily MBM), tallow (primarily BFT), and YG. The Company sells these products nationally and internationally, primarily to producers of oleo-chemicals, soaps, pet foods and livestock feed, for use as ingredients in their products or for further processing. The Company’s operations are currently organized into two segments: Rendering and Restaurant Services. For additional information on the Company’s business, see Item 1, “Business,” and for additional information on the Company’s segments, see Note 15 of Notes to Consolidated Financial Statements.

 

Major challenges faced by the Company during Fiscal 2005 included reduced raw material supplies, lower prices for all finished products and higher energy prices for natural gas and diesel fuel. During Fiscal 2005 a second case of Bovine Spongiform Encephalopathy (“BSE”) was announced. This continued to contribute to an environment of uncertainty regarding the implementation of the anticipated BSE regulations, which have not yet been implemented. Export markets in some foreign countries for U.S.-produced finished beef products and other cattle by-products continued to be closed throughout Fiscal 2005. The effects of these challenges during Fiscal 2005 are summarized in the sections that follow.

 

Operating income decreased by $14.4 million in Fiscal 2005 compared to Fiscal 2004. The challenges faced by the Company indicate there can be no assurance that operating results achieved by the Company in Fiscal 2005 are indicative of future operating performance of the Company.

 

Summary of Critical Issues Faced by the Company during Fiscal 2005

Lower raw material volumes were collected from suppliers during Fiscal 2005. Management believes that weak cattle slaughter margins in the meat processing industry, along with export restrictions on U.S. beef products, contributed to a decline in red meat raw material volumes collected by the Company during Fiscal 2005. This is a continuation of lower raw material volumes noted during the third quarter of Fiscal 2004. The financial impact of lower raw material volumes on sales revenue and raw material cost is summarized below in “Results of Operations.”

The average price of the Company’s finished products was lower during Fiscal 2005 compared to the same period in Fiscal 2004. Management believes that closure of foreign export markets to U.S.-produced beef products in 2004 continued to result in lower commodity prices at the Company’s export locations. In years prior to 2004, the Company received a premium to domestic commodity finished goods prices in certain of its export locations. The export market ban of U.S.-produced beef products resulted in the loss of that price premium during Fiscal 2004, and this continued into 2005. The financial impact of finished goods prices on sales revenue and raw material cost is summarized below in “Results of Operations.” Comparative sales price information from the Jacobsen index, an established trading exchange publisher used by management, is listed below in “Summary of Key Indicators.”

 

 

Page 3

 



 

High energy prices for both natural gas and diesel fuel persisted throughout Fiscal 2005. The Company attempts to manage natural gas price risk by entering into forward purchase agreements, depending on market conditions, in order to purchase natural gas for future months when prices are relatively low. The Company also has the ability to burn alternate fuels at various plant locations when economically favorable to do so. The Company has limited diesel fuel storage capabilities at its plant locations and regional suppliers have not been willing to enter into forward purchase agreements on terms acceptable to the Company. The financial impact of higher natural gas and diesel fuel prices is summarized below in “Results of Operations.”

 

 

Summary of Critical Issues and Known Trends Faced by the Company in Fiscal 2005 and Thereafter

 

BSE Related Issues:

 

Effective August 1997, the FDA promulgated a rule prohibiting the use of mammalian proteins, with some exceptions, in feeds for cattle, sheep and other ruminant animals. The intent of this rule is to prevent the spread of BSE, commonly referred to as “mad cow disease.” See the risk factor entitled “The Company’s business may be affected by the impact of BSE” beginning on page 14 for more information about BSE and its potential effects on the Company, including government regulations, finished product export restrictions by foreign governments, market price fluctuations for finished goods, reduced demand for beef and beef products by consumers, or increases in operating costs.

 

Other Critical Issues and Challenges

 

Over the next year the integration of the assets acquired in the Transaction from NBP will have a significant impact on the Company’s personnel and operations. See the risk factor entitled “The Company may be unable to successfully integrate National By-Products and achieve the benefits expected to result from the Transaction” beginning on page 10 for more information.

Expenses related to compliance with requirements of Section 404 of the Sarbanes-Oxley Act of 2002 (the “Sarbanes Act”) are expected to continue throughout 2006 and thereafter. The Company complied with the Sarbanes Act in Fiscal 2004 and 2005. The Company expects recurring compliance costs related to the required updating of documentation and the testing and auditing of the Company’s system of internal controls, as required by the Sarbanes Act.

Energy prices for natural gas and diesel fuel are expected to remain high in 2006. The Company consumes significant volumes of natural gas to operate boilers in its plants, which generate steam to heat raw material. High natural gas prices represent a significant cost of factory operation included in cost of sales. The Company also consumes significant volumes of diesel fuel to operate its fleet of tractors and trucks used to collect raw material. High diesel fuel prices represent a significant component of cost of collection expenses included in cost of sales. Though the Company will continue to manage these costs and attempt to minimize these expenses, prices remained relatively high in 2005 and represent an ongoing challenge to the Company’s operating results for future periods.

Avian influenza (“Bird Flu”), a highly contagious disease that affects poultry, has recently spread throughout Asia to Europe at an unprecedented rate. Bird Flu is not a new disease, and while it does not currently exist in the U.S., it has occurred in this country twice within the past 25 years. The USDA has developed safeguards to protect the U.S. poultry industry from Bird Flu. Such safeguards are based on import restrictions, disease surveillance and a response plan for isolating and depopulating infected flocks if the disease is detected. Any significant outbreak of Bird Flu in the U.S. could have a negative impact on our business by reducing demand for MBM.

                 These challenges indicate there can be no assurance that operating results of the Company in Fiscal 2005 are indicative of future operating performance of the Company.

 

 

Page 4

 



 

Results of Operations

 

Fifty-two Week Fiscal Year Ended December 31, 2005 (“Fiscal 2005”) Compared to Fifty-two Week Fiscal Year Ended January 1, 2005 (“Fiscal 2004”)

 

Summary of Key Factors Impacting Fiscal 2005 Results:

 

Principal factors that contributed to a $14.4 million (47.1%) decrease in operating income, which are discussed in greater detail in the following section, were:

Lower finished product sales prices,

Lower raw material volume,

Higher natural gas and diesel fuel expense, and

Prior year insurance settlement with certain of the Company’s past insurers.

These decreases to operating income were partially offset by:

Lower raw material prices, and

Improved recovery of collection expense.

 

Summary of Key Indicators of Fiscal 2005 Performance:

Principal indicators that management routinely monitors and compares to previous periods as an indicator of problems or improvements in operating results include:

Finished product commodity prices quoted on the Jacobsen index,

Raw material volume,

Production volume and related yield of finished product,

Natural gas prices quoted on the NYMEX index,

Collection fees and collection operating expense, and

Factory operating expenses.

These indicators and their importance are discussed below in greater detail.

Prices for finished product commodities that the Company produces are quoted each business day on the Jacobsen index, an established trading exchange price publisher. These finished products are MBM, BFT and YG. The prices quoted are for delivery of the finished product at a specified location. These prices are relevant because they provide an indication of a component of revenue and achievement of business plan benchmarks on a daily basis. The Company’s actual sales prices for its finished products may vary from the Jacobsen index because the Company’s finished products are delivered to multiple locations in different geographic regions which utilize different price indexes. Average Jacobsen prices (at the specified delivery point) for Fiscal 2005, compared to average Jacobsen prices for Fiscal 2004 follow:

 

 

Avg. Price
Fiscal 2005

Avg. Price
Fiscal 2004

Increase/
(Decrease)

%
Change

MBM (Illinois)

$167.53/ton

$190.36 /ton

$(22.83/ton)

(12.0%)

BFT (Chicago)

$ 17.46/cwt

$ 17.95 /cwt

$(0.49/cwt)

(2.7%)

YG (Illinois)

$ 14.44/cwt

$ 15.12 /cwt

$(0.68/cwt)

(4.5%)

 

The decrease in the average prices of the finished products the Company sells had an unfavorable impact on revenue which is partially offset by a positive impact to the Company’s raw material cost, due to formula pricing arrangements which compute raw material cost based upon the price of finished product.

 

Raw material volume represents the quantity (pounds) of raw material collected from suppliers, including beef, pork, poultry, and used cooking oils. Raw material volumes provide an indication of future production of finished products available for sale and are a component of potential future revenue.

 

Page 5

 



 

Finished product production volumes are the end result of the Company’s production processes, and directly impact goods available for sale, and thus become an important component of sales revenue. Yield on production is a ratio of production volume (pounds) divided by raw material volume (pounds) and provides an indication of effectiveness of the Company’s production process. Factors impacting yield on production include quality of raw material and warm weather during summer months, which rapidly degrades raw material. Both of these factors negatively impacted the Company’s yield during Fiscal 2005.

 

Natural gas commodity prices are quoted each day on the NYMEX exchange for future months of delivery of natural gas. The prices are important to the Company because natural gas is a major component of factory operating costs and natural gas prices are an indicator of achievement of the Company’s business plan. Average NYMEX pricing for natural gas for the last two fiscal years are set forth below.

 

 

Avg. Price
Fiscal 2005

Avg. Price
Fiscal 2004


Increase

%
Increase

Natural Gas

$8.62 /mmbtu

$6.14 /mmbtu

$2.48 /mmbtu

40.4%

 

The Company charges collection fees which are included in net sales in order to offset a portion of the expense incurred in collecting raw material. Each month the Company monitors both the collection fee charged to suppliers, which is included in net sales, and collection expense, which is included in cost of sales. The importance of monitoring collection fees and collection expense is that they provide an indication of achievement of the Company’s business plan.

The Company incurs factory operating expenses which are included in cost of sales. Each month the Company monitors factory operating expense. The importance of monitoring factory operating expense is that it provides an indication of achievement of the Company’s business plan.

 

Net Sales. The Company collects and processes animal by-products (fat, bones and offal) and used restaurant cooking oil to produce finished products of tallow, protein, and yellow grease. Sales are significantly affected by finished goods prices, quality and mix of raw material, and volume of raw material. Net sales include the sales of produced finished goods, collection fees, grease trap services, and finished goods purchased for resale.

 

During Fiscal 2005, net sales decreased by $11.3 million (3.5%) to $308.9 million as compared to $320.2 million during Fiscal 2004. The decrease in net sales was primarily due to the following increases/(decreases) (in millions of dollars):

 

 

 


Rendering

 

Restaurant
Services

 


Corporate

 


Total

 

 

Lower finished goods prices

$(7.5)

 

$(7.8)

 

$ –

 

$(15.3)

 

 

Lower raw material volume

(2.7)

 

(1.5)

 

 

(4.2)

 

 

Lower yields on production

(2.7)

 

0.2 

 

 

(2.5)

 

 

Improved recovery of collection expenses

2.7 

 

3.0 

 

 

5.7 

 

 

Management fees and third party revenue

– 

 

0.8 

 

 

0.8 

 

 

Purchases of finished product for resale

3.2 

 

0.8 

 

 

4.0 

 

 

Other sales decreases

– 

 

0.2 

 

 

0.2 

 

 

Product transfers

(1.7)

 

1.7 

 

 

– 

 

 

 

$(8.7)

 

$(2.6)

 

$ –

 

$(11.3)

 

 

 

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Cost of Sales and Operating Expenses. Cost of sales and operating expenses include the cost of raw material, the cost of product purchased for resale, and the cost to collect, which includes diesel fuel and processing costs including natural gas. The Company utilizes both fixed and formula pricing methods for the purchase of raw materials. Fixed prices are adjusted where possible for changes in competition and significant changes in finished goods market conditions, while raw materials purchased under formula prices are correlated with specific finished goods prices. Energy costs, particularly diesel fuel and natural gas, are significant components of the Company’s cost structure. The Company has the ability to burn alternative fuels at the plants to help manage the Company’s price exposure to volatile energy markets.

 

During Fiscal 2005, cost of sales and operating expenses increased $3.8 million (1.6%) to $241.7 million as compared to $237.9 million during Fiscal 2004. The increase in cost of sales and operating expenses was primarily due to the following (in millions of dollars):

 

 

 


Rendering

 

Restaurant
Services

 


Corporate

 


Total

 

 

Higher energy costs, primarily natural gas

$ 7.0 

 

$ 2.2 

 

$ –

 

$ 9.2 

 

 

Purchases of finished product for resale

3.2 

 

0.8 

 

 

4.0 

 

 

Prior year insurance settlement with certain
  of the Company’s past insurers


– 

 


– 

 


2.8 

 


2.8 

 

 

Other

0.6 

 

0.6 

 

(0.5)

 

0.7 

 

 

Third party cost of service

– 

 

0.7 

 

– 

 

0.7 

 

 

Sewer and trap disposal

(0.1)

 

1.0 

 

– 

 

0.9 

 

 

Lower raw material prices

(7.4)

 

(6.0)

 

– 

 

(13.4)

 

 

Lower raw material volume

(0.8)

 

(0.3)

 

– 

 

(1.1)

 

 

Payroll and related benefits

(1.3)

 

1.3 

 

– 

 

– 

 

 

Product transfers

(1.7)

 

1.7 

 

– 

 

– 

 

 

 

$(0.5)

 

$ 2.0 

 

$ 2.3 

 

$ 3.8 

 

 

 

Selling, General and Administrative Expenses.   Selling, general and administrative expenses were $35.2 million during Fiscal 2005, a $1.3 million decrease (3.6%) from $36.5 million during Fiscal 2004, primarily due to the following (in millions of dollars):

 

 

 


Rendering

 

Restaurant
Services

 


Corporate

 


Total

 

 

Payroll and related benefits expense

$ 0.3 

 

$ 0.4 

 

$(2.2)

 

$(1.5)

 

 

Lower audit fees

– 

 

– 

 

(0.2)

 

(0.2)

 

 

Other expenses

0.2 

 

0.3 

 

(0.6)

 

(0.1)

 

 

Higher legal and professional fees

– 

 

– 

 

0.5 

 

0.5 

 

 

 

$ 0.5 

 

$ 0.7 

 

$(2.5)

 

$ (1.3)

 

 

 

Depreciation and Amortization.   Depreciation and amortization charges increased $0.6 million (4.0%) to $15.8 million during Fiscal 2005 as compared to $15.2 million during Fiscal 2004. The increase is primarily due to capital expenditure increases from the prior year.

 

Interest Expense.    Interest expense was $6.2 million during Fiscal 2005 compared to $6.8 million during Fiscal 2004, a decrease of $0.6 million (8.8%). A summary of items contributing to the net decrease in interest expense follows (in millions of dollars):

 

Page 7

 



 

 

 

 


Rendering

 

Restaurant
Services

 


Corporate

 


Total

 

 

Decrease in preferred stock dividends and
  accretion


$ –

 


$ –

 


$(0.4)

 


$(0.4)

 

 

Capitalized interest

 

 

(0.3)

 

(0.3)

 

 

Other increases

 

 

0.1 

 

0.1 

 

 

 

$ –

 

$ –

 

$(0.6)

 

$(0.6)

 

 

The decrease in interest expense is partially due to reduced preferred stock dividends and accretion that was charged to interest expense as a result of application of SFAS 150, which was adopted the first day of the third quarter of Fiscal 2003 (see Note 18 to the consolidated financial statements). The Company’s outstanding preferred stock was redeemed during the second quarter of Fiscal 2004.

 

Other Income/Expense.    Other income was $0.9 million in Fiscal 2005, a $1.2 million increase in income from other expense of $0.3 million in Fiscal 2004. The increase in other income in Fiscal 2005 is primarily due to the following (in millions of dollars):

 

 

 


Rendering

 

Restaurant
Services

 


Corporate

 


Total

 

 

Decrease in gain on extinguishment of bank debt

$ –

 

$ –

 

$(1.3)

 

$(1.3)

 

 

Decrease in loss on early redemption of
  preferred stock


 


 


1.7 

 


1.7 

 

 

Increase in gain on disposal of assets

 

 

0.2 

 

0.2 

 

 

Increase in interest income

 

 

0.7 

 

0.7 

 

 

Decrease in other expense

 

 

(0.1)

 

(0.1)

 

 

 

$ –

 

$ –

 

$ 1.2 

 

$ 1.2 

 

 

Interest income increased by $0.7 million in Fiscal 2005 as a result of the investment of the cash on the balance sheet. Also included in other income in Fiscal 2005 is the increase in gain on the sale of property and equipment of approximately $0.2 million, which included the sale of the Company’s properties in Tyler, Texas, and Sunnyside, Washington.

 

Included in other income in Fiscal 2004 was a gain on extinguishment of debt of $1.3 million, which resulted from retirement of debt with a carrying value of $20.1 million with a cash payment of $18.0 million, due to SFAS 15 accounting, net of related deferred loan costs of $0.8 million, also extinguished upon payment of debt. Also included in other income in Fiscal 2004 was a gain on the sale of property and equipment of approximately $0.3 million, which included the sale of the Company’s land in Oklahoma City, Oklahoma.

 

In Fiscal 2004, the Company’s senior credit agreement required early redemption of the Company’s preferred stock outstanding at its face value of $10.0 million and accumulated dividends of approximately $1.2 million, or total aggregate consideration of $11.2 million. The Company’s preferred stock had a carrying value of approximately $9.5 million at April 3, 2004. Subsequent to April 3, 2004, the Company incurred a loss of approximately $1.7 million, which was included in other expense in Fiscal 2004 on the early redemption of the preferred stock.

 

Income Taxes.    The Company recorded income tax expense of $3.2 million for Fiscal 2005, compared to income tax expense of $9.2 million recorded in Fiscal 2004, a decrease of $6.0 million (65.2%), primarily due to the decreased pre-tax earnings of the Company in Fiscal 2005. The effective tax rate of 29.3% for 2005 differed from the statutory rate of 34% primarily due to the reversal of approximately $700,000 in reserves for tax contingencies as a result of the expiration of the statute of limitations for such contingencies. The impact of state income taxes for 2005 of $0.4 million was offset by certain state tax credits recorded in 2005 of $0.3 million. The effective tax rate of 39.3% for 2004 differed from the statutory rate of 35% primarily due to state income taxes.

 

Discontinued Operations.    The Company recorded a slight profit from discontinued operations, net of applicable taxes, related to the closure and sale of certain assets of the Company’s London, Ontario, Canadian subsidiary in Fiscal 2005, compared to a loss from discontinued operations of approximately $0.4 million in Fiscal 2004. The loss in Fiscal 2004 was primarily due to accrued severance and pension costs accrued as a result of the decision to close the Company’s London, Ontario, Canadian subsidiary.

 

Page 8

 



 

Fifty-two Week Fiscal Year Ended January 1, 2005 (“Fiscal 2004”) Compared to Fifty-three Week Fiscal Year Ended January 3, 2004 (“Fiscal 2003”)

 

Summary of Key Factors Impacting Fiscal 2004 Results:

 

Principal factors that contributed to a $3.4 million (12.5%) increase in operating income, which are discussed in greater detail in the following section, were:

Improved margins on the Company’s finished products,

Improved recovery of collection expenses, and

Insurance settlement with certain of the Company’s past insurers.

These favorable increases to operating income were partially offset by:

Lower raw material volume,

Higher diesel fuel and natural gas expense,

Lower hide sales revenue, and

Increased administrative expense related to compliance with the Sarbanes Act .

 

Summary of Key Indicators of Fiscal 2004 Performance:

Principal indicators that management routinely monitors and compares to previous periods as an indicator of problems or improvements in operating results include:

Finished product commodity prices quoted on the Jacobsen index,

Raw material volume,

Production volume and related yield of finished product,

Natural gas prices quoted on the NYMEX index,

Collection fees and collection operating expense, and

Factory operating expenses.

These indicators and their importance are discussed below in greater detail.

Prices for finished product commodities that the Company produces are quoted each business day on the Jacobsen index, an established trading exchange price publisher. These finished products are MBM, BFT and YG. The prices quoted are for delivery of the finished product at a specified location. These prices are relevant because they provide an indication of a component of revenue and achievement of business plan benchmarks on a daily basis. The Company’s actual sales prices for its finished products may vary from the Jacobsen index because the Company’s finished products are delivered to multiple locations in different geographic regions that utilize different price indexes. Average Jacobsen prices (at the specified delivery point) for Fiscal 2004, compared to average Jacobsen prices for Fiscal 2003 follow:

 

 

Avg. Price
Fiscal 2004

Avg. Price
Fiscal 2003

Increase/
(Decrease)

%
Change

MBM (Illinois)

$190.36 /ton

$194.01 /ton

$(3.65 /ton)

(1.9%)

BFT (Chicago)

$ 17.95 /cwt

$ 18.26 /cwt

$(0.31 /cwt)

(1.7%)

YG (Illinois)

$ 15.12 /cwt

$ 13.39 /cwt

$1.73 /cwt

12.9%

 

Increases in the average prices of the finished products the Company sells have a favorable impact on revenue, which is partially offset by a negative impact to the Company’s raw material cost, due to formula pricing arrangements that compute raw material cost based upon the price of finished product. Decreases in the average prices of the finished products the Company sells have a negative impact on revenue, which is partially offset by a positive impact to the Company’s raw material cost due to formula pricing.

 

 

Page 9

 



 

Raw material volume represents the quantity (pounds) of raw material collected from suppliers, including beef, pork, poultry and used cooking oils. Raw material volumes provide an indication of future production of finished products available for sale and are a component of potential future revenue.

 

Finished product production volumes are the end result of the Company’s production processes, and directly impact goods available for sale, and thus become an important component of sales revenue. Yield on production is a ratio of production volume (pounds) divided by raw material volume (pounds), and provides an indication of effectiveness of the Company’s production process. Factors impacting yield on production include quality of raw material and warm weather during summer months, which rapidly degrades raw material. Both of these factors impacted the Company’s yield during Fiscal 2004.

 

Natural gas commodity prices are quoted each day on the NYMEX exchange for future months of delivery of natural gas. The prices are important to the Company because natural gas is a major component of factory operating cost and natural gas prices are an indicator of achievement of the Company’s business plan. Average NYMEX pricing for natural gas for the last two fiscal years are set forth below.

 

 

Avg. Price
Fiscal 2004

Avg. Price
Fiscal 2003


Increase

%
Increase

Natural Gas

$6.14 /mmbtu

$5.39 /mmbtu

$0.75 /mmbtu

13.9%

 

The Company charges collection fees, which are included in net sales in order to offset a portion of the expense incurred in collecting raw material. Each month the Company monitors both the collection fee charged to suppliers, which is included in net sales, and collection expense, which is included in cost of sales. The importance of monitoring collection fees and collection expense is that they provide an indication of achievement of the Company’s business plan.

The Company incurs factory operating expenses, which are included in cost of sales. Each month the Company monitors factory operating expense. The importance of monitoring factory operating expense is that it provides an indication of achievement of the Company’s business plan.

 

Net Sales. The Company collects and processes animal by-products (fat, bones and offal) and used restaurant cooking oil to produce finished products of tallow, protein, and yellow grease. Sales are significantly affected by finished goods prices, quality of raw material, and volume of raw material. Net sales include the sales of produced finished goods, collection fees, grease trap services, and finished goods purchased for resale.

 

During Fiscal 2004, net sales decreased by $3.1 million (1.0%) to $320.2 million as compared to $323.3 million during Fiscal 2003. The decrease in net sales was primarily due to the following increases/(decreases) (in millions of dollars):

 

 

 


Rendering

 

Restaurant
Services

 


Corporate

 


Total

 

 

Lower raw material volume

$ (8.0)

 

$ (1.2)

 

$ –

 

$(9.2)

 

 

Purchases of finished product for resale

0.9 

 

(3.9)

 

 

(3.0)

 

 

Lower hide sales

(1.6)

 

– 

 

 

(1.6)

 

 

Lower yields on production

(0.6)

 

(0.9)

 

 

(1.5)

 

 

Other sales decreases

– 

 

(0.4)

 

 

(0.4)

 

 

Higher finished goods prices

2.9 

 

6.2 

 

 

9.1 

 

 

Improved recovery of collection expenses

1.4 

 

2.1 

 

 

3.5 

 

 

Product reclassifications

(8.0)

 

8.0 

 

 

– 

 

 

 

$(13.0)

 

$ 9.9 

 

$ –

 

$(3.1)

 

 

 

Cost of Sales and Operating Expenses. Cost of sales and operating expenses includes prices paid to raw material suppliers, the cost of products purchased for resale, and the cost to collect and process raw material. The Company utilizes both fixed and formula pricing methods for the purchase of raw materials. Fixed prices are

 

Page 10

 



adjusted where possible for changes in competition and significant changes in finished goods market conditions, while raw materials purchased under formula prices are correlated with specific finished goods prices.

 

During Fiscal 2004, cost of sales and operating expenses decreased $7.3 million (3.0%) to $237.9 million as compared to $245.2 million during Fiscal 2003. The decrease in cost of sales and operating expenses was primarily due to the following (in millions of dollars):

 

 

 


Rendering

 

Restaurant
Services

 


Corporate

 


Total

 

 

Purchases of finished product for resale

$ 0.9 

 

$ (3.9)

 

$ – 

 

$(3.0)

 

 

Insurance settlement

– 

 

– 

 

(2.8)

 

(2.8)

 

 

Lower raw material volume

(2.4)

 

(0.2)

 

– 

 

(2.6)

 

 

Sewer and trap disposal

(0.4)

 

0.2 

 

– 

 

(0.2)

 

 

Higher gas, fuel and oil expense

0.8 

 

0.5 

 

– 

 

1.3 

 

 

Raw material prices

(2.9)

 

3.8 

 

– 

 

0.9 

 

 

Higher energy costs, primarily natural gas

0.2 

 

0.1 

 

– 

 

0.3 

 

 

Higher payroll and related benefits

(2.1)

 

2.3 

 

– 

 

0.2 

 

 

Other

(0.7)

 

(0.7)

 

– 

 

(1.4)

 

 

Product reclassifications

(8.0)

 

8.0 

 

– 

 

– 

 

 

 

$(14.6)

 

$ 10.1 

 

$ (2.8)

 

$(7.3)

 

 

 

Selling, General and Administrative Expenses. Selling, general and administrative expenses were $36.5 million during Fiscal 2004, a $0.7 million increase (2.0%) from $35.8 million during Fiscal 2003, primarily due to the following (in millions of dollars):

 

 

 


Rendering

 

Restaurant
Services

 


Corporate

 


Total

 

 

Payroll and related benefits expense

$(1.8)

 

$ 2.4 

 

$ 1.0 

 

$ 1.6 

 

 

Higher audit fees

– 

 

– 

 

0.7 

 

0.7 

 

 

Higher shareholder relations and board of
director expenses


– 

 


– 

 


0.2 

 


0.2 

 

 

Lower legal and professional fees

– 

 

– 

 

(0.9)

 

(0.9)

 

 

Other expenses

(0.7)

 

0.3 

 

(0.5)

 

(0.9)

 

 

 

$(2.5)

 

$ 2.7 

 

$ 0.5 

 

$ 0.7 

 

 

Increased expenses related to the Company’s efforts to comply with requirements of Section 404 of the Sarbanes Act included higher contract labor (included in payroll expense) and higher audit fees. These expenses related to the Company’s documentation and evaluation of its system of internal controls in accordance with the requirements of the Sarbanes Act. Expenses incurred related to Sarbanes-Oxley compliance were approximately $1.2 million in Fiscal 2004, compared to expenses of less than $0.1 million in Fiscal 2003, an increase of approximately $1.2 million. The Company anticipates there will be on-going costs of compliance with the Sarbanes Act in the future.

 

 

Depreciation and Amortization. Depreciation and amortization charges increased $0.1 million (0.7%) to $15.2 million during Fiscal 2004 as compared to $15.1 million during Fiscal 2003.

 

 

Page 11

 



 

Interest Expense. Interest expense was $6.8 million during Fiscal 2004 compared to $2.4 million during Fiscal 2003, an increase of $4.4 million (183.3%). A summary of items contributing to the net increase in interest expense follows (in millions of dollars):

 

 

 


Rendering

 

Restaurant
Services

 


Corporate

 


Total

 

 

Interest expense on subordinated debt

$ –

 

$ –

 

$ 4.2 

 

$ 4.2 

 

 

Increased interest expense due to reduced
  amortization of the effect of SFAS 15


 


 


2.5 

 


2.5 

 

 

Increased interest expense on the senior
  credit agreement


 


 


0.8 

 


0.8 

 

 

Other increases

 

 

0.1 

 

0.1 

 

 

Decrease in interest expense on the refinanced
  amount of bank debt


 


 


(3.0)


 


(3.0)


 

 

Decrease in preferred stock dividends and
   accretion


 


 


(0.2)


 


(0.2)


 

 

 

$ –

 

$ –

 

$ 4.4 

 

$ 4.4 

 

 

During Fiscal 2004, preferred stock dividends and accretion were charged to interest expense as a result of application of SFAS 150, which was adopted the first day of the third quarter of Fiscal 2003 (see Note 18 to the consolidated financial statements). The Company’s outstanding preferred stock was redeemed during the second quarter of Fiscal 2004.

 

Other Income/Expense. Other expense was $0.3 million in Fiscal 2004, a $4.2 million expense increase from other income of $3.9 million in Fiscal 2003. The increase in other expense in Fiscal 2004 is primarily due to the following (in millions of dollars):

 

 

 


Rendering

 

Restaurant
Services

 


Corporate

 


Total

 

 

Decrease in gain on extinguishment of bank debt

$ –

 

$ –

 

$ 3.4 

 

$ 3.4 

 

 

Loss on redemption of preferred stock

 

 

1.7 

 

1.7 

 

 

Increase in gain on disposal of assets

 

 

(0.3)

 

(0.3)

 

 

Increase in interest income

 

 

(0.3)

 

(0.3)

 

 

Decrease in other expense

 

 

(0.3)

 

(0.3)

 

 

 

$ –

 

$ –

 

$ 4.2 

 

$ 4.2 

 

 

Gain on extinguishment of debt in Fiscal 2004 was $1.3 million, which resulted from retirement of debt with a carrying value of $20.1 million with a cash payment of $18.0 million, due to SFAS 15 accounting, net of related deferred loan costs of $0.8 million also extinguished upon payment of the debt. Included in other income in Fiscal 2003 was a gain on extinguishment of debt of $4.7 million, which resulted from retirement of debt with a carrying value of $43.9 million with a cash payment of $37.2 million, due to SFAS 15 accounting, net of related deferred loan costs of $2.0 million, also extinguished upon payment of the debt.

 

 

Income Taxes.    The Company recorded income tax expense of $9.2 million for Fiscal 2004, compared to income tax expense of $10.6 million recorded in Fiscal 2003, a decrease of $1.4 million (13.2%), primarily due to the decreased pre-tax earnings of the Company in Fiscal 2004.

 

 

Discontinued Operations.     The Company recorded a loss from discontinued operations, net of applicable taxes, related to planned closure and sale of the Company’s London, Ontario, Canadian subsidiary of approximately $0.4 million in Fiscal 2004, compared to income from discontinued operations of approximately $0.1 million in Fiscal 2003, a decrease in income of $0.5 million, primarily due to accrued severance and pension costs accrued as a result of the decision to close the site, as discussed elsewhere herein.

 

Page 12

 



 

FINANCING, LIQUIDITY, AND CAPITAL RESOURCES

 

On April 2, 2004, the Company entered into a senior credit agreement with new lenders and entered into a new lender acknowledgement on May 28, 2004 that increased the committed amount as permitted by the senior credit agreement. This refinancing replaced the Amended and Restated Credit Agreement executed on May 13, 2002. The principal components of the refinancing consist of the following:

 

The senior credit agreement provides for a total of $75.0 million in financing facilities, consisting of a $25.0 million Term Loan Facility and a $50.0 million Revolver Facility, which includes a $25.0 million Letter of Credit subfacility. Availability under the Revolver Facility may vary based on EBITDA, as defined in the senior credit agreement.

The senior credit agreement has a term of five years and matures on April 2, 2009.

The senior credit agreement provides for scheduled amortization payments on the Term Loan Facility of $1.25 million, due each quarter during the five-year term of the agreement.

The senior credit agreement bears interest at a rate which may be based upon either prime or LIBOR or a combination of both rates, plus a margin which may be adjusted quarterly based upon the leverage ratio of the Company, as defined by the senior credit agreement.

On April 2, 2004, proceeds of the new Term Loan Facility were used to pay off the outstanding balance of the prior Amended and Restated Credit Agreement of approximately $18.0 million. The remaining proceeds and cash on hand were used to redeem the Company’s preferred stock during the second quarter of Fiscal 2004 at face value of $10.0 million and accumulated preferred dividends of approximately $1.2 million, and for other general corporate and working capital purposes.

Restrictive covenants in the Company’s senior credit agreement require the maintenance of certain minimum financial ratios and permit the Company, within limitations defined in the senior credit agreement, to incur additional indebtedness; issue additional capital or preferred stock; pay dividends; redeem common shares as treasury stock; create liens; merge, consolidate, or acquire other businesses; sell and dispose of assets; and make investments.

On August 9, 2005, the Company entered into the First Amendment to the senior credit agreement with its lenders to permit the Company to pay cash or in-kind dividends on its common stock, or redeem, repurchase or retire its common stock, in an aggregate amount not to exceed $10 million during the 12-month period beginning August 9, 2005.

 

 

On December 31, 2003, the Company issued senior subordinated notes in the amount of $35 million and applied the net proceeds to reduce the outstanding term loan of its Amended and Restated Credit Agreement executed on May 13, 2002. The senior subordinated notes have a term of six years, maturing on December 31, 2009. Beginning June 1, 2006, the Company may prepay the outstanding principal amount of the senior subordinated notes in whole or in part, plus accrued and unpaid interest, plus a prepayment fee of 5.5%, which declines each year after this date. Interest accrues on the outstanding principal balance of the senior subordinated notes at an annual rate of 12%, payable quarterly in arrears. The senior subordinated notes permit the Company, within limitations defined in the senior subordinated notes, to incur additional indebtedness and to pay cash dividends.

 

The Company’s senior credit agreement and senior subordinated notes consist of the following elements at December 31, 2005 (in thousands):

 

 

Senior Credit Agreement:

 

 

Term Loan

$ 14,500

 

Revolving Credit Facility:

 

 

Maximum availability

$ 50,000

 

Borrowings outstanding

 

Letters of credit issued

14,872

 

Availability

$ 35,128

 

Senior Subordinated Notes Payable

$ 35,000

 

 

Page 13

 



 

Substantially all assets of the Company are either pledged or mortgaged as collateral for borrowings under the senior credit agreement. The senior credit agreement contains certain terms and covenants, which permit the incurrence of additional indebtedness, the payment of cash dividends, the retention of certain proceeds from sales of assets and capital expenditures within limitations defined by the senior credit agreement, and requires the maintenance of certain minimum financial ratios, including: minimum fixed charge coverage ratio, maximum leverage ratio, and minimum tangible net worth, each as defined in the senior credit agreement. The Company is currently in compliance with all of the covenants contained in the senior credit agreement.

 

The classification of long-term debt in the Company’s December 31, 2005 consolidated balance sheet is based on the contractual repayment terms of the debt issued under the senior subordinated notes and the senior credit agreement.

 

On December 31, 2005, the Company had working capital of $40.4 million and its working capital ratio was 1.95 to 1 compared to working capital of $39.6 million and a working capital ratio of 1.96 to 1 on January 1, 2005. At December 31, 2005, the Company had unrestricted cash of $36.0 million and funds available under the revolving credit facility of $35.1 million, compared to unrestricted cash of $37.2 million and funds available under the revolving credit facility of $36.3 million at January 1, 2005. Restricted cash balances were approximately $2.3 million at the end of Fiscal 2005 compared to approximately $2.4 million at the end of Fiscal 2004. Restrictions on these cash balances relate primarily to state statutory insurance requirements and restrictions from the Company’s senior credit agreement on uses of these cash balances.

 

Net cash provided by operating activities was $24.6 million and $38.1 million for the fiscal years ended December 31, 2005 and January 1, 2005, respectively, a decrease of $13.5 million, primarily due to lower net income of $6.2 million and changes in operating assets and liabilities, which includes a reduction in accounts receivable of $1.9 million, and reductions in inventory and prepaid expenses of $2.4 million and $3.3 million, respectively. Cash used by investing activities was $20.6 million during Fiscal 2005, compared to $13.2 million in Fiscal 2004, an increase of $7.4 million, primarily due to increased capital spending in Fiscal 2005. Net cash used by financing activities was $5.2 million in the year ended December 31, 2005 compared to cash used of $12.5 million in the year ended January 1, 2005, a decrease of cash used of $7.3 million, principally due to redemption of preferred stock in Fiscal 2004.

 

Capital expenditures of $21.4 million were made during Fiscal 2005 as compared to $13.3 million in Fiscal 2004, an increase of $8.1 million (60.9%). The Fiscal 2005 increase is due primarily to major projects at the Fresno, California and Wahoo, Nebraska facilities that were identified over normal maintenance and compliance capital expenditures. Capital expenditures related to compliance with environmental regulations were $1.9 million in Fiscal 2005, $1.5 million in Fiscal 2004 and $1.9 million in Fiscal 2003.

 

Based upon the underlying terms of the senior credit agreement, the Company expects approximately $5.0 million in debt, which is included in current liabilities on the Company’s balance sheet at December 31, 2005, will be due during the next twelve months, consisting of scheduled installment payments of $1.25 million due each quarter. The Company made voluntary payments of an additional $3.0 million during Fiscal 2004.

 

Based upon the annual actuarial estimate, current accruals, and claims paid during Fiscal 2005, the Company has accrued approximately $4.7 million it expects will become due during the next twelve months in order to meet obligations related to the Company’s self insurance reserves and accrued insurance, which are included in current accrued expenses at December 31, 2005. The self insurance reserve is composed of estimated liability for claims arising for workers’ compensation and for auto liability and general liability claims. The self insurance reserve liability is determined annually, based upon a third party actuarial estimate. The actuarial estimate may vary from year to year, due to changes in cost of health care, the pending number of claims or other factors beyond the control of management of the Company. No assurance can be given that the Company’s funding obligations under its self insurance reserve will not increase in the future.

 

Based upon current actuarial estimates, the Company does not expect to make any additional payments in order to meet minimum pension funding requirements during Fiscal 2006. The minimum pension funding requirements are determined annually, based upon a third party actuarial estimate. The actuarial estimate may vary from year to year, due to fluctuations in return on investments or other factors beyond the control of management of the Company or the administrator of the Company’s pension funds. No assurance can be given that the minimum pension funding requirements will not increase in the future.

 

Page 14

 



 

The Company is currently in negotiations with new lenders to obtain new financing as a result of the acquisition of NBP. This new financing is expected to include a revolving credit facility of $125 million and a term loan facility of $50 million totaling $175 million in the aggregate. The Company’s new financing is expected to replace its current senior credit agreement and senior subordinated notes.

 

The Company’s management believes that cash flows from operating activities consistent with the current level in Fiscal 2005, unrestricted cash, and funds available under the new financing that is currently being negotiated should be sufficient to meet the Company’s working capital needs and capital expenditures, including the acquisition of NBP, through the term of the new facility. Numerous factors could have consequences to the Company that cannot be known at this time, such as: any additional occurrence of BSE in the U.S. or elsewhere; further reduced raw material volumes available to the Company due to weak margins in the meat processing industry or otherwise; unforeseen new governmental regulations affecting the rendering industry (including new or modified BSE regulations); and/or unfavorable export markets. These factors, coupled with high prices for natural gas and diesel fuel, among others, could either positively or negatively impact the Company’s results of operations in 2006 and thereafter. The Company cannot provide assurance that the cash flows from operating activities generated in Fiscal 2005 are indicative of the future cash flows from operating activities which will be generated by the Company’s operations. The Company reviews the appropriate use of unrestricted cash periodically. Although no decision has been made as to non-ordinary course cash usages at this time, potential usages could include opportunistic capital expenditures and/or acquisitions, investments in response to governmental regulations relating to BSE, unforeseen problems relating to the integration of NBP after closing, and paying dividends or repurchasing stock, subject to limitations under the new facility, as well as suitable cash conservation to withstand adverse commodity cycles.

 

The current economic environment in the Company’s markets has the potential to adversely impact its liquidity in a variety of ways, including through reduced sales, potential inventory buildup or higher operating costs.

 

The principal products that the Company sells are commodities, the prices of which are quoted on established commodity markets and are subject to volatile changes. A decline in these prices has the potential to adversely impact the Company’s liquidity. A further disruption in international sales, a decline in commodities prices, a further decline in raw material volume, or further increases in energy prices resulting from the recent war with Iraq and the subsequent political instability and uncertainty, all have the potential to adversely impact the Company’s liquidity. There can be no assurance that a decline in commodities prices, a rise in energy prices, a slowdown in the U.S. or international economy, or other factors, including political instability in the Middle East or elsewhere and the macroeconomic effects of those events, will not cause the Company to fail to meet management’s expectations or otherwise result in liquidity concerns.

 

CONTRACTUAL OBLIGATIONS AND OTHER COMMERCIAL COMMITMENTS

 

The following table summarizes the Company’s expected material contractual payment obligations, including both on- and off-balance sheet arrangements at December 31, 2005 (in thousands):

 

 


Total

Less than
1 Year

1 – 3
Years

3 – 5
Years

More than
5 Years

Contractual obligations:

 

 

 

 

 

Long-term debt obligations

$ 49,528

$ 5,026

$ 9,502

$35,000

$        –

Operating lease obligations

35,286

7,104

11,960

6,599

9,623

Estimated accrued interest payable

20,793

5,544

9,882

4,979

388

Purchase commitments

6,265

6,265

Pension funding obligation (a)

Other long-term liabilities

      628

    236

    321

      71

       –

Total

$112,500

$24,175

$31,665

$46,649

$10,011

 

 

(a)

Pension funding requirements are determined annually, based upon a third party actuarial estimate. The Company does not expect to make any payments to its pension plan in Fiscal 2006. The Company is not able to estimate pension funding requirements beyond the next twelve months. The accrued pension benefit liability was approximately $14.6 million at the end of Fiscal 2005.

 

 

 

Page 15

 



 

The Company’s off-balance sheet contractual obligations and commercial commitments as of December 31, 2005 relate to operating lease obligations, letters of credit, forward purchase agreements, and employment agreements. The Company has excluded these items from the balance sheet in accordance with accounting principles generally accepted in the United States.

 

The following table summarizes the Company’s other commercial commitments, including both on- and off-balance sheet arrangements at December 31, 2005.

 

Other commercial commitments:

 

Standby letters of credit

$ 14,872

Total other commercial commitments:

$ 14,872

 

OFF BALANCE SHEET OBLIGATIONS

 

Based upon underlying purchase agreements, the Company has commitments to purchase $6.3 million of finished products and natural gas during Fiscal 2006, which are not included in liabilities on the Company’s balance sheet at December 31, 2005. These purchase agreements are entered into in the normal course of the Company’s business and are not subject to derivative accounting. The commitments will be recorded on the balance sheet of the Company when delivery of these commodities occurs and ownership passes to the Company during Fiscal 2006, in accordance with accounting principles generally accepted in the United States.

 

Based upon underlying lease agreements, the Company expects to pay approximately $7.1 million in operating lease obligations during Fiscal 2006 which are not included in liabilities on the Company’s balance sheet at December 31, 2005. These lease obligations are included in cost of sales or selling, general, and administrative expense as the underlying lease obligation comes due, in accordance with accounting principles generally accepted in the United States.

 

CRITICAL ACCOUNTING POLICIES

The Company follows certain significant accounting policies when preparing its consolidated financial statements. A complete summary of these policies is included in Note 1 to the Consolidated Financial Statements included in this report.

 

Certain of the policies require management to make significant and subjective estimates or assumptions which may deviate from actual results. In particular, management makes estimates regarding valuation of inventories, estimates of useful life of long-lived assets related to depreciation and amortization expense, estimates regarding fair value of the Company’s reporting units and future cash flows with respect to assessing potential impairment of both long-lived assets and goodwill, self-insurance, environmental and litigation reserves, pension liability, estimates of income tax expense, and estimates of pro-forma expense related to stock options granted. Each of these estimates is discussed in greater detail in the following discussion.

 

 

 

Page 16

 



 

Inventories

 

The Company’s inventories are valued at the lower of cost or market. Finished product manufacturing cost is calculated using the first-in, first-out (FIFO) method, based upon the Company’s raw material costs, collection and factory production operating expenses, and depreciation expense on collection and factory assets. Market values of inventory are estimated at each plant location, based upon either the backlog of unfilled sales orders at the balance sheet date, or for unsold inventory, upon regional finished product prices quoted in the Jacobsen index at the balance sheet date. Estimates of market value, based upon the backlog of unfilled sales orders or upon the Jacobsen index, assume that the inventory held by the Company at the balance sheet date will be sold at the estimated market finished product sales price, subsequent to the balance sheet date. Actual sales prices received on future sales of inventory held at the end of a period may vary from either the backlog unfilled sales order price or the Jacobsen index quotation at the balance sheet date. Such variances could cause actual sales prices realized on future sales of inventory to be different than the estimate of market value of inventory at the end of the period. Inventories were approximately $6.6 million and $6.0 million at December 31, 2005 and January 1, 2005, respectively.

 

Long-Lived Assets Depreciation and Amortization Expense and Valuation

 

The Company’s property, plant and equipment are recorded at cost when acquired. Depreciation expense is computed on property, plant and equipment based upon a straight line method over the estimated useful life of the assets, which is based upon a standard classification of the asset group. Buildings and improvements are depreciated over a useful life of 15 to 30 years, machinery and equipment are depreciated over a useful life of 3 to 10 years and vehicles are depreciated over a life of 2 to 6 years. These useful life estimates have been developed based upon the Company’s historical experience of asset life utility, and whether the asset is new or used when placed in service. The actual life and utility of the asset may vary from this estimated life. Useful lives of the assets may be modified from time to time when the future utility or life of the asset is deemed to change from that originally estimated when the asset was placed in service. Depreciation expense was approximately $11.9 million, $11.3 million and $11.0 million in Fiscal years ending December 31, 2005, January 1, 2005 and January 3, 2004, respectively.

 

The Company’s intangible assets, including routes, raw material supply agreements and non-compete agreements are recorded at fair value when acquired. Amortization expense is computed on these intangible assets based upon a straight line method over the estimated useful life of the assets, which is based upon a standard classification of the asset group. Collection routes are amortized over a useful life of 8 to 15 years, and raw material supply agreements and non-compete agreements are amortized over a useful life of 3 to 10 years. The actual economic life and utility of the asset may vary from this estimated life. Useful lives of the assets may be modified from time to time when the future utility or life of the asset is deemed to change from that originally estimated when the asset was placed in service. Amortization expense was approximately $3.9 million, $3.9 million and $4.2 million in Fiscal years ending December 31, 2005, January 1, 2005 and January 3, 2004, respectively.

 

The Company reviews the carrying value of long lived assets for impairment at the end of each fiscal year and when events or changes in circumstances indicate that the carrying amount of an asset, or related asset group, may not be recoverable from estimated future undiscounted cash flows. For purposes of calculating impairment on long lived operating assets, the Company estimates fair value of its long lived assets at each plant based upon future undiscounted net cash flows from use of those assets. In calculating such estimates, actual historical operating results and anticipated future economic factors, such as future business volume, future finished product prices, and future operating costs and expense are evaluated and estimated as a component of the calculation of future undiscounted cash flows for each operating plant location. The estimates of fair value of the reporting units and of future undiscounted net cash flows from operation of these assets could change if actual volumes, prices, costs or expenses vary from these estimates. A future reduction of earnings in the Company’s plants could result in an impairment charge because the estimate of fair value would be negatively impacted by a reduction of earnings.

 

The Company reviews the carrying value of assets held for sale on a regular basis for indications of impairment. Impairment is indicated whenever the carrying value of the asset exceeds estimated fair value less costs to sell. For purposes of calculating impairment on assets held for sale, the Company utilizes estimated sales value of the assets as an estimate of fair value. The estimates of fair value of the assets held for sale could change if the actual sales value realized, or realizable, varies from the estimated sale value.

 

 

Page 17

 



 

The net book value of property, plant and equipment was approximately $85.2 million and $75.4 million at December 31, 2005 and January 1, 2005, respectively. The net book value of intangible assets was approximately $12.5 million and $16.0 million at December 31, 2005 and January 1, 2005, respectively.

 

Goodwill Valuation

 

The Company reviews the carrying value of goodwill on a regular basis, including at the end of each fiscal year, for indications of impairment at each plant location which has recorded goodwill as an asset. Impairment is indicated whenever the carrying value of plant assets exceeds the estimated fair value of plant assets. For purposes of evaluating impairment of goodwill, the Company estimates fair value of plant assets at each plant, based upon future discounted net cash flows from use of those assets. In calculating such estimates, actual historical operating results and anticipated future economic factors, such as future business volume, future finished product prices, and future operating costs and expenses are evaluated and estimated as a component of the calculation of future discounted cash flows for each operating plant location with recorded goodwill. The estimates of fair value of assets at these plant locations and of future discounted net cash flows from operation of these assets could change if actual volumes, prices, costs or expenses vary from these estimates. A future reduction of earnings in the plants with recorded goodwill could result in an impairment charge because the estimate of fair value would be negatively impacted by a reduction of earnings at those plants. Goodwill was approximately $4.4 million at both December 31, 2005 and January 1, 2005.

 

Self Insurance, Environmental and Legal Reserves

 

The Company’s workers compensation, auto, and general liability policies contain significant deductibles or self insured retentions. The Company estimates and accrues for its expected ultimate claim costs related to accidents occurring during each fiscal year and carries this accrual as a reserve until such claims are paid by the Company. In developing estimates for self insured losses, the Company utilizes its staff, a third party actuary, and outside counsel as sources of information and judgment as to the expected undiscounted future costs of the claims. The Company accrues reserves related to environmental and litigation matters based on estimated undiscounted future costs. With respect to the Company’s self insurance, environmental and litigation reserves, estimates of reserve liability could change if future events are different than those included in the estimates of the actuary, consultants and management of the Company. The reserve for self insurance, environmental and litigation contingencies included in accrued expenses and other non-current liabilities was approximately $15.0 million and $13.9 million at December 31, 2005 and January 1, 2005, respectively.

 

Pension Liability

 

The Company provides retirement benefits to employees under separate final-pay noncontributory pension plans for salaried and hourly employees (excluding those employees covered by a union-sponsored plan), who meet service and age requirements. Benefits are based principally on length of service and earnings patterns during the five years preceding retirement. Pension expense and pension liability recorded by the Company is based upon an annual actuarial estimate provided by a third party administrator. Factors included in estimates of current year

 

Page 18

 



pension expense and pension liability at the balance sheet date include estimated future service period of employees, estimated future pay of employees, estimated future retirement ages of employees, and the projected time period of pension benefit payments. Two of the most significant assumptions used to calculate future pension obligations are the discount rate applied to pension liability and the expected rate of return on pension plan assets. These assumptions and estimates are subject to the risk of change over time, and each factor has inherent uncertainties which neither the actuary nor the Company is able to control or to predict with certainty.

 

The discount rate applied to the Company’s pension liability is the interest rate used to calculate the present value of the pension benefit obligation. The discount rate is based on the yield of long-term corporate fixed income securities at the measurement date of October 1 in the year of calculation. The Company considered the Citigroup Pension Discount Liability Index (5.54% as of October 1, 2005) as well as the Lehman A/AA/AAA Indices which combined to average 5.41% as of October 1, 2005. With estimated liability payment streams under the plans being 30 to 40 years out and no bonds available with maturity dates that far into the future, but with the yield curve historically flat, the Company believes it is appropriate to reference from the Citigroup and Lehman bond rates. The weighted average discount rate was 5.5% and 6.0% at October 1 in Fiscal 2005 and Fiscal 2004, respectively. The net periodic benefit cost for fiscal 2006 would increase by approximately $0.5 million if the discount rate was 0.5% lower at 5.0%. The net periodic benefit cost for fiscal 2006 would decrease by approximately $0.6 million if the discount rate was 0.5% higher at 6.0%.

 

The expected rate of return on the Company’s pension plan assets is the interest rate used to calculate future returns on investment of the plan assets. The expected return on plan assets is a long-term assumption whose accuracy can only be assessed over a long period of time. The weighted average expected return on pension plan assets was 8.75% for both Fiscal 2005 and Fiscal 2004.

 

The Company has recorded a minimum pension liability of approximately $14.6 million and $13.6 million at December 31, 2005 and January 1, 2005, respectively. The Company’s net pension cost was approximately $3.2 million, $2.7 million and $2.3 million for the Fiscal years ending December 31, 2005, January 1, 2005 and January 3, 2004, respectively.

 

Income Taxes

 

In calculating net income, the Company includes estimates in the calculation of tax expense, the resulting tax liability, and in future utilization of deferred tax assets which arise from temporary timing differences between financial statement presentation and tax recognition of revenue and expense. The Company’s deferred tax assets include a net operating loss carry-forward which is limited to approximately $0.7 million per year in future utilization due to the change in majority control, resulting from the May 2002 recapitalization of the Company. As a result of these matters, the estimate of future utilization of deferred tax assets relies upon the forecast of future reversal of the Company’s deferred tax liabilities, which provide some evidence of the ability of the Company to utilize deferred tax assets in future years. Valuation allowances for deferred tax assets are recorded when it is more likely than not that deferred tax assets will expire before they are utilized and the tax benefit is realized. Based upon the Company’s evaluation of these matters, a significant portion of the Company’s net operating loss carry-forwards will expire unused. The valuation allowance established to provide a reserve against these deferred tax assets was approximately $19.1 million and $20.3 million at December 31, 2005 and January 1, 2005, respectively.

 

Stock Option Expense

 

The Company currently discloses the pro forma effects on net income of using a fair value measurement to calculate the expense of stock options issued, and the Company will begin recording compensation expense related to stock options, beginning in the first quarter of Fiscal 2006, in accordance with implementation requirements for recently issued Statement of Financial Accounting Standards, No. 123 (revised 2004). The calculation of expense of stock options issued utilizes the Black-Scholes valuation model which estimates the fair value of the option award to the holder, based upon estimates of volatility, risk-free rates of return at the date of issue, and expected life of the option grants. If actual share price volatility or vesting differs from the projection, the actual expense recorded may vary. The Company’s pro forma expense related to stock options granted was approximately $0.6 million, $0.6 million and $0.6 million in Fiscal years ending December 31, 2005, January 1, 2005 and January 3, 2004.

 

 

Page 19

 



 

NEW ACCOUNTING PRONOUNCEMENTS

 

The Company adopted Statement of Financial Accounting Standard No. 150 (“SFAS 150”), Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity, on the first day of the third quarter of Fiscal 2003. The adoption of SFAS 150 affected accounting for the Company’s 100,000 shares of preferred stock, which was issued in May 2002, had a carrying amount of $9.2 million including accumulated preferred stock dividends payable of $1.0 million at January 3, 2004, and was redeemed in 2004 as discussed in Note 2 to the consolidated financial statements and elsewhere herein. The Company’s preferred stock contained a mandatory redemption feature that would have required redemption of the preferred stock on May 10, 2007, at face value of the preferred stock of $10.0 million, plus accumulated preferred stock dividends payable. SFAS 150 requires that mandatorily redeemable financial instruments, such as the Company’s preferred stock, be reported as a liability rather than as a component of stockholders’ equity. SFAS 150 also requires that preferred stock dividends and accretion related to the preferred stock outstanding shall be included in interest expense, beginning in the third quarter of Fiscal 2003, on a prospective basis. Preferred stock dividends and accretion included in interest expense in Fiscal 2003 were approximately $0.5 million. Preferred stock dividends and accretion included in interest expense in Fiscal 2004 were approximately $0.3 million. During the second quarter of Fiscal 2004, the Company redeemed the preferred stock outstanding at face value of $10.0 million and accumulated preferred dividends of approximately $1.2 million.

 

In November 2004, the FASB issued Statement of Financial Accounting Standard No. 151 (“SFAS 151”), Accounting for Inventory Costs, which amends Accounting Research Bulletin No. 43, related to Inventory Pricing. SFAS 151 will require that abnormal freight, handling costs, and amounts of wasted materials be treated as current period costs, and will no longer permit these costs to be capitalized as inventory costs on the balance sheet. SFAS 151 will be effective for inventory costs incurred during annual fiscal periods beginning after June 15, 2005 (the first day of Fiscal 2006). Adoption of SFAS 151 is not expected to result in a material impact to the Company’s financial statements.

 

In December 2004, the FASB issued Statement of Financial Accounting Standard No. 123 (revised 2004), Share-Based Payment (“SFAS 123(R)”). SFAS 123(R) requires all entities to recognize compensation expense in an amount equal to the fair value of the share-based payments (e.g., stock options and restricted stock) granted to employees or by incurring liabilities to an employee or other supplier (a) in amounts based, at least in part, on the price of the entity’s shares or other equity instruments, or (b) that require or may require settlement by issuing the entity’s equity shares or other equity instruments. This Statement is a revision of FASB Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation. This Statement supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and its related implementation guidance. This Statement was to be effective for public entities that do not file as small business issuers as of the beginning of the first interim or annual reporting period that begins after June 15, 2005. On April 14, 2005, the SEC announced the amendment of Rule 4-01(a) of Regulation S-X that amends the compliance dates for SFAS 123(R). The SEC’s new rule allows companies to implement SFAS 123(R) at the beginning of their next fiscal year, instead of the next reporting period, that begins after June 15, 2005. Adoption of SFAS 123(R) is expected to result in additional compensation expense to the Company, net of applicable taxes of approximately $0.4 million in Fiscal 2006, of approximately $0.3 million in Fiscal 2007 and less than $0.1 million each year in Fiscal 2008 and Fiscal 2009. Future estimates of option-based compensation expense are based upon outstanding options currently held by employees and directors, expected vesting periods, and upon historic option pricing model used by the Company for valuation of options-based compensation expense, and do not take into account the impact of subsequent issuance of options after December 31, 2005 which may occur.

 

In December 2004, the FASB issued Statement of Financial Accounting Standard No. 153 (“SFAS 153”) related to Exchanges of Non-monetary Assets, an Amendment to APB Opinion No. 29, which removes the exceptions for recording exchanges at other than fair value for the exchange of similar productive assets and replaces it with a general exception only for exchanges of non-monetary assets that do not have commercial substance. A non-monetary exchange is deemed to have commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. The provisions of this statement are effective for non-monetary exchanges occurring in the fiscal periods beginning after June 15, 2005. Adoption of SFAS 153 is not expected to have a material impact to the Company’s financial statements.

 

In March 2005, the FASB issued Financial Accounting Standard Interpretation No. 47 (“FIN 47”), Accounting for Conditional Asset Retirement Obligations, to clarify that the term “conditional asset retirement

 

Page 20

 



obligation” as used in FASB Statement No. 143, Accounting for Asset Retirement Obligations. The term refers to a legal obligation to perform an asset retirement activity in which the timing and/or method of settlement are conditional on a future event that may or may not be within the control of the entity. This Interpretation is effective no later than the end of fiscal years ending after December 15, 2005. Adoption of FIN 47 did not have a material impact on the Company’s financial statements.

 

In May 2005, the FASB issued Statement of Financial Accounting Standards No. 154, Accounting Changes and Error Correction - A Replacement of APB Opinion No. 20 and FASB Statement No. 3(“SFAS 154”), which changes the requirements for the accounting and reporting of a change in accounting principle. SFAS 154 applies to all voluntary changes in accounting principle as well as to changes required by an accounting pronouncement that does not include specific transition provisions. SFAS 154 eliminates the requirement in APB Opinion No. 20, Accounting Changes, to include the cumulative effect of changes in accounting principle in the income statement in the period of change. Instead, to enhance the comparability of prior period financial statements, SFAS 154 requires changes in accounting principle to be retrospectively applied. Under retrospective application, the new accounting principle is applied as of the beginning of the first period presented as if that principle had always been used. The cumulative effect of the change is reflected in the carrying value of assets and liabilities as of the first period presented and the offsetting adjustments are recorded to opening retained earnings. Each period presented is adjusted to reflect the period-specific effects of applying the changes. SFAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. Early adoption is permitted for accounting changes and corrections of errors made in fiscal years beginning after the date SFAS 154 was issued. SFAS 154 does not change the transition provisions of any existing accounting pronouncements, including those that are in a transition phase as of the effective date of SFAS 154.

 

 

FORWARD LOOKING STATEMENTS

 

This Annual Report on Form 10-K includes “forward-looking” statements that involve risks and uncertainties. The words “believe,” “anticipate,” “expect,” “estimate,” “intend,” and similar expressions identify forward-looking statements. All statements other than statements of historical facts included in the Annual Report on Form 10-K, including, without limitation, the statements under the section entitled “Business,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Legal Proceedings” and located elsewhere herein regarding industry prospects and the Company’s financial position are forward-looking statements. Actual results could differ materially from those discussed in the forward-looking statements as a result of certain factors. Although the Company believes that the expectations reflected in such forward-looking statements are reasonable, it can give no assurance that such expectations will prove to be correct.

 

In addition to those factors discussed under the heading “Risk Factors” in Item 1A of this report and elsewhere in this report, and in the Company’s other public filings with the SEC, important factors that could cause actual results to differ materially from the Company’s expectations include: the Company’s continued ability to obtain sources of supply for its rendering operations; general economic conditions in the American, European and Asian markets; prices in the competing commodity markets which are volatile and are beyond the Company’s control; and BSE and its impact on finished product prices, export markets, and government regulation are still evolving and are beyond the Company’s control. Among other things, future profitability may be affected by the Company’s ability to grow its business which faces competition from companies which may have substantially greater resources than the Company.

 

 

 

Page 21

 



 

ITEM 8.

FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

 

 

 

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

 

 

 

Page

 

 

 

 

Report of Independent Registered Public Accounting Firm on Consolidated
   Financial Statements

23

 

Report of Independent Registered Public Accounting Firm on Internal Control
   Over Financial Reporting

24

 

Consolidated Balance Sheets -

 

 

December 31, 2005 and January 1, 2005

26

 

Consolidated Statements of Operations -

 

 

Three years ended December 31, 2005

27

 

Consolidated Statements of Stockholders’ Equity -

 

 

Three years ended December 31, 2005

28

 

Consolidated Statements of Cash Flows -

 

 

Three years ended December 31, 2005

29

 

Notes to Consolidated Financial Statements

30

 

 

 

 

 

 

 

Financial Statement Schedule:

 

 

II - Valuation and Qualifying Accounts -

 

 

Three years ended December 31, 2005

55

 

All other schedules are omitted since the required information is not present or is not present in amounts sufficient to require submission of the schedule, or because the information required is included in the consolidated financial statements and notes thereto.

 

 

Page 22

 



 

Report of Independent Registered Public Accounting Firm

 

The Board of Directors and Stockholders

Darling International Inc.:

 

We have audited the consolidated financial statements of Darling International Inc. and subsidiaries as listed in the accompanying index. In connection with our audits of the consolidated financial statements, we have also audited the financial statement schedule as listed in the accompanying index. These consolidated financial statements and financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule based on our audits.

 

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Darling International Inc. and subsidiaries as of December 31, 2005 and January 1, 2005, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2005, in conformity with U.S. generally accepted accounting principles. Also in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.

 

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Darling International Inc.'s internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 16, 2006, expressed an unqualified opinion on management's assessment of, and an adverse opinion on the effective operation of, internal control over financial reporting.

 

As discussed in Note 18 to the consolidated financial statements, the Company changed its method of accounting for redeemable preferred stock in 2003.

 

KPMG LLP

 

Dallas, Texas

March 16, 2006

 

 

Page 23

 



 

Report of Independent Registered Public Accounting Firm

 

The Board of Directors and Stockholders

Darling International Inc.:

 

We have audited management's assessment, included in Management's Annual Report on Internal Control Over Financial Reporting (Item 9A(b)), that Darling International Inc. did not maintain effective internal control over financial reporting as of December 31, 2005, because of the effect of the material weakness identified in management's assessment, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Darling International Inc.'s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management's assessment and an opinion on the effectiveness of the Company's internal control over financial reporting based on our audit.

 

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management's assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

 

A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

A material weakness is a control deficiency, or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. The following material weakness related to accounting for state income taxes has been identified and included in management's assessment as of December 31, 2005: The Company's policies and procedures did not provide for an effective review of state tax credits to ensure that it was probable that the related benefits would be sustained. As a result of this deficiency, there was a material error in state income tax expense in the Company's preliminary 2005 consolidated financial statements, and thus more than a remote likelihood that a material misstatement of the consolidated financial statements would not have been prevented or detected.

 

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements of Darling International Inc. and subsidiaries as listed in the accompanying index. This material weakness was considered in determining the nature, timing, and extent of audit tests applied in our audit of the 2005 consolidated financial statements as listed in the accompanying index, and this report does not affect our report dated March 16, 2006, which expressed an unqualified opinion on those consolidated financial statements.

 

 

Page 24

 



In our opinion, management's assessment that Darling International Inc. did not maintain effective internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also, in our opinion, because of the effect of the material weakness described above on the achievement of the objectives of the control criteria, Darling International Inc. has not maintained effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

 

 

KPMG LLP

 

Dallas, Texas

March 16, 2006

 

Page 25

 



 

DARLING INTERNATIONAL INC. AND SUBSIDIARIES

 

Consolidated Balance Sheets

December 31, 2005 and January 1, 2005

(in thousands, except share and per share data)

 

 


ASSETS (Note 2 

December 31,
2005

 

January 1,
2005

Current assets:

 

 

 

 

 

Cash and cash equivalents

$ 36,000 

 

 

$ 37,249 

 

Restricted cash

2,349 

 

 

2,379 

 

Accounts receivable, less allowance for bad debts of $728
           at December 31, 2005 and $757 at January 1, 2005


25,886 

 

 


26,675 

 

Inventories (Note 3)

6,601 

 

 

6,000 

 

Prepaid expenses

6,231 

 

 

3,740 

 

Deferred income taxes (Note 10)

6,002 

 

 

4,080 

 

Assets held for sale (Note 5)

– 

 

 

837 

 

Other

        6 

 

 

      13 

 

Total current assets

83,075 

 

 

80,973 

 

 

 

 

 

 

 

Property, plant and equipment, net (Note 4)

85,178 

 

 

75,398 

 

Collection routes and contracts, less accumulated amortization of

 

 

 

 

 

$33,047 at Dec. 31, 2005 and $29,163 at Jan. 1, 2005

12,469 

 

 

16,006 

 

Goodwill

4,429 

 

 

4,429 

 

Deferred loan costs

2,815 

 

 

3,565 

 

Other assets

   2,806 

 

 

   2,438 

 

 

$190,772 

 

 

$182,809 

 

LIABILITIES AND STOCKHOLDERS’ EQUITY

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Current portion of long-term debt (Notes 2 and 8)

$ 5,026 

 

 

$ 5,030 

 

Accounts payable, principally trade

12,264 

 

 

8,144 

 

Accrued expenses (Note 6)

25,341 

 

 

28,005 

 

Accrued interest

        37 

 

 

     192 

 

Total current liabilities

42,668 

 

 

41,371 

 

 

 

 

 

 

 

Long-term debt, net (Notes 2 and 8)

44,502 

 

 

49,528 

 

Other noncurrent liabilities (Note 9)

27,372 

 

 

20,197 

 

Deferred income taxes (Note 10)

   2,550 

 

 

   4,478 

 

Total liabilities

117,092 

 

 

115,574 

 

 

 

 

 

 

 

Stockholders’ equity (Notes 2 and 11):

 

 

 

 

 

Common stock, $.01 par value; 100,000,000 shares authorized,

 

 

 

 

 

64,437,410 and 63,918,346 shares issued and outstanding

 

 

 

 

 

at December 31, 2005 and January 1, 2005, respectively

644 

 

 

639 

 

Additional paid-in capital

79,370 

 

 

77,393 

 

Treasury stock, at cost; 21,000 shares at December 31, 2005
           and January 1, 2005


(172)


 

 


(172)


 

Accumulated other comprehensive loss (Notes 1 and 12)

(9,282)

 

 

(7,331)

 

Accumulated earnings/(deficit)

4,447 

 

 

(3,294)

 

Unearned compensation

  (1,327)

 

 

        – 

 

Total stockholders’ equity

  73,680 

 

 

  67,235 

 

Commitments and contingencies (Notes 7 and 14)

 

 

 

 

 

 

$190,772 

 

 

$182,809 

 

The accompanying notes are an integral part of these

consolidated financial statements.

 

Page 26

 


 



 

DARLING INTERNATIONAL INC. AND SUBSIDIARIES

 

Consolidated Statements of Operations

Three years ended December 31, 2005

(in thousands, except per share data)

 

 

 

 

December 31,
2005

 

January 1,
2005

 

January 3,
2004

 

 

 

 

 

 

 

 

 

Net sales

$308,867 

 

 

$320,229 

 

 

$323,267 

 

Costs and expenses:

 

 

 

 

 

 

 

 

Cost of sales and operating expenses

241,707 

 

 

237,925 

 

 

245,175 

 

Selling, general and administrative
      expenses


35,240 

 

 


36,509 

 

 


35,808 

 

Depreciation and amortization

  15,787 

 

 

  15,224 

 

 

  15,124 

 

Total costs and expenses

292,734 

 

 

289,658 

 

 

296,107 

 

Operating income

  16,133 

 

 

  30,571 

 

 

  27,160 

 

 

 

 

 

 

 

 

 

 

Other income/(expense):

 

 

 

 

 

 

 

 

Interest expense

(6,157)

 

 

(6,759)

 

 

(2,363)

 

Other, net

     903 

 

 

    (299) 

 

 

  3,914 

 

Total other income/(expense)

  (5,254)

 

 

(7,058) 

 

 

  1,551 

 

 

 

 

 

 

 

 

 

 

Income from continuing operations
   before income taxes


10,879 

 

 


23,513 

 

 


28,711 

 

Income taxes (Note 10)

  3,184 

 

 

  9,245 

 

 

 10,632 

 

Income from continuing operations

7,695 

 

 

14,268 

 

 

18,079 

 

 

 

 

 

 

 

 

 

 

Income/(loss) from discontinued
   operations, net of tax (Note 5)

 

      46 

 

 

 

   (376)


 

 

 

     112 

 

 

 

 

 

 

 

 

 

 

Net income

7,741 

 

 

13,892 

 

 

18,191 

 

Preferred dividends and accretion

       – 

 

 

       – 

 

 

    (101)

 

Net income applicable to common
      shareholders


$  7,741 

 

 


$ 13,892 

 

 


$ 18,090 

 

 

 

 

 

 

 

 

 

 

Basic and diluted earnings per share:

 

 

 

 

 

 

 

 

Continuing operations

$  0.12 

 

 

$  0.22 

 

 

$  0.29 

 

Discontinued operations

      – 

 

 

      – 

 

 

      – 

 

Total

$  0.12 

 

 

$  0.22 

 

 

$  0.29 

 

 

 

 

 

 

 

 

 

 

 

The accompanying notes are an integral part

of these consolidated financial statements.

 

Page 27

 



DARLING INTERNATIONAL INC. AND SUBSIDIARIES

 

Consolidated Statements of Stockholders’ Equity

Three years ended December 31, 2005

(in thousands, except share data)

 


                                     Common Stock                             Accumulated    Retained                    Total
                               ----------------------   Additional              Other       Earnings                  Stockholders'
                                  Number     $.01 par     Paid-In   Treasury    Compre-    (Accumulated   Unearned      Equity/
                                 of Shares     Value      Capital     Stock   hensive Loss   Deficit)    Compensation  (Deficit)
                                ----------   --------   ----------  --------  ------------  -----------  ------------  ------------

Balances at December 28, 2002    62,281,448    $  623     $ 74,747    $ (172)   $ (3,907)   $ (35,377)  $      -       $  35,914
                                ===========     =====      =======     =====     =======     ========    ========       ========

Net income                               -         -             -         -           -       18,191           -         18,191

Minimum pension liability
   adjustment, net of tax                -         -             -         -      (1,269)           -           -         (1,269)
                                                                                                                        --------
Total comprehensive income               -         -             -         -           -            -           -         16,922

Issuance of common stock         1,351,792        14         2,533         -           -            -           -          2,547

Preffered stock - accretion
   and accumulative dividends            -        -           (101)        -           -            -           -           (101)
                                ----------      -----      -------     -----     -------     --------    --------       --------

Balances at January 3, 2004     63,633,240     $  637     $ 77,179    $ (172)   $ (5,176)   $ (17,186)  $       -      $  55,282
                                ==========      =====      =======     =====     =======     ========    ========       ========

Net income                               -         -             -         -           -       13,892           -         13,892

Minimum pension liability
  adjustment, net of tax                 -         -             -         -      (1,958)           -           -         (1,958)

Natural gas hedge derivative
   adjustment                            -         -             -         -        (197)           -           -           (197)
                                                                                                                        --------
Total comprehensive income               -         -             -         -           -            -           -         11,737

Issuance of common stock           264,106         2           214         -           -            -           -            216
                                ----------     -----       -------     -----     -------     --------    --------       --------

Balances at January 1, 2005     63,897,346    $  639      $ 77,393    $ (172)   $ (7,331)   $  (3,294)  $       -      $  67,235
                                ==========     =====       =======     =====     =======     ========    ========       ========

Net income                               -         -             -         -           -        7,741           -          7,741

Minimum pension liability
  adjustment, net of tax                 -         -             -         -      (2,148)           -           -         (2,148)

Natural gas hedge
   derivative adjustment                 -         -             -         -         197            -           -            197
                                                                                                                        --------
Total comprehensive income               -         -             -         -           -            -           -          5,790

Issuance of restricted
   common stock                    489,150         5         1,923         -           -            -      (1,928)             -

Amortization of unearned
   compensation                          -         -             -         -           -            -         601            601

Issuance of common stock            50,914         -            54         -           -            -           -             54
                                ----------     -----       -------     -----     -------     --------    --------       --------

Balances at December 31, 2005   64,437,410    $  644      $ 79,370    $ (172)   $ (9,282)   $   4,447   $  (1,327)     $  73,680
                                ==========     =====       =======     =====     =======     ========    ========       ========


 

The accompanying notes are an integral part

of these consolidated financial statements.

 

 

Page 28

 



DARLING INTERNATIONAL INC. AND SUBSIDIARIES

 

Consolidated Statements of Cash Flows

Three years ended December 31, 2005

(in thousands)

 

 

December 31,
2005

 

 

January 1,
2005

 

 

January 3,
2004

 

Cash flows from operating activities:

 

 

 

 

 

 

 

 

Net income

$ 7,741 

 

 

$ 13,892 

 

 

$ 18,191 

 

Adjustments to reconcile net income
        to net cash provided by
       operating activities:

 

 

 

 

 

 

 

 

Depreciation and amortization

15,787 

 

 

15,224 

 

 

15,124 

 

Deferred income taxes

(3,850)

 

 

779 

 

 

1,718 

 

Gain on sale of assets

(555)

 

 

(364)

 

 

(76)

 

Increase in long-term pension
                 liability


2,863 

 

 


3,190 

 

 


2,624 

 

Amortization of unearned
                 compensation


601 

 

 


– 

 

 


– 

 

Gain on early retirement of debt

– 

 

 

(1,306)

 

 

(4,698)

 

Loss on early redemption of
                 preferred stock


– 

 

 


1,678 

 

 


– 

 

Changes in operating assets
                 and liabilities:

 

 

 

 

 

 

 

 

Restricted cash

30 

 

 

(1,799)

 

 

(480)

 

Accounts receivable

793 

 

 

2,702 

 

 

(5,279)

 

Inventories and prepaid
                          expenses


(3,074)

 

 


2,621 

 

 


(367)

 

Accounts payable and
                          accrued expenses


1,431 

 

 


3,431 

 

 


(1,750)

 

Accrued interest

(155)

 

 

(134)

 

 

12 

 

Other

2,926 

 

 

(1,421)

 

 

2,682 

 

Net cash provided/(used) by
       discontinued operations


      46 

 

 


   (370)

 

 


    121 

 

Net cash provided by
                 operating activities


24,584 

 

 


38,123 

 

 


27,822 

 

Cash flows from investing activities:

 

 

 

 

 

 

 

 

Capital expenditures

(21,406)

 

 

(13,312)

 

 

(11,586)

 

Gross proceeds from sale of property,
       plant and equipment, assets held
       for disposition and other assets



1,115 

 

 



589 

 

 



177 

 

Payments related to routes and
       other intangibles


   (347)


 


 


   (428)


 


 


   (534)


 

Net cash used in
                 investing activities


(20,638)


 


 


(13,151)


 


 


(11,943)


 

 

 

 

 

 

 

 

 

 

Cash flows from financing activities:

 

 

 

 

 

 

 

 

Proceeds from long-term debt

– 

 

 

92,302 

 

 

256,162 

 

Payments on long-term debt

(5,030)

 

 

(91,354)

 

 

(262,204)

 

Contract payments

(178)

 

 

(177)

 

 

(460)

 

Deferred loan costs

(41)

 

 

(2,209)

 

 

(2,022)

 

Redemption of preferred stock

– 

 

 

(10,000)

 

 

– 

 

Payment of preferred dividends

– 

 

 

(1,240)

 

 

– 

 

Issuance of common stock

      54 

 

 

    152 

 

 

2,011 

 

Net cash used in
                 financing activities


(5,195)


 


 


(12,526)


 


 


(6,513)


 

 

 

 

 

 

 

 

 

 

Net increase/(decrease) in cash and
   cash equivalents


(1,249)


 


 


12,446 


 


 


9,366 


 

Cash and cash equivalents at
   beginning of year


37,249 


 


 


24,803 


 


 


15,437 


 

Cash and cash equivalents at end of year

$36,000 

 

 

$37,249 

 

 

$24,803 

 

 

 

 

 

 

 

 

 

 

Supplemental disclosure of cash flow information:

 

 

 

 

 

 

 

 

Cash paid during the year for:

 

 

 

 

 

 

 

 

Interest

$ 5,765 

 

 

$ 5,879 

 

 

$ 3,370 

 

Income taxes, net of refunds

$ 3,859 

 

 

$ 8,104 

 

 

$ 7,786 

 

 

 

 

 

 

 

 

 

 

The accompanying notes are an integral part

of these consolidated financial statements.

 

Page 29

 



DARLING INTERNATIONAL INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements

 

 

 

NOTE 1.

GENERAL

 

 

(a)

NATURE OF OPERATIONS

 

Darling International Inc. is a recycler of food and animal by-products and provides grease trap services to food service establishments. The Company collects and recycles animal by-products and used cooking oil from food service establishments. The Company processes such raw materials at 24 facilities located throughout the United States into finished products such as protein (primarily meat and bone meal, "MBM"), tallow (primarily bleachable fancy tallow, "BFT") and yellow grease ("YG"). The Company sells these products nationally and internationally, primarily to producers of oleo-chemicals, soaps, pet foods and livestock feed, for use as ingredients in their products or for further processing. The Company’s operations are currently organized into two segments: Rendering and Restaurant Services. For additional information on the Company’s segments, see Note 15.

 

On October 22, 1993, the Company entered into a settlement agreement approved by the U.S. District Court providing for a restructure of the Company’s debt and equity and resolution of a class action lawsuit (the “Settlement”). The terms of the Settlement were tantamount to a prepackaged bankruptcy despite the Settlement not occurring under Chapter 11 of the Bankruptcy Code. On December 29, 1993, the Settlement was consummated and became binding on all original noteholders. The Company has accounted for the Settlement using “Fresh Start Reporting” as of January 1, 1994, in accordance with Statement of Position 90-7, “Financial Reporting by Entities in Reorganization Under the U.S. Bankruptcy Code” issued by the American Institute of Certified Public Accountants. Using a valuation of the Company performed by an independent appraiser, the Company determined the total reorganization value of all its assets to be approximately $236,294,000 as of January 1, 1994, and the Company’s accumulated deficit was eliminated as of January 1, 1994.

 

In May 2002, the Company completed a recapitalization. See Note 2 below.

 

 

 

(b)

SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

 

(1)

Basis of Presentation

 

The consolidated financial statements include the accounts of the Company and its subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation. As disclosed in Note 5, the operations of the London, Ontario, Canada facility, as defined below, are classified as discontinued operations.

 

 

 

(2)

Fiscal Year

 

The Company has a 52/53 week fiscal year ending on the Saturday nearest December 31. Fiscal years for the consolidated financial statements included herein are for the 52 weeks ended December 31, 2005, the 52 weeks ended January 1, 2005, and the 53 weeks ended January 3, 2004.

 

 

 

(3)

Inventories

 

Inventories are stated at the lower of cost or market. Cost is determined using the first-in, first-out (FIFO) method.

 

 

 

(4)

Property, Plant and Equipment

 

Property, plant and equipment are recorded at cost. Depreciation is computed by the straight-line method over the estimated useful lives of assets: 1) Buildings and improvements, 15 to 30 years; 2) Machinery and equipment, 3 to 10 years; and 3) Vehicles, 2 to 6 years.

Maintenance and repairs are charged to expense as incurred and expenditures for major renewals and improvements are capitalized.

 

 

Page 30

 



 

 

(5)

Collection Routes and Contracts

 

Collection routes consist of groups of suppliers of raw materials in similar geographic areas from which the Company derives collection fees and a dependable source of raw materials for processing into finished products. Non-compete agreements represent contractual arrangements with former competitors whose businesses were acquired. Amortization is computed by the straight-line method over the following periods: 1) Collection routes, 8-15 years, and 2) Restrictive covenants, 3-10 years.

 

 

(6)

Goodwill and Other Intangible Assets

 

Goodwill and other intangible assets not subject to amortization are tested for impairment annually or more frequently if events or changes in circumstances indicate that the asset might be impaired. SFAS 142 requires a two-step process for testing impairment. First, the fair value of each reporting unit is compared to its carrying value to determine whether an indication of impairment exists. If impairment is indicated, then the fair value of the reporting unit’s goodwill is determined by allocating the unit’s fair value of its assets and liabilities (including any unrecognized intangible assets) as if the reporting unit had been acquired in a business combination. The amount of impairment for goodwill is measured as the excess of its carrying value over its fair value.

 

The Company has identified its reporting units for purposes of assessing goodwill impairment to be the individual plant locations. The fair values of the Company’s reporting units containing goodwill exceed the related carrying values; consequently, there has been no impairment of goodwill since the adoption of SFAS 142. Intangible assets subject to amortization under SFAS 142 consist of collection routes and contracts and non-compete agreements. Amortization expense is calculated using the straight-line method over the estimated useful life of the asset ranging from 3 to 15 years.

 

The gross carrying amount of collection routes and contracts and non-compete agreements subject to amortization include (in thousands):


December 31,
2005

January 1,
2005

Collection Routes and Contracts:

 

 

Routes

$ 42,887 

$ 42,809 

Non-compete agreements

2,216 

1,947 

Royalty and consulting agreements

     413 

     413 

 

45,516 

45,169 

Accumulated Amortization:

 

 

Routes

(31,175)

(27,739)

Non-compete agreements

(1,602)

(1,175)

Royalty and consulting agreements

    (270)

    (249)

 

(33,047)

(29,163)

Collection routes and contracts,
less accumulated amortization

 

$ 12,469 

 

$ 16,006 

 

Amortization expense for the three years ended December 31, 2005, January 1, 2005 and January 3, 2004, was approximately $3,884,000, $3,879,000 and $4,166,000, respectively. Amortization expense for the next five fiscal years is estimated to be $3,729,000, $3,619,000, $3,559,000, $715,000 and $461,000.

 

The Company has also recorded an intangible asset related to unrecognized prior service costs in connection with its minimum pension liability as discussed in Note 12.

 

Page 31

 



 

(7)

Environmental Expenditures

 

Environmental expenditures incurred to mitigate or prevent environmental contamination that has yet to occur and that otherwise may result from future operations are capitalized. Expenditures that relate to an existing condition caused by past operations and that do not contribute to current or future revenues are expensed or charged against established environmental reserves. Reserves are established when environmental assessments and/or clean-up requirements are probable and the costs are reasonably estimable.

 

 

(8)

Income Taxes

 

The Company accounts for income taxes using the asset and liability method. Under the asset and liability method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.

 

 

(9)

Net Income Per Common Share

 

Basic income per common share is computed by dividing net income or loss attributable to outstanding common stock by the weighted average number of common shares outstanding during the year. Diluted income per common share is computed by dividing net income attributable to outstanding common stock by the weighted average number of common shares outstanding during the year increased by dilutive common equivalent shares determined using the treasury stock method.

 

 

  Net Income per Common Share (in thousands)
  December 31,
2005

  January 1,
2005

  January 3,
2004

 
   Income
Shares
Per 
Share

  Income
Shares
Per 
Share

  Income
Shares
Per 
Share

 
Income from
   continuing operations
 
$7,695 
 
63,929 
 
$0.12 
   
$14,268 
 
63,840 
 
$0.22 
   
$18,079
 
62,588 
 
$0.29
 
Income/(loss) from
   discontinued
  operations, net of tax
 
 
46 

 
 
63,929 
 
 

   
 
(376)

 
 
63,840 
 
 

   
 
112 

 
 
62,588 
 
 

 
Net income 7,741  63,929  0.12    13,892  63,840 0.22    18,191  62,588  0.29   
Less:  Preferred dividends
   and accretion
 
 

 

 

   

 

 

   
(101)

 

 

 
 
Basic:
Income applicable
  to common shareholders
 
 
 
7,741 
 
 
 
63,929 
 
 
 
0.12 
   
 
 
13,892 
 
 
 
63,840 
 
 
 
0.22 
   
 
 
18,090 
 
 
 
62,588 
 
 
 
0.29 
 
 
Effect of Dilutive Securities
Add:  Option shares in the
  money and dilutive effect
  of restricted stock
 
 
 
 
 
 
 
 
1,053 
 
 
 
 
   
 
 
 
 
 
 
 
1,079 
 
 
 
 
   
 
 
 
 
 
 
 
1,120 
 
 
 
 
 
Less:  Proforma treasury
   shares
 

 
(457)

 

   

 
(456)

 

   

 
(520)

 

 
 
Diluted:
Income available to
  common shareholders
 
 
 
$7,741 

 
 
 
64,525 

 
 
 
$0.12 

   
 
 
$13,892 

 
 
 
64,463 

 
 
 
$0.22 

   
 
 
$18,090 

 
 
 
63,188 

 
 
 
$0.29 

 

 

For Fiscal 2005, 2004 and 2003, respectively, 726,092, 195,879 and 233,674 outstanding stock options were excluded from diluted income per common share as the effect was antidilutive.

 

 

Page 32

 



 

(10)

Stock Option Plans

 

The Company accounts for its stock option plan in accordance with the provisions of Accounting Principles Board (“APB”) Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations. As such, compensation expense is recorded on the date of grant only if the current market price of the underlying stock exceeds the exercise price. Statement of Financial Accounting Standards (“SFAS”) No. 123, Accounting for Stock-Based Compensation , permits entities to recognize as expense over the vesting period the fair value of all stock-based awards. Alternatively, SFAS No. 123 allows entities to continue to apply the provisions of APB Opinion No. 25 and provide pro forma net income and pro forma earnings per share disclosures for employee stock option grants as if the fair-value-based method defined in SFAS No. 123 had been applied. The Company has elected to continue to apply the provisions of APB Opinion No. 25 and provide the pro forma disclosure provisions of SFAS No. 123.

Under the intrinsic-value method, compensation expense is recorded only to the extent that the grant price is less than market on the measurement date. All options granted by the Company were issued at or above market price, and therefore no stock-based compensation has been recorded due to option grants.

The following table illustrates the effect on net income and income per share if the fair value based method, net of applicable taxes, had been applied to all outstanding and vested awards in each period (in thousands, except per share amounts).

 

 

December 31,
2005

January 1,
2005

January 3,
2004

Reported net income

 

$7,741

 

$13,892

 

$18,191

 

Add: Stock-based employee
compensation expense included
in reported net income, net of tax

 

 

391

 

 

 

 

 

Deduct: Total stock-based employee compensation expense determined under fair-value-based method for all rewards,
net of tax

 

 

 

 

   (973)

 

 

 

 

   (569)

 

 

 

 

   (622)

 

Pro forma net income

$ 7,159

$13,323

$17,569

 

Earnings per share:

 

 

 

 

Basic – as reported

$0.12

$0.22

$0.29

 

Basic – pro forma

$0.11

$0.21

$0.28

 

 

 

 

 

 

Diluted – as reported

$0.12

$0.22

$0.29

 

Diluted – pro forma

$0.11

$0.21

$0.28

 

 

The fair value of each stock option grant under the Company’s stock option plan was estimated on the date of grant using the Black Scholes option-pricing model with the following weighted average assumptions and results:

 

Page 33

 



 

 

Weighted Average

 

2005

2004

2003

Expected dividend yield

 

0.0%

0.0%

0.0%

Risk-free interest rate

 

3.94%

3.86%

3.45%

Expected life

 

5.9 years

10 years

10 years

Expected volatility

 

55.0%

100.32%

106.03%

Fair value of options granted

 

$2.04

$3.56

$1.96

 

In December 2004, the FASB issued Statement of Financial Accounting Standard No. 123 (revised 2004), Share-Based Payment (“SFAS 123(R)”). SFAS 123(R) requires all entities to recognize compensation expense in an amount equal to the fair value of the share-based payments (e.g., stock options and restricted stock) granted to employees or by incurring liabilities to an employee or other supplier (a) in amounts based, at least in part, on the price of the entity’s shares or other equity instruments, or (b) that require or may require settlement by issuing the entity’s equity shares or other equity instruments. This Statement is a revision of FASB Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation. This Statement supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and its related implementation guidance. Under SFAS 123(R) pro forma disclosure is no longer an alternative. Effective January 1, 2006 under the new standard, the Company will begin recording compensation expense related to stock options, in accordance with the implementation requirement of SFAS 123(R). The Company expects that the adoption of SFAS 123(R) on January 1, 2006 will reduce Fiscal 2006 earnings by approximately $0.4 million based on the options outstanding as of December 31, 2005. See Note 11 for further information on the Company’s stock-based compensation plans.

 

 

(11)

Statements of Cash Flows

 

The Company considers all short-term highly liquid instruments, with an original maturity of three months or less, to be cash equivalents. The statements of cash flows have been revised for Fiscal 2004 and 2003 to reconcile net income of $13,892,000 and $18,191,000, respectively, rather than income from continuing operations of $14,268,000 and $18,079,000, respectively, to net cash provided by operating activities.

 

 

(12)

Use of Estimates

 

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

If it is at least reasonably possible that the estimate of the effect on the financial statements of a condition, situation, or set of circumstances that exist at the date of the financial statements will change in the near term due to one or more future confirming events and the effect of the change would be material to the financial statements, the Company will disclose the nature of the uncertainty and include an indication that it is at least reasonably possible that a change in the estimate will occur in the near term. If the estimate involves a loss contingency covered by FASB Statement No. 5, the disclosure will also include an estimate of the possible loss or range of loss or state that such an estimate cannot be made.

 

 

(13)

Impairment of Long-Lived Assets and Long-Lived Assets to be Disposed Of

 

The Company follows Statement of Financial Accounting Standards No. 144, Accounting for the Impairment of Disposal of Long-Lived Assets (SFAS 144). The Company reviews the carrying value of long-lived assets for impairment when events or changes in circumstances indicate that the carrying amount of an asset, or related asset group, may not be recoverable from estimated future undiscounted cash flows. For purposes of calculating impairment on long-lived operating assets, the Company estimates fair value of its long-lived assets at each plant based upon future undiscounted net cash flows from use of those assets. In calculating such estimates, actual historical operating results and anticipated future economic factors, such as future business volume, future finished product prices, and future operating costs and expense are evaluated and estimated as a component of the calculation of future undiscounted cash flows for each operating plant location. The estimates of fair value of the reporting units and of future undiscounted net cash flows from operation of these assets could change if actual volumes, prices, costs or expenses vary from these estimates.

SFAS 144 requires discontinued operations to be carried at the lower of cost or fair value less costs to sell and requires the classification of operating results of discontinued operations to be separately presented, net of tax, within the statement of operations. During the third quarter of Fiscal 2003, the Company recorded an impairment charge of approximately $435,000 to reduce to fair value the carrying value of the assets at the Company’s Linkwood, Maryland rendering plant, which was sold on October 18, 2002, to a third party purchaser for cash consideration of $4.3 million.

 

 

Page 34

 



 

The Fiscal 2003 impairment charge of $435,000 was necessary to reduce the carrying value of these assets to management’s estimate of their net realizable value. Estimated net realizable value was based upon the sales price received from the third party purchaser. A summary of the impairment charge follows (in thousands):

 

Land

$200

Leaseholds and buildings

235

Total impairment

$435

 

 

 

(14)

Financial Instruments

 

The carrying amount of cash and cash equivalents, accounts receivable, accounts payable and accrued expenses approximates fair value due to the short maturity of these instruments. In addition, the carrying amount of the Company's outstanding borrowings under the Credit Agreement and Term Loan described in Notes 2 and 8 approximates the fair value due to the floating interest rates on the borrowings.

 

The Company's outstanding senior subordinated notes as described in Note 2 and 8 have a fair value of approximately $37.2 million. The fair value for these senior subordinated notes was estimated based on current rates the Company believes it would pay for debt of the same remaining maturity.

 

 

(15)

Derivative Instruments

 

The Company makes limited use of derivative instruments to manage cash flow risks related to interest and natural gas expense. Interest rate swaps are entered into with the intent of managing overall borrowing costs. The Company does not use derivative instruments for trading purposes.

 

The Company follows the provisions of SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, (“SFAS 133”). Under the standard, entities are required to report all derivative instruments in the statement of financial position at fair value. The accounting for changes in the fair value (i.e., gains or losses) of a derivative instrument depends on whether it has been designated and qualifies as part of a hedging relationship and, if so, on the reason for holding the instrument. If certain conditions are met, entities may elect to designate a derivative instrument as a hedge of exposures to changes in fair value, cash flows, or foreign currencies. If the hedged exposure is a cash flow exposure, the effective portion of the gain or loss on the derivative instrument is reported initially as a component of other comprehensive income (outside of earnings) and is subsequently reclassified into earnings when the forecasted transaction affects earnings. Any amounts excluded from the assessment of hedge effectiveness as well as the ineffective portion of the gain or loss are reported in earnings immediately. If the derivative instrument is not designated as a hedge, the gain or loss is recognized in earnings in the period of change.

 

The Company has designated its natural gas swap agreements as cash flow hedges and such agreements qualify for hedge accounting under SFAS 133.

 

As of January 1, 2005, the Company was party to fixed for float swap agreements for the purchase of natural gas. At January 1, 2005, the fair value of the Company’s positions in these swap agreements was a liability of approximately $0.3 million. The Company’s positions in these swap agreements were settled during January and February 2005.

 

As of December 31, 2005, the Company was not a party to any fixed for float swap agreements for the purchase of natural gas.

 

A summary of the derivative adjustment recorded to accumulated other comprehensive income, the net change arising from hedging transactions, and the amounts recognized in earnings during the years ended December 31, 2005 and January 1, 2005 are as follows (in thousands):

 

Page 35

 



 

 

 

2005  

 

2004  

Derivative adjustment included in accumulated other comprehensive loss at January 1, 2005 and January 3, 2004

 

$  319 

 

 

$    –

Net change arising from current period
hedging transactions

 

(132)

 

 

428 

Reclassifications into earnings

(187)

 

(109)

Accumulated other comprehensive loss at December 31, 2005 and January 1, 2005 (a)

 

$    – 

 

 

$  319 

 

(a)

Reported as accumulated other comprehensive loss of approximately $0.2 million recorded net of taxes of approximately $0.1 million at January 1, 2005.

 

A summary of the gains and losses recognized in earnings during the years ended December 31, 2005 and January 1, 2005 are as follows (in thousands):

 

 

2005  

 

2004  

Loss to operating expenses related

to natural gas swap agreements (effective portion)

 

$  187 

 

 

$  109 

Loss/(Gain) to other expenses related to
natural gas swap agreements (ineffective portion)

 

(1)

 

 

Total reclassifications into earnings

$  186 

 

$  118 

 

 

At December 31, 2005, the Company has forward purchase agreements in place for purchases of approximately $1.0 million of natural gas for the month of January 2006.

 

These forward purchase agreements have no net settlement provisions and the Company intends to take physical delivery. Accordingly, the forward purchase agreements are not subject to the requirements of SFAS No. 133 because they qualify as normal purchases as defined in the standard.

 

 

(16)

Comprehensive Income

 

The Company follows the provisions of SFAS No. 130, "Reporting Comprehensive Income." SFAS No. 130 establishes standards for reporting and presentation of comprehensive income and its components. In accordance with SFAS No. 130, the Company has presented the components of comprehensive income in its consolidated statement of stockholders’ equity.

 

 

(17)

Revenue Recognition

 

The Company recognizes revenue on sales when products are shipped and the customer takes ownership and assumes risk of loss. Collection fees are recognized in the month the service is provided.

 

 

Page 36

 



 

(18)

Reclassification

 

Certain other reclassifications of amounts previously reported have been made to the Fiscal 2003 and Fiscal 2004 consolidated financial statements to conform to the presentation for each year.

 

 

 

(19)

Discontinued Operations

 

At a scheduled meeting held during the fourth quarter of 2004, the Company’s board of directors approved a plan for the Company to dispose of its operations at London, Ontario, Canada. Results of operations of the London facility were previously included in results of the Company’s rendering segment, and have been reclassified to income/(loss) from discontinued operations in the accompanying consolidated statements of operations, as discussed elsewhere herein.

 

 

NOTE 2.

FINANCING

 

 

(a)

Refinancing – Senior Credit Agreement

 

The Company entered into a senior credit agreement with new lenders on April 2, 2004, and entered into a new lender acknowledgement on May 28, 2004, that increased the committed amount as permitted by the senior credit agreement. The refinancing replaced the Amended and Restated Credit Agreement executed on May 13, 2002. The senior credit agreement provides for $75 million in financing facilities, has a term of five years, maturing on April 2, 2009, and bears interest at a rate which may be based upon either prime or LIBOR, or a combination of both rates plus a margin which may be adjusted quarterly based upon the Company’s leverage ratios. The senior credit agreement provides for a $25.0 million Term Loan Facility, with scheduled amortization of $1.25 million each quarter during the five-year agreement. Additionally, the senior credit agreement provides for a $50 million Revolver Facility which includes a $25.0 million Letter of Credit sub-facility. At December 31, 2005, the interest rate for $13.25 million of the term loan balance was based upon a two- and three-month LIBOR rate of 4.45% per annum, plus a margin of 2.75% per annum for a total of 7.20% per annum. The interest rate on the remaining $1.25 million balance of the term loan was based upon a prime rate of 7.25% per annum plus a margin of 1.50% per annum for a total of 8.75% per annum.

 

Restrictive covenants in the Company’s senior credit agreement require the maintenance of certain minimum financial ratios and permit the Company, within limitations defined in the senior credit agreement, to incur additional indebtedness; issue additional capital or preferred stock; pay dividends; redeem common shares as treasury stock; create liens; merge, consolidate, or acquire other businesses; sell and dispose of assets; and make investments.

 

On April 2, 2004, proceeds of the new Term Loan Facility were used to pay off the outstanding balance of the Amended and Restated Credit Agreement of approximately $18.0 million. Additional proceeds were used for other general corporate and working capital purposes. The terms of the senior credit agreement required the Company to redeem the Company’s preferred stock during the second quarter of 2004. As such, the remaining proceeds and cash on hand were used to redeem the Company’s preferred stock at face value of $10.0 million plus accumulated preferred dividends of approximately $1.2 million, for a total aggregate consideration of $11.2 million. The preferred stock had a carrying value of approximately $9.5 million at April 3, 2004. Consequently, redemption of the preferred stock and accumulated dividends during the second quarter of 2004 resulted in a loss on extinguishment of approximately $1.7 million, which is included in other expense.

 

 

Page 37

 



 

On May 13, 2002, the Company consummated a recapitalization and executed the Amended and Restated Credit Agreement with its lenders. The Amended and Restated Credit Agreement reflects the effect of applying the provisions of Statement of Financial Accounting Standards No. 15, Accounting by Debtors and Creditors for Troubled Debt Restructurings (“SFAS No. 15”). SFAS No. 15 requires that the previously existing amount of debt owed by the Company to the lenders be reduced by the fair value of the equity interest granted and that no gain from restructuring the Company’s bank debt be recognized. As a result, the carrying amount of the debt of $20.6 million exceeded its contractual amount of $18.3 million by $2.3 million at January 3, 2004. The outstanding balance of the Amended and Restated Credit Agreement at April 2, 2004 of approximately $20.1 million was reduced to zero through a payment of approximately $18.0 million in cash proceeds from the senior credit agreement. The remaining balance related to the SFAS 15 effect of approximately $2.1 million was recorded as a gain on early retirement of debt, included in other income in the operating statement, net of related deferred loan costs of approximately $0.8 million, also extinguished upon payment of the related debt, which results in a net gain on early retirement of debt of approximately $1.3 million recorded in the first quarter of Fiscal 2004.

 

(b)

Senior Subordinated Notes

 

On December 31, 2003, the Company issued senior subordinated notes in the principal amount of $35,000,000 and applied the net proceeds of such issuance to reduce the outstanding term loan portion of its Amended and Restated Credit Agreement executed on May 13, 2002. The senior subordinated notes have a term of six years, maturing on December 31, 2009. Beginning June 1, 2006, the Company may prepay the outstanding principal amount of the senior subordinated notes in whole or in part, plus accrued and unpaid interest, plus a prepayment fee of 5.5%, which declines each year after this date. Interest accrues on the outstanding principal balance of the senior subordinated notes at an annual rate of 12% that is payable quarterly in arrears. Restrictive covenants in the senior subordinated notes permit the Company, within limitations defined in the senior subordinated notes, to incur additional indebtedness and to pay cash dividends.

 

The Company’s senior credit agreement and senior subordinated notes consisted of the following elements at December 31, 2005 and January 1, 2005, respectively (in thousands):

 

December 31,
2005

January 1,
2005

Senior Credit Agreement:

 

 

Term Loan

$ 14,500

$ 19,500

Revolving Credit Facility:

 

 

Maximum availability

$ 50,000

$ 50,000

Borrowings outstanding

Letters of credit issued

  14,872

  13,700

Availability

$ 35,128

$ 36,300

Senior Subordinated Notes Payable:

$ 35,000

$ 35,000

 

 

 

Substantially all of the Company’s assets are either pledged or mortgaged as collateral for borrowings under the senior credit agreement. Additionally, on August 9, 2005, the Company entered into the First Amendment to the senior credit agreement with its lenders to permit the Company to pay cash or in-kind dividends on its common stock, or redeem, repurchase or retire its common stock, in an aggregate amount not to exceed $10 million during the 12-month period beginning August 9, 2005.

 

 

NOTE 3.

INVENTORIES

 

 

A summary of inventories follows (in thousands):

 

December 31,
2005

January 1,
2005

Finished product

$ 4,904

$ 4,099

Supplies and other

  1,697

  1,901

 

$ 6,601

$ 6,000

 

 

Page 38

 



 

 

NOTE 4.

PROPERTY, PLANT AND EQUIPMENT

 

 

A summary of property, plant and equipment follows (in thousands):

 

 

December 31,
2005

January 1,
2005

Land

$ 11,234

$    9,552

Buildings and improvements

31,149

28,627

Machinery and equipment

166,973

159,794

Vehicles

42,957

43,175

Construction in process

    6,136

       603

 

258,449

241,751

Accumulated depreciation

(173,271)

(166,353)

 

$ 85,178

$ 75,398

 

 

NOTE 5.

ASSETS HELD FOR SALE AND DISCONTINUED OPERATIONS

 

 

Assets held for sale consist of the following (in thousands):

 

 

December 31,
2005

January 1,
2005

Petaluma, CA

$  –

$497

Tyler, TX

183

Sunnyside, WA

133

London, Canada

   –

   24

 

$   –

$837

 

Assets held for sale are carried at the lower of amortized cost or fair value less costs to sell. The assets are expected to be sold within the next 12 months and, accordingly, are classified as current assets. These assets were previously utilized in rendering operations.

 

At a meeting held during the fourth quarter of 2004, the Company’s board of directors approved a plan for the Company to dispose of its operation at London, Ontario, Canada. Results of operations of the London facility were previously included in results of the Company’s rendering segment, and have been reclassified to income/(loss) from discontinued operations in the accompanying consolidated statements of operations. The Sunnyside, Washington sale was completed on April 8, 2005, the Tyler, Texas sale was completed on May 6, 2005, and the London, Ontario, Canada sale was completed on September 30, 2005. During the second quarter of 2005, the Petaluma, California property was removed as an asset held for sale and reclassified to property, plant and equipment. Revenue, costs and expenses, net of applicable taxes of the London location, are as follows (in thousands):

 

Page 39

 



 

 

 

Fiscal Year Ended

 

December 31,
    2005

January 1,
    2005

January 3,
    2004

Net sales

$      –

$    685

$ 1,162

Cost of sales and operating expenses

572

886

Selling, general and administrative

248

163

Depreciation and amortization

      –

       6

       9

Total costs and expenses

826

1,058

Operating and pretax loss, now classified as loss from
   discontinued operations

 

 

(141)

 

104

Other income/(expense)

     69

   (442)

     22

Income/(loss) before income taxes

     69

   (583)

   126

Income tax (expense)/benefit

  (23)

     207

   (14)

Income/(loss) from discontinued operations, net of tax

 

$     46

 

$   (376)

 

$    112

 

 

NOTE 6.

ACCRUED EXPENSES

 

 

Accrued expenses consist of the following (in thousands):

 

December 31,
    2005

January 1,
      2005

Compensation and benefits

$ 4,719

$ 9,053

Utilities and sewage

3,447

2,946

Accrued income, ad valorem, and franchise taxes

1,782

2,551

Reserve for self insurance, litigation, environmental
   and tax matters (Note 14)

 

5,422

 

5,733

Medical claims liability

2,808

2,300

Non-compete agreements

236

156

Other accrued expense

6,898

5,237

Insurance

      29

      29

 

$25,341

$28,005

 

 

NOTE 7.

LEASES

 

 

The Company leases four plants and storage locations, three office locations and a portion of its transportation equipment under operating leases. Leases are noncancellable and expire at various times through the year 2028. Minimum rental commitments under noncancellable leases as of December 31, 2005, are as follows (in thousands):

 

Period Ending Fiscal

Operating Leases

2006

$  7,104

2007

6,571

2008

5,389

2009

4,259

2010

2,340

Thereafter

  9,623

Total

$35,286

 

Rent expense for the fiscal years ended December 31, 2005, January 1, 2005, and January 3, 2004 was $5.5 million, $4.8 million and $4.8 million, respectively.

 

 

Page 40

 



 

 

NOTE 8.

DEBT

 

 

Debt consists of the following (in thousands):

 

   December 31,

   2005

   January 1,

   2005

Senior Credit Agreement (Note 2):

 

 

Revolving Credit Facility

$        –

$        –

Term Loan

14,500

19,500

Senior Subordinated Notes

35,000

35,000

Other Notes

       28

       58

 

49,528

54,558

Less Current Maturities

  5,026

  5,030

 

$44,502

$49,528

 

 

Maturities of long-term debt at December 31, 2005 follow (in thousands):

 

 

Contractual
Debt Payment

2006

$  5,026

2007

5,002

2008

4,500

2009

35,000

2010 and thereafter

      –

 

$49,528

 

 

Under the terms of the senior credit agreement, $5.0 million included in current maturities of debt at December 31, 2005, will be due during Fiscal 2006, consisting of scheduled installment payments of $1.25 million due each quarter.

 

 

NOTE 9.

OTHER NONCURRENT LIABILITIES

 

 

Other noncurrent liabilities consist of the following (in thousands):

 

 

   December 31,

   2005

   January 1,

   2005

Accrued pension liability

$14,590

$11,727

Reserve for self insurance, litigation,
    environmental and tax matters (Note 14)

 

12,389

 

8,106

Liabilities associated with acquisitions and
    noncompete agreements


     393


     364

 

$27,372

$20,197

 

 

Page 41

 



 

 

NOTE 10.

INCOME TAXES

 

 

Income tax expense/(benefit) attributable to income from continuing operations before income taxes consists of the following (in thousands):

 

 

December 31,

2005

January 1,

2005

January 3,

2004

Current:

 

 

 

 

 

Federal

$ 4,826

 

$ 7,265

 

$ 7,452

State

176

 

1,201

 

1,462

Deferred:

 

 

 

 

 

Federal

(1,818

)

   779

 

 1,718

 

$ 3,184

 

$ 9,245

 

$10,632

 

 

 

 

 

 

 

Income tax expense for the years ended December 31, 2005, January 1, 2005 and January 3, 2004, differed from the amount computed by applying the statutory U.S. federal income tax rate to income from continuing operations before income taxes as a result of the following (in thousands):

 

 

December 31,

2005

January 1,

2005

January 3,

2004

Computed “expected” tax expense

$ 3,753

 

$ 8,230

 

$10,049

 

State income taxes

393

 

729

 

866

 

Change in valuation allowance

 

(334

)

 

Tax credits

(257

)

 

 

Reversal of reserve for taxes

(700

)

 

 

Other, net

      (5

)

   620

 

   (283

)

 

$ 3,184

 

$ 9,245

 

$10,632

 

 

 

 

 

 

 

 

 

The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 2005 and January 1, 2005 are presented below (in thousands):

 

 

December 31,

2005

January 1,

2005

Deferred tax assets:

 

 

 

 

Net operating loss carryforwards

$ 21,179

 

$ 22,683

 

Loss contingency reserves

5,583

 

3,941

 

Other

  9,179

 

  6,889

 

Total gross deferred tax assets

35,941

 

33,513

 

Less valuation allowance

(19,086

)

(20,257

)

Net deferred tax assets

 16,855

 

 13,256

 

Deferred tax liabilities:

 

 

 

 

Collection routes and contracts

 (1,750

)

 (2,511

)

Property, plant and equipment

(9,915

)

(10,926

)

Other

(1,738

)

    (217

)

Total gross deferred tax liabilities

(13,403

)

(13,654

)

 

$  3,452

 

$    (398

)

 

The net change in the total valuation allowance was a decrease of $1,171,000 for the year ended December 31, 2005 due to the expiration of NOL carryforwards.

 

Page 42

 



 

At December 31, 2005, the Company had net operating loss carryforwards for federal income tax purposes of approximately $58,403,000 expiring through 2020. The availability of the net operating loss carryforwards to reduce future taxable income is subject to various limitations. As a result of the change in ownership which occurred pursuant to the May 2002 recapitalization (see Note 2), utilization of its net operating loss carryforwards is limited to approximately $687,000 per year for the remaining life of the net operating losses.

 

NOTE 11.

STOCKHOLDERS’ EQUITY

 

 

On May 11, 2005, the shareholders approved the Company’s 2004 Omnibus Incentive Plan (the “2004 Plan”). The 2004 Plan has replaced both the 1994 Employee Flexible Stock Option Plan and the Non-Employee Directors Stock Option Plan and thus broadens the array of equity alternatives available to the Company. Under the 2004 Plan, the Company is allowed to grant stock options, stock appreciation rights, restricted stock (including performance stock), restricted stock units (including performance units), other stock-based awards, non-employee director awards, dividend equivalents, and cash-based awards. There are up to 6,074,969 Common Shares available under the 2004 Plan, which may be granted to any participant in any plan year as defined in the 2004 Plan. Some of those shares are subject to outstanding awards as detailed below. To the extent these outstanding awards are forfeited or expire without exercise, the shares will be returned to and available for future grants under the 2004 Plan. The 2004 Plan’s purpose is to attract, retain and motivate employees, directors and third party service providers of the Company and its subsidiaries and to encourage them to have a financial interest in the Company. The 2004 Plan is administered by the Compensation Committee (the “Committee”) of the Board of Directors. The Committee has the authority to select plan participants, grant awards, and determine the terms and conditions of such awards as defined in the 2004 Plan. At December 31, 2005, the number of equity awards available for issuance under the 2004 Plan was 3,796,400.

 

The following is a summary of stock-based compensation granted during the year ended December 31, 2005.

 

Nonqualified Stock Options.    On March 17, 2005, under the previous Non-Employee Director Stock Option Plan, the Company granted 20,000 nonqualified non-employee director stock options, in the aggregate, to five directors. The exercise price for these options was $4.04 per share (fair market value at grant date). Under the 2004 Plan, on May 11, 2005, the Company granted 4,000 nonqualified stock options to the non-employee director newly elected to the board by the stockholders. The exercise price for the May 11, 2005, stock options was $3.95 per share (fair market value at grant date). These options vest 25 percent six months after the grant date and 25 percent on each anniversary date thereafter.

 

On November 19, 2004, subject to the approval of the 2004 Plan, the Company issued 276,600 nonqualified stock options to four of the executive officers of the Company, that is the Chief Executive Officer and the Executive Vice Presidents of Finance and Administration, Operations, and Commodities, but not to the Executive Vice President of Sales and Services (collectively the five are referred to as “Named Executive Officers”). The nonqualified stock options at November 19, 2004 were issued at an exercise price of $4.16. This exercise price represents a 10% premium to the fair market value of the Company’s common stock at the issue date. On May 11, 2005 these issued stock options were authorized by the shareholders and made effective as a result of the approval of the 2004 Plan. Additionally, on June 16, 2005, the Company granted 194,350 nonqualified stock options under the 2004 Plan to the Named Executive Officers at an exercise price of $3.94, which represented a 10% premium to the fair market value of the Company’s common stock at the grant date. The nonqualified stock options vest over a three-year period at 33-1/3 percent per year.

 

Incentive Stock Options.    On June 16, 2005, the Company granted 82,500 incentive stock options to various additional employees other than the Named Executive Officers. The exercise price was equal to the fair market price at the grant date of $3.58 per share. These incentive stock options vest 20 percent at grant date and 20 percent on each anniversary date thereafter.

 

Restricted Stock Awards.     On November 19, 2004, subject to the approval of the 2004 Plan, the Company issued 477,200 restricted stock awards to the Chief Executive Officer and the Executive Vice Presidents of Finance and

Page 43

 



Administration, Operations, and Commodities. On May 11, 2005, upon approval of the 2004 Plan these awards were authorized by the shareholders and made effective. Additionally, on June 16, 2005, the Company granted 11,950 restricted stock awards to the Executive Vice President of Sales and Services. These restricted stock awards contain vesting periods of four to six years from date of issuance. The six-year awards contain accelerated vesting provisions based upon specified increases in the Company’s stock price. During the second quarter of 2005, the Company recorded $1.9 million of unearned compensation for the market value of the shares on the date of grant. The unearned compensation is being amortized to expense over the estimated lapse in restrictions of 1.3 - 4 years. For the year ended December 31, 2005, the Company recorded $0.6 million as compensation expense. The unearned compensation amounts are shown as a reduction of stockholders’ equity at December 31, 2005.

 

A summary of transactions for all stock options granted follows:

 

 

Number of shares

Option exercise price per share

Weighted-avg. exercise price per share

Options outstanding at December 28, 2002

2,917,165

0.50-9.04

1.93

Granted

516,000

1.96-2.30

2.13

Exercised

(1,351,792)

0.50-2.86

1.61

Canceled

 (727,838)

0.50-9.042

3.72

Options outstanding at January 3, 2004

1,353,535

0.50-9.042

1.77

Granted

200,000

2.86-4.02

3.92

Exercised

(264,106)

0.50-1.99

0.62

Canceled

    (14,460)

0.50-0.50

0.50

Options outstanding at January 1, 2005

1,274,969

0.50-9.042

2.18

Granted

577,450

3.58-4.16

4.00

Exercised

(50,914)

0.50-2.86

0.93

Canceled

    (50,500)

1.99-8.833

6.15

Options outstanding at December 31, 2005

1,751,005

0.50-9.042

2.70

Options exercisable at December 31, 2005

1,051,756

0.50-9.042

2.08

 

 

At December 31, 2005, the range of exercise prices and weighted-average remaining contractual life of outstanding options was $0.50-$9.042 and 7.5 years, respectively.

 

 

The following table summarizes information about the stock options outstanding at December 31, 2005:

 

 

Options Outstanding

 

Options Exercisable

 

Range of Exercise Prices

 

Options
Outstanding

 

Weighted Average Remaining Contractual Life

 

Weighted
Average Exercise Price

 

Options Exercisable

 

Weighted Average Exercise Price

$9.042

 

15,000

 

0.6 yrs

 

$9.04

 

15,000

 

$9.04

$8.667

 

15,000

 

1.6 yrs

 

  8.67

 

15,000

 

  8.67

$7.375

 

15,000

 

2.6 yrs

 

  7.38

 

15,000

 

  7.38

$1.813-$2.625

 

8,000

 

3.2 yrs

 

  2.52

 

8,000

 

  2.52

$0.50

 

10,350

 

4.9 yrs

 

  0.50

 

10,350

 

  0.50

$0.50

 

407,705

 

5.4 yrs

 

  0.50

 

407,705

 

  0.50

$0.80

 

8,000

 

6.3 yrs

 

  0.80

 

8,000

 

  0.80

$1.96-$2.30

 

510,000

 

7.3 yrs

 

  2.13

 

382,000

 

  2.13

$2.86-$4.02

 

188,500

 

8.6 yrs

 

  3.94

 

77,000

 

  3.92

$3.58-$4.16

 

573,450

 

9.4 yrs

 

  4.00

 

113,701

 

  4.07

$0.50-$9.042

 

1,751,005

 

7.5 yrs

 

$2.70

 

1,051,756

 

$2.08

 

 

Page 44

 



 

 

NOTE 12.

EMPLOYEE BENEFIT PLANS

 

 

The Company has retirement and pension plans covering substantially all of its employees. Most retirement benefits are provided by the Company under separate final-pay noncontributory pension plans for all salaried and hourly employees (excluding those covered by union-sponsored plans) who meet service and age requirements. Benefits are based principally on length of service and earnings patterns during the five years preceding retirement.

 

The following table sets forth the plans’ funded status and amounts recognized in the Company’s consolidated balance sheets based on the measurement date (October 1, 2005 and 2004) (in thousands):

 

 

December 31,
2005

January 1,
2005

Change in projected benefit obligation:

 

 

 

 

Projected benefit obligation at beginning of period

$71,638

 

$62,718

 

Service cost

1,998

 

1,752

 

Interest cost

4,206

 

3,985

 

Amendments

 

180

 

Actuarial loss

7,813

 

5,878

 

Benefits paid

(3,005

)

(2,875

)

Projected benefit obligation at end of period

82,650

 

71,638

 

 

 

 

 

 

Change in plan assets:

 

 

 

 

Fair value of plan assets at beginning of period

50,656

 

47,327

 

Actual return on plan assets

6,297

 

4,886

 

Employer contribution

6,135

 

1,318

 

Benefits paid

(3,005

)

(2,875

)

Fair value of plan assets at end of period

60,083

 

50,656

 

 

 

 

 

 

Funded status

(22,567

)

(20,982

)

Unrecognized actuarial loss

23,096

 

18,466

 

Unrecognized prior service cost

     681

 

     823

 

Net amount recognized

$   1,210

 

$  (1,693

)

Amounts recognized in the consolidated balance
sheets consist of:

 

 

 

 

Accrued benefit liability

$(14,590

)

$(13,601

)

Prepaid asset

1,210

 

823

 

Accumulated other comprehensive income (a)

 14,590

 

 11,085

 

Net amount recognized

$   1,210

 

$   (1,693

)

 

 

 

 

 

 

(a)

Reported as net accumulated other comprehensive loss of $9.3 million, net of cumulative taxes of $5.3 million at December 31, 2005.

 

The Company has recorded a minimum liability of $14.6 million and $13.6 million at December 31, 2005 and January 1, 2005, respectively, related to the excess of the accumulated benefit obligations associated with its pension plans over the fair value of the plans’ assets.

 

 

Page 45

 



 

The accumulated benefit obligation for all defined benefit pension plans was $74.7 million and $64.3 million at December 31, 2005 and January 1, 2005, respectively.

 

 

December 31,
2005

January 1,
2005

Projected benefit obligation

$82,650

$71,638

Accumulated benefit obligation

 74,673

 64,257

Fair value of plan assets

 60,083

 50,656

 

Net pension cost includes the following components (in thousands):

 

 

December 31,

2005

January 1,

2005

January 3,

2004

Service cost

$1,998

 

$1,752

 

$1,432

 

Interest cost

4,206

 

3,985

 

3,824

 

Expected return on plan assets

(4,379

)

(4,038

)

(3,704

)

Net amortization and deferral

 1,406

 

 1,007

 

    790

 

Net pension cost

$ 3,231

 

$ 2,706

 

$ 2,342

 

 

 

 

 

 

 

 

 

The Company participates in several multi-employer pension plans which provide defined benefits to certain employees covered by labor contracts. These plans are not administered by the Company and contributions are determined in accordance with provisions of negotiated labor contracts. Information with respect to the Company's proportionate share of the excess, if any, of the actuarially computed value of vested benefits over these pension plans’ net assets is not available. The cost of such plans amounted to $1.8 million, $1.8 million and $1.7 million for the years ended December 31, 2005, January 1, 2005 and January 3, 2004, respectively.

 

Weighted average assumptions used to determine benefit obligations were:

 

 

December 31,
2005

January 1,
2005

January 3,
2004

 

Discount rate

5.50%

6.00%

6.50%

Rate of compensation increase

4.32%

4.66%

4.62%

 

Weighted average assumptions used to determine net periodic benefit cost for the employee benefit pension plans were:

 

December 31,
2005

January 1,
2005

January 3,
2004

Discount rate

6.00%

6.50%

7.25%

Rate of increase in future compensation levels

4.66%

4.62%

5.16%

Expected long-term rate of return on assets

8.75%

8.75%

8.75%

 

Consideration was made to the long-term time horizon for the plans’ benefit obligations as well as the related asset class mix in determining the expected long-term rate of return. Historical returns are also considered, over the long-term time horizon, in determining the expected return. Considering the overall asset mix of approximately 60% equity and 40% fixed income, several years in the last ten years having strong double digit returns, including 2003, along with several years of single digit losses, the Company believes it is reasonable to expect a long-term rate of return of 8.75% for the plans’ investments as a whole.

 

 

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Plan Assets

 

The Company’s pension plan weighted-average asset allocations at December 31, 2005 and January 1, 2005, by asset category, are as follows:

 

Plan Assets at


Asset Category

December 31,
2005

January 1,
2005

Equity Securities

62.3%

61.9%

Debt Securities

  37.7%

  38.1%

Total

100.0%

100.0%

 

The investment objectives have been established in conjunction with a comprehensive review of the current and projected financial requirements. The primary investment objectives are: 1) to have the ability to pay all benefit and expense obligations when due; 2) to maximize investment returns within reasonable and prudent levels of risk in order to minimize contributions; and 3) to maintain flexibility in determining the future level of contributions.

 

Investment results are the most critical element in achieving funding objectives, while reliance on contributions is a secondary element.

 

The investment guidelines are based upon an investment horizon of greater than ten years; therefore, interim fluctuations are viewed with this perspective. The strategic asset allocation is based on this long-term perspective. However, because the participants’ average age is somewhat older than the typical average plan age, consideration is given to retaining some short-term liquidity. Analysis of the cash flow projections of the plans indicates that benefit payments will continue to exceed contributions.

 

Based upon the plans’ time horizon, risk tolerances, performance expectations and asset class constraints, target asset allocation ranges are as follows:

 

 

Fixed Income

35% - 45%

 

Domestic Equities

45% - 55%

 

International Equities

7% - 13%

 

The fixed income asset allocation may be invested in corporate and government bonds denominated in U.S. dollars, private and publicly traded mortgages, private placement debt, and cash equivalents. The average maturity of the asset class will not exceed ten years. The portfolio is expected to be well diversified.

 

The domestic equity allocation is invested in stocks traded on one of the U.S. stock exchanges. Securities convertible into such stocks, convertible bonds and preferred stock, may also be purchased. The majority of the domestic equities are invested in large, mid, and small cap index accounts that are well diversified. By definition, small cap investments carry greater risk, but also are expected to create greater returns over time. The plans target approximately 7.5% of the total asset mix to small cap. American Depository Receipts (“ADR’s”) may not account for more than 3% of the holdings. Small company stocks may not exceed 15% of the plans’ assets. Small company definitions fluctuate with market levels, but generally will be considered companies with market capitalizations less than $500 million. The portfolio will be diversified in terms of individual company securities and industries.

 

The international equity allocation is invested in companies whose stock is traded outside the U.S. and/or companies that conduct the major portion of their business outside of the U.S. The portfolio may invest in ADR’s. The emerging market portion of the international equity investment is held below 20% due to greater volatility in the asset class. The portfolio is expected to be diversified in terms of companies, industries and countries.

 

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All investment objectives are expected to be achieved over a market cycle anticipated to be a period of five years. Reallocations are performed at a minimum of twice a year to retain target asset allocation ranges.

 

Contributions

 

The Company's funding policy for employee benefit pension plans is to contribute annually not less than the minimum amount required nor more than the maximum amount that can be deducted for federal income tax purposes. Contributions are intended to provide not only for benefits attributed to service to date but also for those expected to be earned in the future.

 

Based on current actuarial estimates, the Company does not expect to make any payments to meet funding requirements for its pension plan in Fiscal 2006.

 

Estimated Future Benefit Payments

 

The following benefit payments, which reflect expected future service, as appropriate, are expected to be paid (in thousands):

 

 

Year Ending

Pension Benefits

 

2006

$3,221

 

2007

3,381

 

2008

3,681

 

2009

3,843

 

2010

4,233

 

Years 2011 – 2015

28,120

 

 

NOTE 13.

CONCENTRATION OF CREDIT RISK

 

 

Concentration of credit risk is limited due to the Company’s diversified customer base and the fact that the Company sells commodities. No single customer accounted for more than 10% of the Company’s net sales in fiscal years 2005, 2004 and 2003.

 

 

NOTE 14.

CONTINGENCIES

 

 

 

LITIGATION

 

The Company is a party to several lawsuits, claims and loss contingencies arising in the ordinary course of its business, including assertions by certain regulatory agencies related to air, wastewater, and storm water discharges from the Company’s processing facilities.

 

The Company’s workers compensation, auto and general liability policies contain significant deductibles or self-insured retentions. The Company estimates and accrues its expected ultimate claim costs related to accidents occurring during each fiscal year and carries this accrual as a reserve until such claims are paid by the Company.

 

As a result of the matters discussed above, the Company has established loss reserves for insurance, environmental and litigation matters. At December 31, 2005 and January 1, 2005, the reserves for insurance, environmental and litigation contingencies reflected on the balance sheet in accrued expenses and other non-current liabilities were approximately $15.0 million and $13.9 million, respectively. Management of the Company believes these reserves for contingencies are reasonable and sufficient based upon present governmental regulations and information

 

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currently available to management; however, there can be no assurance that final costs related to these matters will not exceed current estimates. The Company believes that the likelihood is remote that any additional liability from such lawsuits and claims that may not be covered by insurance would have a material effect on the financial statements.

 

During the third quarter of Fiscal 2004, the Company concluded a settlement with certain past insurers on certain policies of insurance issued primarily before 1972, whereby the Company received a cash payment of approximately $2.8 million in return for an executed Settlement Agreement and Release in which the Company released the participating insurers from all actual and potential claims and liability under the subject insurance policies. The Company recorded receipt of the payment as a credit (recovery) of claims expense and previous insurance premiums included in cost of sales, within the Corporate segment.

 

 

NOTE 15.

BUSINESS SEGMENTS

 

 

The Company operates on a worldwide basis within two industry segments: Rendering and Restaurant Services. The measure of segment profit (loss) includes all revenues, operating expenses (excluding certain amortization of intangibles), and selling, general and administrative expenses incurred at all operating locations and excludes general corporate expenses.

Rendering

Rendering consists of the collection and processing of animal by-products from butcher shops, grocery stores and independent meat and poultry processors, converting these wastes into similar products such as useable oils and proteins utilized by the agricultural and oleo-chemical industries.

Restaurant Services

Restaurant Services consists of the collection of used cooking oils from food service establishments and recycling them into similar products such as high-energy animal feed ingredients and industrial oils. Restaurant Services also provides grease trap servicing.

 

Included in corporate activities are general corporate expenses and the amortization of intangibles related to “Fresh Start Reporting.” Assets of corporate activities include cash, unallocated prepaid expenses, deferred tax assets, prepaid pension, and miscellaneous other assets.

 

Business Segment Net Revenues (in thousands):

 

Year Ended

 

December 31,
2005

January 1,
2005

January 3,
2004

Rendering:

 

 

 

Trade

$192,340

$201,138

$214,189

Intersegment

  20,757

  26,082

  28,339

 

213,097

227,220

242,528

Restaurant Services:

 

 

 

Trade

116,527

119,091

109,078

Intersegment

  13,014

  11,300

  12,838

 

129,541

130,391

121,916

 

 

 

 

Eliminations

(33,771)

(37,382)

(41,177)

Total

$308,867

$320,229

$323,267

 

 

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Business Segment Profit/(Loss) (in thousands):

 

December 31,
2005

January 1,
2005

January 3,
2004

Rendering

$ 21,668

$ 30,982

$ 26,284

Restaurant Services

15,385

20,723

23,542

Corporate Activities

(23,201)

(30,678)

(29,384)

Interest expense

  (6,157)

  (6,759)

  (2,363)

Income from continuing operations

$  7,695

$14,268

$18,079

 

Certain assets are not attributable to a single operating segment but instead relate to multiple operating segments operating out of individual locations. These assets are utilized by both the Rendering and Restaurant Services business segments and are identified in the category Combined Rendering/Restaurant Services. Depreciation of Combined Rendering/Restaurant Services assets is allocated based upon an estimate of the percentage of corresponding activity attributed to each segment. Additionally, although intangible assets are allocated to operating segments, the amortization related to the adoption of “Fresh Start Reporting” is not considered in the measure of operating segment profit/(loss) and is included in Corporate Activities.

 

During the first quarter of Fiscal 2005, the Company increased the allocation of plant selling, general and administrative expense to the Restaurant Services segment, which resulted in additional expense of approximately $1.7 million of expense allocated to this segment during Fiscal 2005.

 

During the third quarter of Fiscal 2004, the Company concluded a settlement with certain past insurers on certain policies of insurance issued primarily before 1972, whereby the Company received a cash payment of approximately $2.8 million in return for an executed Settlement Agreement and Release in which the Company released the participating insurers from all actual and potential claims and liability under the subject insurance policies. The Company recorded receipt of the payment as a credit (recovery) of claims expense and previous insurance premiums included in cost of sales, within the Corporate segment.

 

Business Segment Assets (in thousands):