UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
(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, 2002
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 333-31931
NORTH ATLANTIC TRADING COMPANY, INC.
------------------------------------
(Exact name of registrant as specified in its charter)
DELAWARE 13-3961898
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(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
257 PARK AVENUE SOUTH, NEW YORK, NEW YORK 10010-7304
----------------------------------------------------
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (212) 253-8185
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes [X] No [ ].
Indicate by check mark 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 registrant's knowledge, in definitive proxy materials 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 an accelerated filer (as
defined in Exchange Act Rule 12b-2). Yes [ ] No [X].
As of March 26, 2003, the only class of voting or non-voting common equity
issued and outstanding was the Registrant's Voting Common Stock, par value $.01
per share, 100% of which was owned by 43 holders of record, 13 of whom are
affiliates or employees of the Registrant. There is no trading market for the
Voting Common Stock.
As of March 26, 2003, 528,241 shares of the Registrant's Voting Common Stock,
par value $.01 per share were outstanding.
North Atlantic Trading Company, Inc.
2002 Form 10-K Annual Report
TABLE OF CONTENTS
PAGE
PART I
ITEM 1. BUSINESS........................................................................................................3
ITEM 2. PROPERTIES.....................................................................................................14
ITEM 3. LEGAL PROCEEDINGS..............................................................................................15
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS............................................................19
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS...........................................19
ITEM 6. SELECTED FINANCIAL DATA....................................................................................... 20
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS..........................21
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.....................................................33
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA....................................................................33
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE...........................33
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.............................................................34
ITEM 11. EXECUTIVE COMPENSATION.........................................................................................36
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS.................46
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.................................................................48
ITEM 14. CONTROLS AND PROCEDURES........................................................................................50
PART IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K...............................................51
SIGNATURES.....................................................................................................................60
PART I
ITEM 1. BUSINESS
OVERVIEW
North Atlantic Trading Company, Inc. (the "Company") is a
holding company, which is organized under the laws of the State of Delaware. The
Company has two significant wholly owned subsidiaries: National Tobacco Company,
L.P. ("NTC") and North Atlantic Operating Company, Inc. ("NAOC"). NTC is the
third largest manufacturer and marketer of loose leaf chewing tobacco in the
United States, selling its products under the brand names BEECH-NUT REGULAR,
BEECH-NUT WINTERGREEN, TROPHY, HAVANA BLOSSOM and DURANGO. NAOC is the largest
importer and distributor in the United States of premium cigarette papers and
related products, which are sold under the ZIG-ZAG brand name pursuant to an
exclusive long-term distribution and license agreement with Bollore, S.A.
("Bollore"). NAOC also contracts for the manufacture of and distributes
Make-Your-Own ("MYO") smoking tobaccos and related products under the ZIG-ZAG
brand name.
EVOLUTION OF THE COMPANY
In 1988, Thomas F. Helms, Jr., Chairman and Chief Executive
Officer of the Company, and an investor group led by Lehman Brothers, formed NTC
to acquire the smokeless tobacco division of Lorillard Tobacco Company
("Lorillard"). Lorillard had manufactured and sold the popular BEECH-NUT brand
of loose leaf chewing tobacco since 1897. Since 1988, Mr. Helms has continued to
upgrade and expand the core of the management team which directs the Company
today.
In 1997, the Company was formed to facilitate a corporate
reorganization undertaken in connection with the acquisition (the "1997
Acquisition") of NATC Holdings USA, Inc., which owned the exclusive rights to
market and distribute ZIG-ZAG premium cigarette papers in the United States,
Canada and certain other international markets. The ZIG-ZAG brand was originally
introduced in France in 1879 by Bollore, a major French industrial concern. Upon
consummation of the 1997 Acquisition and the related reorganization, the Company
became the holding company of NTC, which operates the Company's smokeless
tobacco business, and NAOC, which operates the Company's premium cigarette paper
and MYO cigarette business.
The Company's principal executive offices are located at
257 Park Avenue South, 7th Floor, New York, New York 10010, and its telephone
number is (212) 253-8185.
RECENT EVENTS
On February 18, 2003, the Company entered into an asset
purchase agreement (the "Star Cigarette Asset Purchase Agreement") with Star
Scientific, Inc. ("Star Scientific"), and Star Tobacco, Inc., a wholly-owned
subsidiary of Star Scientific ("Star Tobacco" and, together with Star
Scientific, "Star"). Pursuant to the Star Cigarette Asset Purchase Agreement,
the Company has agreed to purchase substantially all of the assets of Star
relating to the manufacturing, marketing and distribution of four discount
cigarette brands in the United States (the "Star Cigarette Assets"). The
purchase price for the Star Cigarette Assets is $80 million in cash, subject to
certain closing adjustments and the assumption of certain liabilities related to
the Star Cigarette Assets.
All requisite corporate approvals for this transaction have
been obtained, including the approvals of the Star Cigarette Asset Purchase
Agreement by the respective Boards of Directors of the Company and Star, by the
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holders of a majority of the outstanding shares of common stock of Star
Scientific and by Star Scientific as the sole stockholder of Star Tobacco.
The transaction is expected to close in the second quarter
of 2003. The closing is subject to the Company's receipt of financing and to
customary closing conditions. Contemporaneously with the signing of the Star
Cigarette Asset Purchase Agreement, the Company placed a $2 million earnest
money deposit into escrow. In the event that, on or after July 15, 2003, the
Star Cigarette Asset Purchase Agreement is terminated by either the Company or
Star and, at that time, the Company has been unable to obtain the requisite
financing for the transaction and all other conditions to closing have been
satisfied or are capable of being satisfied, then such deposit will be paid to
Star. In all other events, the deposit will either be used to satisfy a portion
of the purchase price or repaid to the Company, as applicable.
BUSINESS STRATEGY
The Company's business strategy is to grow, both internally
and through acquisitions, by responsibly marketing its products to adult
consumers and by complying with all applicable laws, regulations and statutes.
The Company intends to (i) capitalize on the strong brand identities of its
products with a focus on product linkages and extensions; and (ii) improve the
sales, marketing and operating efficiencies of its subsidiaries. Through the
acquisition of the Star Cigarette Assets, the Company intends to enter the
discount cigarette market and to expand that business with a strategy tailored
to maximize profitability.
INDUSTRY AND MARKETS
The Company currently competes in two distinct markets: (1)
the smokeless tobacco market and (2) the MYO cigarette segment of the cigarette
market. The Company believes that both the smokeless tobacco market, which
includes the loose leaf chewing tobacco segment, and the MYO cigarette segment
of the cigarette market, which is composed of the premium cigarette papers
sector and the rapidly growing MYO smoking tobaccos and related products sector,
are each characterized by non-cyclical demand, relative brand loyalty,
meaningful barriers to entry, similar channels of distribution, modest capital
expenditure requirements, relatively high profit margins, generally stable
wholesale prices and the ability to generate significant and consistent free
cash flows.
Smokeless Tobacco
Smokeless tobacco products, including chewing tobacco, have
a long, established tradition of use in the United States dating back to
colonial times. Currently, an estimated 7 million Americans are regular users of
smokeless tobacco products, according to the Smokeless Tobacco Council.
The smokeless tobacco market is composed of the following
five product categories:
o Moist snuff, which is cured, aged, flavored and finely ground
tobacco packaged in round fiber or plastic cans;
o Loose leaf chewing tobacco, which is typically made from
air-cured leaf tobacco, using both domestic and imported
tobaccos, aged, flavored and packed in foil pouches;
o Plug chewing tobacco, which is made from air-cured leaf tobacco,
heavily flavored and pressed into small bricks or blocks;
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o Twist chewing tobacco, which is made of dark, air-cured leaf
tobacco twisted into strands that are dried and packaged like a
dry, pliable rope; and
o Dry snuff, which is a powdered tobacco product that is sometimes
flavored and is packaged in a variety of containers.
The Company believes that many consumers of smokeless
tobacco regularly use products in more than one of these categories. Further,
many of its competitors in the smokeless tobacco market offer products in more
than a single smokeless tobacco category.
According to information provided by the Smokeless Tobacco
Council, manufacturers' sales for the smokeless tobacco market were $1.1 billion
in 1990 and $2.2 billion in 2001, representing a compounded annual growth rate
of 5.9%. This growth is primarily related to the increase in manufacturers'
sales of moist snuff which have grown from $705.7 million in 1990 to $1.8
billion in 2001, representing a compounded annual sales growth rate of 8.1%, an
increase from 42.5 million pounds in 1990 to 62.4 million pounds in 2001,
representing a compounded annual volume growth rate of 3.2%. Manufacturers'
sales of chewing tobacco products were $334.0 million in 1990 and $321.8 million
in 2001, representing a compounded annual sales rate of decline of 0.3%. During
the same period, the volume of chewing tobacco products has declined from 66.9
million pounds to 44.7 million pounds, a compounded annual volume rate of
decline of 3.3%.
Loose leaf chewing tobacco, which is the second largest
product category in the smokeless tobacco market, has generally been most
popular in the Southeast, Southwest and rural Northeast and North Central
regions of the United States. Loose leaf chewing tobacco products are typically
sold through mass merchandisers, chain and independent convenience stores,
tobacco outlets, food stores and chain and independent drug stores. Tobacco
outlets have become an increasingly important distribution channel for all
tobacco products, including loose leaf chewing tobacco, as their volume has
grown to approximately 23% of all tobacco sales in 2002. Convenience stores have
also grown their share of the tobacco market by increasing their sales of
tobacco products while, during the same period, food stores and drug stores have
been deemphasizing their focus on sales of tobacco products and, as a result,
their volume has declined. Among these channels of distribution, some retail
customers choose to purchase loose leaf chewing tobacco directly from
manufacturers, although most choose to purchase through wholesale distributors.
MYO Cigarettes
Although rapidly growing, the MYO cigarette segment remains
a minor component of the overall U.S. cigarette market. If viewed as a part of
that total market, sales of MYO smoking tobacco on a cigarette equivalent basis,
would represent an estimated market share of 1.4% for 2002, up from 0.6% in
1997. In 2002, according to the USDA, the U.S. cigarette market sold
approximately 415 billion cigarettes. According to industry sources, these
cigarettes were consumed by approximately 23.3% of the adult population, or
approximately 45 million persons.
The MYO cigarette segment consists of several different
products, designed to work with each other. Among these products are cigarette
papers; cigarette tubes, which are cigarette papers with a filter fashioned into
an "empty" cigarette; cigarette smoking tobacco in loose form, packaged
typically in canisters, pouches or bags; cigarette rolling machines, used to
roll cigarette papers and smoking tobacco into a cigarette; and cigarette
injector machines, used to insert the smoking tobacco into the empty cigarette
tubes.
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Cigarette papers are sold in booklets, and come in various
size papers. Cigarette papers can also be segmented by price and quality
characteristics, for example, premium interleaved papers in contrast to discount
"flat" or non-interleaved papers.
The MYO products are typically sold through mass
merchandisers, chain and independent convenience stores, tobacco outlets, food
stores and chain and independent drug stores. Among these channels of
distribution, certain retail customers choose to purchase MYO products directly
from manufacturers, although most choose to purchase through wholesale
distributors.
PRODUCTS
Currently, the Company manufactures and markets loose leaf
chewing tobacco for the smokeless tobacco market, and imports and distributes
premium cigarette papers and related products and contract manufactures and
markets MYO smoking tobaccos and related products for the MYO cigarette market.
Loose Leaf Chewing Tobacco
Loose leaf chewing tobacco is made from aged, air-cured
tobacco, which is processed and flavored and then packaged in foil pouches.
Loose leaf chewing tobacco products can be broadly characterized as either
full-flavored or mild. According to A.C. Nielsen, in 2002 full-flavored products
accounted for approximately 47% of the loose leaf volume and mild flavored
products comprised an estimated 53%. The Company sells its loose leaf chewing
tobacco products under the BEECH-NUT, TROPHY, HAVANA BLOSSOM and DURANGO brand
names. The BEECH-NUT brands are available in two flavors: Regular and
Wintergreen. BEECH-NUT REGULAR is a full-flavored product, which is ranked
second in market share in the full-flavored loose leaf chewing tobacco category,
and third overall. BEECH-NUT WINTERGREEN was introduced in 1979 and has the
largest market share of any flavored loose leaf brand. The Company introduced
its TROPHY brand into the mild product category in 1992. The Company's HAVANA
BLOSSOM brand is a regional brand, sold primarily in West Virginia, Pennsylvania
and Ohio. Its DURANGO brand, which was introduced in March 1998, is a nationally
distributed value brand.
Premium Cigarette Papers and MYO Smoking Tobaccos and Related Products
The Company sells its premium cigarette papers under the
ZIG-ZAG brand. Although premium cigarette papers are sold in a variety of
different widths and styles, the Company's primary styles are its standard width
ZIG-ZAG White and ZIG-ZAG 1 1/4 sized French Orange premium cigarette papers.
These styles are the most important in terms of sales, and they accounted for
approximately 91% of the Company's unit volume in 2002. Other premium paper
products sold under the ZIG-ZAG name are Kutcorners, which are designed for
easier handrolling; 1 1/2 sized, king sized; and double-wide.
The Company's MYO smoking tobacco products include its
European blend, ZIG-ZAG Gold Standard, and its American blend, ZIG-ZAG Classic
American Blend, tobaccos. MYO related products include ZIG-ZAG cigarette tubes,
ZIG-ZAG cigarette rolling and injector machines and a complete line of ZIG-ZAG
MYO cigarette starter kits.
SALES AND MARKETING
The Company has a 112 person nationwide sales organization,
which is divided into a national accounts group, a field sales organization, a
sales training department and a sales administration staff. The sales
organization was expanded and re-organized in 2002, primarily to allow the
6
Company to more effectively provide sales coverage and to penetrate the
distribution channel of the large chain convenience stores.
The Company has focused and will continue to focus its
sales efforts on both wholesale distributors and retail merchants in the
independent large chain convenience store, drug store and mass merchandising
channels as well as the food store and tobacco outlet channels. Since the 1997
Acquisition, the Company has expanded and will continue to expand the sales of
its smokeless tobacco and MYO products into geographic markets and retail
channels that had previously been underdeveloped. The Company currently
distributes its products through approximately 1,000 customers.
At the retail level, the Company's loose leaf chewing
tobacco products are promoted through volume and price-discount programs and the
use of innovative, high visibility point-of-purchase floor and shelf displays,
banners and posters. The Company has neither relied upon nor conducted any
advertising in the consumer media for its loose leaf chewing tobacco products.
The majority of ZIG-ZAG premium cigarette papers
promotional activity is at the wholesale distributor level and consists of
distributor promotions, trade shows and trade advertising. The MYO smoking
tobaccos and related products' promotional activity is more focused at the
retail level with spending on point-of-sale displays and at the consumer level
with price-off promotions, primarily through the use of coupons.
The Company's largest customers, COD Company and McLane
Company, accounted for approximately 13.1% and 8.7%, respectively, of its net
sales in 2002. The loss of either of these customers could have a material
adverse effect on the results of operations, financial position and cash flows
of the Company. The Company does not believe that the loss of any other customer
would have a material effect on the results of operations, financial position or
cash flows of the Company either in the intermediate or long term.
DISTRIBUTION AGREEMENTS
NAOC is party to two long-term distribution and licensing
agreements with Bollore with respect to sales of premium cigarette papers,
cigarette tubes and cigarette injector machines (collectively the "Products") in
the United States and Canada (the "U.S. Distribution Agreement" and the "Canada
Distribution Agreement," respectively). Under these distribution agreements,
Bollore granted NAOC the exclusive right to purchase the Products bearing the
ZIG-ZAG brand name from Bollore for resale in the United States and Canada. NAOC
has the sole right to determine the price and other terms upon which NAOC may
resell any products purchased from Bollore, including the right to determine the
distributors of such products within these countries.
The Company also has a long-term distribution and licensing
agreement for sales of ZIG-ZAG brand premium cigarette papers in Hong Kong,
Singapore, Dubai, Oman and Jordan (the "Other Countries Distribution Agreement"
and, together with the U.S Distribution Agreement and the Canada Distribution
Agreement, the "Distribution Agreements"). Under this agreement, Bollore granted
NAOC the exclusive right to purchase premium cigarette papers bearing the
ZIG-ZAG brand name for resale in those countries. NAOC has the sole right to
determine the price and other terms upon which NAOC may resell any products
purchased from Bollore, including the right to determine the distributors of
such products within the countries noted above. The Company and Bollore are
currently in dispute as to whether the Other Countries Distribution Agreement is
renewable after March 31, 2003 based on whether or not certain minimum purchase
requirements have been satisfied. The expiration and failure to renew the Other
7
Countries Distribution Agreement would not have a material adverse effect on the
results of operations, financial position or cash flows of the Company.
The Distribution Agreements establish the purchase price
for premium cigarette papers through 2004, subject to certain adjustments to
reflect increases in the U.S. and Canadian Consumer Price Indices and to account
for material currency fluctuations. The Distribution Agreements provide that, in
order to assure each of the parties commercially reasonable profits in light of
inflationary trends and currency translation factors, prior to December 31, 2004
and each fifth-year anniversary from such date thereafter, the parties would
enter into good faith negotiations to agree on an index and currency adjustment
formula to replace the index and formula currently in effect. If the parties are
unable to agree, the dispute is to be submitted to binding arbitration.
Pursuant to the Distribution Agreements, export duties,
insurance and shipping costs are the responsibility of Bollore and import duties
and excise taxes are the responsibility of NAOC. Bollore's terms of sale are 45
days after the bill of lading date and its invoices are payable in Euros. The
Distribution Agreements reduce catastrophic foreign exchange risk by providing
that Bollore will bear certain exchange rate risks at levels fixed through 2004.
The catastrophic foreign exchange risk allocations set forth in the Distribution
Agreements will be renegotiated in 2004 in a similar manner as set forth above.
According to the Distribution Agreements, NAOC must
purchase the Products from Bollore, subject to Bollore fulfilling its
obligations under these agreements. Bollore is required by the agreements to
provide NAOC with the quantities and quality of the products that it desires.
The Distribution Agreements provide NAOC with certain safeguards to help ensure
that NAOC will be able to secure a steady supply of product. Such safeguards
include (i) granting NAOC the right to seek third party suppliers with continued
use of the ZIG-ZAG trademark if Bollore is unable to perform its obligations or
ceases its cigarette paper manufacturing operation, in each case as set forth in
the Distribution Agreements, and (ii) maintaining a two month supply of
emergency inventory in the United States at Bollore's expense.
Under the Distribution Agreements, NAOC, in agreeing to the
terms of the Distribution Agreements, has also agreed for a period of five years
after termination of such Distribution Agreements not to engage, directly or
indirectly, in the manufacturing, selling, distributing, marketing or otherwise
promoting in the countries identified above, of premium cigarette paper or
premium cigarette paper booklets of a competitor without Bollore's consent,
except for certain de minimis acquisitions of debt or equity securities of such
a competitor and certain activities with respect to an alternative supplier used
by NAOC as permitted under the Distribution Agreements.
Each of the Distribution Agreements was entered into on
November 30, 1992. Each of the U.S. Distribution Agreement and the Canada
Distribution Agreement was for an initial twenty year term commencing on the
date of such agreement and will be renewed automatically for successive twenty
year terms unless terminated in accordance with the provisions of such
agreement. Each of the Distribution Agreements permits Bollore to terminate such
agreement (i) if certain minimum purchases (which, in the case of the U.S.
Distribution Agreement and the Canada Distribution Agreement were significantly
exceeded in 2002 and which the Company believes were exceeded in the case of the
Other Countries Distribution Agreement) of premium cigarette paper booklets have
not been made by the Company for resale in the jurisdiction covered by such
agreement within a calendar year; (ii) if the Company assigns such agreement
without the consent of Bollore (other than certain permissible assignments to
wholly owned subsidiaries of the Company); (iii) upon a change of control of
NAOC or any parent of NAOC without the consent of Bollore; (iv) upon certain
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acquisitions of equity securities of NAOC or any parent of NAOC by a competitor
of NAOC or certain investments by significant stockholders of the Company in a
competitor of NAOC; and (v) certain material breaches, including NAOC's
agreement not to promote, directly or indirectly, premium cigarette paper or
premium cigarette paper booklets of a competitor. Additionally, the Canada
Distribution Agreement is terminable by either NAOC or Bollore upon the
termination of the U.S. Distribution Agreement.
TRADEMARKS AND TRADE SECRETS
NTC has numerous registered trademarks relating to its
loose leaf chewing tobacco products, including the trademarks for its BEECH-NUT,
TROPHY, HAVANA BLOSSOM and DURANGO products. These trademarks, which are
significant to NTC's business, expire periodically and are renewable for
additional 20-year terms upon expiration. Flavor and blend formulae trade
secrets relating to NTC's and NAOC's tobacco products, which are key assets of
their businesses, are maintained under strict secrecy. The ZIG-ZAG trade name
and trademark for premium cigarette papers and related products are owned by
Bollore and have been exclusively licensed in the U.S. and Canada to NAOC. The
ZIG-ZAG trademark with respect to tobacco products is owned by NAOC.
RAW MATERIALS, PRODUCT SUPPLY AND INVENTORY MANAGEMENT
Loose Leaf Chewing Tobacco
NTC's loose leaf chewing tobacco is produced from air-cured
leaf tobacco. Each of the Company's brands has its own unique tobacco blend. NTC
utilizes tobaccos grown domestically in Pennsylvania and Wisconsin as well as
those imported from other countries, such as Argentina, Brazil, Columbia,
Germany, Indonesia, Italy, Mexico, and the Philippines. Management does not
believe that it is dependent on any single country source for tobacco. Pursuant
to an agreement with Lancaster Leaf Tobacco Company of Pennsylvania, a wholly
owned subsidiary of Universal Corporation ("Lancaster"), and under instructions
from NTC, Lancaster (i) purchases and processes tobacco on an exclusive basis,
(ii) stores tobacco inventory purchased on behalf of NTC and (iii) generally
maintains a 12- to 24-month supply of NTC's various tobacco types at its
facilities. NTC generally maintains a one- to two-month operating supply of
tobacco at its manufacturing facilities in Louisville, Kentucky.
In addition to raw tobacco, NTC's loose leaf chewing
tobacco products include food grade flavorings, all of which have been approved
by the Food and Drug Administration and other federal agencies. NTC is not
dependent upon any single supplier for those raw materials or for the supply of
its products' packaging materials.
NTC generally maintains a one- to two-month supply of
finished loose leaf chewing tobacco. This supply is maintained at its Louisville
facility and in four regional bonded public warehouses to facilitate
distribution.
Premium Cigarette Paper and MYO Smoking Tobaccos and Related Products
Pursuant to NAOC's Distribution Agreements with Bollore,
NAOC must purchase its premium cigarette papers, cigarette tubes and cigarette
injecting machines from Bollore, subject to Bollore fulfilling its obligations
under these agreements. If Bollore is unable or unwilling to perform its
obligations or ceases its cigarette paper manufacturing operation, in each case
as set forth in the Distribution Agreements, NAOC may seek third-party suppliers
and continue the use of the ZIG-ZAG trademark. To ensure NAOC has a steady
9
supply of premium cigarette paper products and each style of cigarette tubes and
injectors, Bollore is required to maintain, at its expense, a two-month supply
of inventory in a public warehouse in the United States. See "--Distribution
Agreements."
To facilitate general distribution, in addition to the
inventory maintained by Bollore, NAOC also maintains a supply of its products at
NTC's Louisville facility and in four regional bonded public warehouses.
NAOC obtains its MYO smoking tobaccos primarily from
international sources and is not dependent on any one type of tobacco for its
blends. NAOC purchases this smoking tobacco principally through a single
purchasing agent. The MYO related products are purchased in finished form from
various suppliers at Bollore's direction.
Bollore has from time to time been unable to produce and
supply the Company with sufficient quantities of cigarette tubes and injectors
due, in part, to the rapid growth in NAOC's sales of those products. In
addition, Bollore is currently unable to maintain the required two-month supply
of inventory of cigarette tubes and injectors in the United States. As a result,
NAOC currently has a two-month backlog of orders for certain styles of tubes. As
part of recent contract negotiations with Bollore for the cigarette tubes and
injectors, NAOC has given Bollore additional time to build the required
two-month supply of inventory in the United States. Bollore currently
anticipates that it will resolve the supply problem by the third quarter of
2003. Bollore has not experienced any problems supplying the Company with
sufficient quantities of its premium cigarette paper products and is currently
maintaining the required two-month supply of such products in the United States.
Management currently believes that the Company's other sources for its supplies
are adequate for its projected needs.
MANUFACTURING
NTC manufactures its loose leaf chewing tobacco products at
its manufacturing facility in Louisville, Kentucky, and NAOC contracts for the
manufacture of its premium cigarette papers, cigarette tubes, rolling and
injector machines and MYO smoking tobaccos. In the case of its MYO smoking
tobacco products, NAOC packages these products at its manufacturing facility in
Louisville. The Company believes that its production capabilities, quality
control procedures, research and development activities and overall facilities
and equipment are adequate for its projected operations as these activities are
vital to maintaining the high-quality brand image and operating efficiency of
its operations.
Production and Quality Control
The Company uses proprietary production processes and
techniques, including strict quality controls. During the course of each day,
NTC's quality control group periodically tests the quality of the tobacco;
flavorings; application of flavorings; premium cigarette papers, tubes and
injectors; and packaging materials. The Company utilizes sophisticated quality
control and pilot plant production equipment to test and closely monitor the
quality of its products. The quality of the Company's products is largely the
result of using high grade tobacco leaf, food-grade flavorings and an ongoing
analysis of tobacco cut, flavorings and moisture content.
Given the importance of contract manufacturing to the
Company, the Company's quality control group ensures that established standards
are strictly adhered to by each of its contract manufacturers.
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Research and Development
The Company has a Research and Development Department that
reformulates existing loose leaf and MYO tobaccos products in an effort to
maintain a high level of product consistency and to facilitate the use of less
costly raw materials without sacrificing product quality. The Company believes
that for all of its tobacco products, including MYO, it has been and will
continue to be able to develop cost effective blends of tobacco and flavorings
that will maintain or reduce overall costs without compromising high product
quality. The Research and Development Department is also responsible for new
product development.
The Company spent approximately $464,000, $487,000 and
$539,000 on its research and development and quality control efforts for the
years 2000, 2001 and 2002, respectively.
Facilities
NTC's Louisville facility was formerly owned and used by
Lorillard for the manufacture of cigarettes, little cigars and chewing tobacco.
This approximately 600,000 square foot facility occupies a 26 acre urban site
near downtown Louisville. The facility's structures occupy approximately
one-half of the total acreage. The facilities are in good condition and have
received regular maintenance and capital improvements. The facility provides
ample space to accommodate an expansion of the Company.
COMPETITION
NTC is the third largest manufacturer and marketer of loose
leaf chewing tobacco. The other three principal competitors in the loose leaf
chewing tobacco segment, which, together with NTC, generate approximately 95% of
this segment's sales, are Swedish Match, Conwood Corporation and Swisher
International Group Inc. Management believes that moist snuff products are used
interchangeably with loose leaf products by many consumers and, as a result, US
Smokeless Tobacco Company, the largest manufacturer of moist snuff (and of all
smokeless tobacco products when taken as a whole) is also a significant
competitor. As indicated above under "Industry and Markets," sales of moist
snuff have grown over the past decade while sales of loose leaf have declined
during that same period. In addition, NTC's three principal competitors in the
loose leaf segment also manufacture and market moist snuff.
NAOC is the largest importer and distributor in North
America of premium cigarette papers. NAOC's two major competitors for premium
cigarette paper sales, which, together with NAOC, generate approximately 93% of
such sales, are Republic Tobacco Company and Robert Burton Associates, a
wholly-owned subsidiary of Imperial Tobacco Group plc. Although there is no
source for comprehensive industry data, the Company believes that it has
approximately a 50% share of the total market for U.S. sales of premium
cigarette paper and that Republic Tobacco's share is approximately 25% and
Robert Burton Associates' share is approximately 18%.
The Company's principal competitors in the MYO segment are
Republic Tobacco Co., in conjunction with its TOP Tobacco, L.P. subsidiary, and
Lane Ltd, an affiliate of Brown & Williamson Tobacco Company, the third largest
cigarette company in the United States. Many other companies also compete in
this segment, including Peter Stokebye International and RBJ Sales, Inc.
Many of the Company's competitors are better capitalized
than the Company and have greater financial and other resources than those
available to the Company. The Company believes that its ability to effectively
compete and its strong market positions in its principal product lines are due
11
to its high brand recognition and the recognized quality of each of its
products, its manufacturing and operating efficiencies, and its sales, marketing
and distribution efforts.
EMPLOYEES
As of March 21, 2003, the Company employed a total of 253
full-time employees. With the exception of 90 manufacturing employees, none of
the Company's other employees are represented by unions. The manufacturing
employees, who are represented by three unions, are covered by three collective
bargaining agreements. One of these agreements, covering 85 employees will
expire in December 2004. The other two agreements, covering five employees, were
extended during 2002 and will expire in 2005.
REGULATION
The tobacco industry, in particular cigarette
manufacturers, has been under public scrutiny for over forty years. Industry
critics include special interest groups, the U.S. Surgeon General and many
legislators at the state and federal levels. Although smokeless tobacco
companies have recently come under some scrutiny, the principal focus has been
directed at the manufactured cigarette market due to its large size relative to
the smokeless tobacco market and the MYO segment of the cigarette market.
Producers of tobacco products are subject to regulation in
the United States at federal, state and local levels. Together with changing
public attitudes towards tobacco consumption, the constant expansion of
regulations, including increases in various taxes, requirements that tobacco
products be displayed "behind-the-counter" and smoking restrictions, has been a
major cause of the overall decline in the consumption of tobacco products since
the early 1970's. Moreover, the future trend is toward increasing regulation of
the tobacco industry.
In recent years, a variety of bills relating to tobacco
issues have been introduced in the U.S. Congress, including bills that would (i)
prohibit the advertising and promotion of all tobacco products and/or restrict
or eliminate the deductibility of such advertising expenses; (ii) increase
labeling requirements on tobacco products to include, among other things,
additional warnings and lists of additives and toxins; (iii) modify federal
preemption of state laws to allow state courts to hold tobacco manufacturers
liable under common law or state statutes; (iv) shift regulatory control of
tobacco products and advertisements from the Federal Trade Commission to the
Food and Drug Administration; (v) increase tobacco excise taxes; and (vi)
require tobacco companies to pay for health care costs incurred by the federal
government in connection with tobacco related diseases. Hearings have been held
on certain of these proposals; however, to date, none of such proposals have
been enacted by Congress. Future enactment of such proposals or similar bills,
depending upon their content, could have a material adverse effect on the
results of operations or financial condition of the Company.
In 1996, Massachusetts enacted a statute which requires all
tobacco companies to disclose information regarding the ingredients and nicotine
content of their products sold in Massachusetts, which information would,
subject to certain conditions, be made publicly available. The ingredients of
NTC's products are considered by the Company to be proprietary and such
disclosure could result in the manufacture and sale of imitation products, which
could have a material adverse effect on its tobacco business. In December 1997,
the U.S. District Court for the District of Massachusetts entered a preliminary
injunction on behalf of five smokeless tobacco companies (including NTC) against
the Attorney General of Massachusetts and the Commissioner of Public Health,
barring the officials from taking any steps to enforce the ingredient-reporting
requirements of the Massachusetts statute pending a trial on the merits. In
September 2000, the District Court enjoined enforcement of provisions of the law
12
relating to ingredient reporting and issued a judgment in favor of the tobacco
companies. The United States Court of Appeals for the First Circuit upheld the
District Court's judgment on December 2, 2002.
While there are no current regulations that materially and
adversely affect the sale of premium cigarette papers, there can be no
assurance that federal, state or local regulations will not be enacted which
will seek to regulate premium cigarette papers. In the event such regulations
are enacted, depending upon their parameters, they could have a material adverse
effect on the results of operations, financial position and cash flows of NAOC
and the Company.
STATE ATTORNEY GENERAL SETTLEMENT AGREEMENTS
Forty-six states, certain U.S. territories and the District
of Columbia are parties to the Master Settlement Agreement ("MSA") and the
Smokeless Tobacco Master Settlement Agreement ("STMSA"). To the Company's
knowledge, the other signatories to the MSA are 34 cigarette manufacturers
and/or distributors and the only other signatory to the STMSA is US Smokeless
Tobacco Company. In the Company's opinion, the fundamental basis for each
agreement is the states' consents to withdraw all claims for monetary, equitable
and injunctive relief against certain tobacco products manufacturers and others
and, in return, the signatories have agreed to certain marketing restrictions
and regulations as well as certain payment obligations.
Pursuant to the MSA and subsequent states' statutes, a
"cigarette manufacturer" (which is defined to also include MYO cigarette
tobacco) has the option of either becoming a signatory to the MSA or opening,
funding and maintaining an escrow account, with subaccounts on behalf of each
settling state. The MSA escrow accounts are governed by states' statutes that
expressly give the manufacturers the option of opening, funding and maintaining
an escrow account in lieu of becoming a signatory to the MSA. The statutes
require companies, who are not signatories to the MSA, to deposit into qualified
banks, on an annual basis, escrow funds based on the number of cigarettes or
cigarette equivalents, i.e., the pounds of MYO smoking tobacco, sold. The
purpose of these statutes is expressly stated to be to eliminate the cost
disadvantage the settling manufacturers have as a result of entering into the
MSA. Any company that establishes an escrow account is entitled to direct the
investment of the escrowed funds and withdraw any appreciation, but cannot
withdraw the principal for twenty-five years from the year of each annual
deposit, except to withdraw funds deposited pursuant to an individual state's
escrow statute to pay a final judgment to that state's plaintiffs in the event
of such a final judgment against that company. Either option - becoming a MSA
signatory or establishing an escrow account - is permissible under the MSA. The
STMSA has no similar provisions under the MSA.
NAOC has chosen to open and fund an MSA escrow account as
its means of compliance. As of December 31, 2002, NAOC has funded a total of
approximately $1.1 million into its account. It is management's opinion, due to
the possibility of future federal or state regulations, though none have to date
been enacted, that entering into one or both of the settlement agreements or
establishing and maintaining an escrow account, as NAOC has chosen to do, would
not necessarily prevent future regulations from having a material adverse effect
on the results of operations, financial position and cash flows of the Company.
Various states have enacted or proposed complementary
legislation intended to curb the activity of certain manufacturers and importers
of cigarettes that are selling into MSA states without signing the MSA or that
have failed to properly establish and fund a qualifying escrow account. To date,
no such statute has been enacted which could inadvertently and negatively impact
the Company, which has been and is currently fully compliant with all applicable
laws, regulations and statutes, but there can be no assurance that the enactment
13
of any such complementary legislation in the future will not have a material
adverse effect on the results of operations, financial position or cash flows
of the Company.
EXCISE TAXES
Tobacco products and premium cigarette papers have long
been subject to federal, state and local excise taxes, and such taxes have
frequently been increased or proposed to be increased, in some cases
significantly, to fund various legislative initiatives. Since 1986, smokeless
tobacco (including dry and moist snuff and chewing tobacco) has been subject to
federal excise tax. Smokeless tobacco is taxed by weight (in pounds or
fractional parts thereof) manufactured or imported. Effective January 1, 2002,
the federal excise tax on loose leaf chewing tobacco was increased to $0.195 per
pound from $0.17 per pound. Effective January 1, 2002, the federal excise tax on
premium cigarette paper was increased to $0.0122 from $0.0106 per fifty papers,
the federal excise tax on cigarette tubes was increased to $0.0244 from $0.0213
per fifty tubes, and the federal excise tax on MYO tobacco was increased to
$1.0969 from $0.9567 per pound. Although these more recent increases in the rate
of federal excise taxes are not expected to have an adverse effect on the
Company's business, future enactment of increases in federal excise taxes on the
Company's products could have a material adverse effect on the results of
operations or financial condition of the Company. The Company is unable to
predict the likelihood of passage of future increases in federal excise taxes.
Tobacco products and premium cigarette papers are also
subject to certain state and local taxes. The imposition of state and local
taxes in a jurisdiction could have a detrimental impact on sales in that
jurisdiction. Any enactment of new state or local excise taxes or an increase in
existing excise taxes on the Company's products is likely to have an adverse
effect on sales.
ENVIRONMENTAL REGULATIONS
The Company believes that it is currently in substantial
compliance with all material environmental regulations and pollution control
laws.
OTHER
Additional information in response to Item 1 can be found
in Note 21 (Segment Information) to the Consolidated Financial Statements.
ITEM 2. PROPERTIES
As of December 31, 2002, the Company operated
manufacturing, distribution, office and warehouse space in the United States
with a total floor area of approximately 610,351 square feet. Of this footage,
approximately 600,000 square feet are owned and 10,351 square feet are leased.
To provide a cost-efficient supply of products to its
customers, the Company maintains centralized management of manufacturing and
nationwide distribution facilities. NTC has one manufacturing and distribution
facility located in Louisville, Kentucky, which is also utilized by NAOC.
14
The following table describes the principal properties of
the Company as of December 31, 2002:
Square Owned or
Location Principal Use Feet Leased
-------- ------------- ---- ------
New York, NY Corporate 10,351 Leased
headquarters
Louisville, KY manufacturing, 600,000 Owned(1)
R&D, warehousing,
distribution and
administration
(1) Encumbered by a mortgage securing all obligations and liabilities under the
senior secured facilities.
ITEM 3. LEGAL PROCEEDINGS
LITIGATION WITH REPUBLIC TOBACCO
Kentucky and Illinois Complaints. On July 15, 1998, NAOC
and NTC filed a complaint (the "Kentucky Complaint") against Republic Tobacco,
Inc. and its affiliates ("Republic Tobacco") in Federal District Court for the
Western District of Kentucky. Republic Tobacco imports and sells Roll-Your-Own
("RYO") premium cigarette papers under the brand names JOB and TOP as well as
other brand names. The Kentucky Complaint alleges, inter alia, that Republic
Tobacco's use of exclusivity agreements, rebates, incentive programs, buy-backs
and other activities related to the sale of premium cigarette papers in the
southeastern United States violate federal and state antitrust and unfair
competition laws and that Republic Tobacco defaced and directed others to deface
NAOC's point of purchase vendor displays for premium cigarette papers by
covering up the ZIG-ZAG brand name and advertising material with advertisements
for Republic Tobacco's RYO cigarette paper brands. The Kentucky Complaint
alleges that these activities constitute unfair competition under federal and
state laws.
On June 30, 1998, Republic Tobacco filed a complaint
against the Company, NAOC and NTC in the U.S. District Court of the Northern
District of Illinois (the "Illinois Complaint") and served it on the Company
after the institution of the Kentucky action. In the Illinois Complaint,
Republic Tobacco seeks declaratory relief with respect to the Company's claims.
In addition, the Illinois Complaint alleges that certain actions taken by the
Company to inform its customers of its claims against Republic Tobacco
constitute tortuous interference with customer relationships, false advertising,
violations of Uniform Deceptive Trade Practices and Consumer Fraud Acts,
defamation and unfair competition. In addition, although not included in its
original complaint but in its amended complaint, Republic Tobacco alleged that
the Company has unlawfully monopolized and attempted to monopolize the market on
a national and regional basis for premium cigarette papers.
On October 20, 2000, Republic Tobacco filed a motion to
dismiss, stay, or transfer the Kentucky Complaint to the Illinois Court. On
December 19, 2000, the Court denied Republic Tobacco's motion, holding that it
was premature. The Court noted also that it had communicated with the Court in
Illinois and that it had concluded that Republic Tobacco may not be entitled to
any preference on forum selection, which would ordinarily be given because it
was first to file.
15
Prior to the completion of discovery, the Court dismissed
Republic Tobacco's antitrust claims against the Company. After discovery was
completed in 2001, both parties moved for summary judgment on the others claims.
In April 2002, the District Court for the Northern District of Illinois decided
the summary judgment motions by dismissing all claims of both the Company and
Republic Tobacco and its affiliates, except for Republic Tobacco's claim of
defamation per se against the Company, on which it granted summary judgment on
liability in favor of Republic Tobacco, and a Lanham Act false advertising
claim, based on the same facts as the defamation claim, for equitable relief.
The Company believes it has viable defenses to the Republic
claims, however, no assurances can be given that it will prevail. If the
Company were not to prevail, management does not believe that any adverse
judgment would be material to the Company's results of operations, financial
position or cash flows.
LITIGATION RELATED TO ALLEGED PERSONAL INJURY
West Virginia Complaints. Trial of the West Virginia
complaints has been postponed indefinitely, as described below. On October 6,
1998 NTC was served with a summons and complaint on behalf of 65 individual
plaintiffs in an action in the Circuit Court of Kanawha County, West Virginia,
entitled Kelly Allen, et al. v. Philip Morris Incorporated, et al. (Civil Action
Nos. 98-C-2401). On November 13, 1998, NTC was served with a second summons and
complaint on behalf of 18 plaintiffs in an action in the Circuit Court of
Kanawha County, West Virginia, entitled Billie J. Akers, et al. v. Philip Morris
Incorporated et al. (Civil Action Nos. 98-C-2696 to 98-C-2713). The complaints
are identical in most material respects. In the Allen case, the plaintiffs have
specified the defendant companies for each of the 65 cases. NTC is named in only
one action. One Akers plaintiff alleged use of an NTC product, alleging lung
cancer.
On September 14, 2000, NTC was served with a summons and
complaint on behalf of 539 separate plaintiffs filed in Circuit Court of Ohio
County, West Virginia, entitled Linda Adams, et al. v. Philip Morris Inc., et
al. (Civil Action Nos. 00-C-373 to 00-C-911). Only one of these plaintiffs
alleged use of a product currently manufactured by NTC. The time period during
which this plaintiff allegedly used the product has not yet been specified.
Thus, it is not yet known whether NTC is a proper defendant in this case.
On September 19, 2000, NTC was served with a second summons
and complaint on behalf of 561 separate plaintiffs filed in Circuit Court of
Ohio County, West Virginia, entitled Ronald Accord, et al. v. Philip Morris
Inc., et al. (Civil Action Nos. 00-C-923 to 00-C-1483). A total of five of these
plaintiffs allege use of a product currently manufactured by NTC. One of these
plaintiffs does not specify the time period during which the product was
allegedly used, and one alleges use that covers, in part, a period when NTC did
not manufacture the product. Of the remaining three, one alleges consumption of
a competitor's chewing tobacco from 1966 to 2000 and NTC's BEECH-NUT chewing
tobacco from 1998 to 2000; another alleges a twenty-four year smoking history
ending in 1995 and consumption of BEECH-NUT chewing tobacco from 1990 to 1995;
and the last alleges a thirty-five year smoking history ending in 2000, and
consumption of NTC's DURANGO ICE chewing tobacco from 1990 to 2000 (although
DURANGO ICE did not come onto the market until 1999).
In November 2001, NTC was served with an additional four
separate summons and complaints in actions filed in the Circuit Court of Ohio
County, West Virginia. The actions are entitled Donald Nice v. Philip Morris
Incorporated, et al., (Civil Action No. 01-C-479), Korene S. Lantz v. Philip
Morris Incorporated, et al., (Civil Action No. 01-C-480), Ralph A. Prochaska, et
al. v. Philip Morris, Inc., et al., (Civil Action No. 01-C-481), and Franklin
16
Scott, et al. v. Philip Morris, Inc., et al., (Civil Action No. 01-C-482).
All of the West Virginia smokeless tobacco actions have
been consolidated before the West Virginia Mass Litigation Panel for discovery
and trial of certain issues. Trial of these matters was planned in two phases.
In the initial phase, a trial was to be held to determine whether tobacco
products, including all forms of smokeless tobacco, cigarettes, cigars and pipe
and roll-your-own tobacco, can cause certain specified diseases or conditions.
In the second phase, individual plaintiffs would attempt to prove that they were
in fact injured by tobacco products. Fact and expert discovery in these cases
has closed, however, in the cigarette cases the Court has allowed additional
discovery.
The claims against the Company in the various consolidated
West Virginia actions include negligence, strict liability, fraud in differing
forms, conspiracy, breach of warranty and violations of the West Virginia
consumer protection and antitrust acts.
The trial of the smokeless tobacco cases has been postponed
indefinitely. The manufacturers of smokeless tobacco products (as well as the
manufacturers of cigarettes) moved to sever the claims against the smokeless
tobacco manufacturer defendants from the claims against the cigarette
manufacturer defendants. That motion was granted, thus, the trial date on the
smokeless tobacco claims has now been postponed indefinitely.
Minnesota Complaint. On September 24, 1999, NTC was served
with a complaint in a case entitled Tuttle v. Lorillard Tobacco Company, et al.
(Case No. C2-99-7105), brought in Minnesota. The other manufacturing defendants
are Lorillard and The Pinkerton Tobacco Company. The Complaint alleges that
plaintiff's decedent was injured as a result of using NTC's (and, prior to the
formation of NTC, Lorillard's) BEECH-NUT brand and Pinkerton's RED MAN brand of
loose-leaf chewing tobacco. Plaintiff asserts theories of liability, breach of
warranty, fraud, and variations on fraud and misrepresentation. After discovery,
summary judgment motions were filed on behalf of all defendants. On March 3,
2003, the Court granted defendants' motions, dismissing all claims against all
defendants. The plaintiffs have moved the Court to reconsider its decision.
Although the Company believes that it has good defenses to
the above actions in West Virginia and Minnesota and it intends to vigorously
defend each such action, no assurances can be given that it will prevail. If any
of the plaintiffs were to prevail, the results could have a material adverse
effect on the results of operations, financial position and cash flows of the
Company.
LITIGATION TO STEM COUNTERFEITING
Texas Infringing Products Litigation. In Bollore, S.A. v.
Import Warehouse, Inc., Civ. No. 3-99-CV-1196-R (N.D. Texas), Bollore, the
Company's Licensor of ZIG-ZAG brand premium cigarette papers, obtained a sealed
order allowing it to conduct a seizure of infringing and counterfeit ZIG-ZAG
products in the United States. On June 7, 1999, seizures of products occurred in
Michigan and Texas. Subsequently, all named defendants have been enjoined from
buying and selling such infringing or counterfeit goods. Bollore and the Company
have negotiated settlements with one group of defendants, including Import
Warehouse Inc. and its owner/operator Ravi Bhatia. Those settlements included a
consent injunction against distribution of infringing or counterfeit goods.
Management believes that successful prosecution of this litigation, either by
settlement or otherwise, will have a favorable impact on its future premium
cigarette paper business.
17
On May 18, 2001, the Company, in conjunction with Bollore,
conducted raids on the businesses and homes of certain defendants previously
enjoined from selling infringing or counterfeit ZIG-ZAG brand products in the
Bollore S.A. v. Import Warehouse litigation. Evidence was uncovered that showed
that these defendants and certain other individuals were key participants in
importing and distributing counterfeit ZIG-ZAG premium cigarette papers. After a
two day hearing in the U.S. District Court for the Northern District of Texas,
on May 30, 2001, the Court held the previously enjoined defendants in contempt
of court.
The Company entered into a settlement with the defendants,
the principal terms of which included a cash payment, an agreed permanent
injunction, the withdrawal of the defendants' appeal of the civil contempt
order, an agreed judgment of $11 million from the civil contempt order and an
agreement to forbear from enforcing that $11 million money judgment until such
time in the future that the defendants violate the terms of the permanent
injunction. Two of the defendants also agreed to provide complete information
concerning the counterfeiting conspiracy as well as information on other parties
engaged in the purchase and distribution of infringing ZIG-ZAG premium cigarette
papers.
Pursuant to the U.S. Distribution Agreement and a related
agreement between Bollore and the Company, any collections on the judgments
issued in the Bollore v. Import Warehouse case are to be divided evenly between
Bollore and the Company after the payment of all expenses.
On February 7, 2002, Bollore, NAOC and the Company filed a
motion with the District Court in the Texas action seeking to hold Ravi Bhatia
and Import Warehouse Inc. in contempt of court for violating the terms of the
consent order and injunction entered against those defendants. The Company
alleges that Mr. Bhatia and Import Warehouse sold counterfeit goods to at least
three different companies over an extended period of time. A hearing was held on
April 10, 2002. After evidence related to this matter was discovered by
plaintiffs and upon plaintiffs' application, another hearing was held on August
1, 2002. The Court allowed the defendants three weeks to supplement the record
with additional evidence. Final arguments were held on January 22, 2003 and a
decision is pending.
California Infringing Products Litigation. On March 23,
2001, the Company participated as co-plaintiff with NAOC and Bollore in an
action entitled Bollore, S.A. v. A&A Smart Shopping (Case No. CV 01-02766 FMC
(MANx)), filed in the U.S. District Court for the Central District of
California. The plaintiffs alleged that nine distributors in California were
selling counterfeit ZIG-ZAG brand premium cigarette papers.
On May 22, 2001, the Company participated as co-plaintiff
with NAOC and Bollore in an action entitled Bollore, S.A. v. Buy-Rite Wholesale
(Case No. CV 01-4570 FMC (MAN)), filed in the U.S. District Court for the
Central District of California. The plaintiffs alleged that seven distributors
and retailers in California were selling counterfeit ZIG-ZAG brand premium
cigarette papers.
On June 5, 2002, the Court granted the plaintiffs
application to consolidate the A&A Smart Shopping and Buy Rite Wholesalecases
for trial purposes. In an effort to better manage this case for trial, the
plaintiffs settled against certain defendants, obtained judgments for damage
against most the defendants and obtained permanent injunctions against all of
the settling defendants.
A trial of the plaintiffs' claims against the remaining
defendants, in the A&A Smart Shopping case, Downey Wholesale and Fadel
El-Shahawi, Downey's principal, began October 1, 2002. On October 15, 2002,
after a two week jury trial, the jury found for the plaintiffs on all counts.
The plaintiffs were awarded a total of $2,000,000 in damages, and the jury found
that defendant Downey and the defendant Fadel El-Shahawi acted willfully and
with fraud, oppression or malice. As a result, plaintiffs were entitled to and
18
did request the Court to award them their reasonable attorney fees and expenses.
That application is pending. The verdict also allowed the Court, in its
discretion, to apply a multiple of up to three times the verdict amount in order
to adequately compensate plaintiffs and also, to award punitive damages. The
parties settled the punitive damages and multiplier portions of the case for
$500,000, of which half was paid on November 15, 2002 and the remainder will be
paid in equal monthly installments over the next two year period, commencing on
December 1, 2002. All recoveries from this litigation will be shared equally by
NAOC and Bollore. Defendants filed a new trial motion which the Court has
denied. However, the Court reduced the plaintiff's damages award to
approximately $1.7 million. On March 13, 2003, the Court denied the defendants'
motions.
On June 6, 2002, the plaintiffs moved for contempt
sanctions against JT Saniya Inc., asserting that JT Saniya had violated the
terms of the preliminary injunction issued against it by selling 38 cases of
counterfeit product. JT Saniya failed to dispute the allegations and a default
judgment of $420,369.09 was entered against JT Saniya on July 23, 2002. The
plaintiffs have entered into a settlement agreement with JT Saniya in respect of
the default judgment pursuant to which JT Saniya has paid $82,500 in full
satisfaction of the judgment.
In addition to the above described legal proceedings, the
Company is subject to other litigation in the ordinary course of its business.
The Company does not believe that any of these other proceedings will have a
material adverse effect on the results of operations, financial position or cash
flows of the Company. For a description of regulatory matters and related
industry litigation to which the Company is a party, see Part I, Item 1.
"Business--Regulation."
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER
MATTERS
There is no established public trading market for the
Company's Voting Common Stock, par value $.01 per share, 100% of which was owned
by 43 holders of record, 13 of whom are affiliates or employees of the Company.
There have been no dividends declared on the Voting Common
Stock. The current policy of the Company's Board of Directors is to retain any
future earnings to provide funds for the operation and expansion of the
Company's business; however, the Board of Directors will review the dividend
policy periodically to determine whether the declaration of dividends is
appropriate. The payment of dividends by the Company currently is subject to
restrictions contained in (i) the Company's senior secured credit facility, (ii)
the indenture governing the Company's outstanding senior notes and (iii) the
Company's Certificate of Incorporation relating to its preferred stock.
19
ITEM 6. SELECTED FINANCIAL DATA
Year Ended December 31,
--------------------------------------------------------------------------
2002 2001 2000 1999 1998
----------- ----------- ----------- ----------- -----------
(amounts in thousands, except per share amounts)
STATEMENT OF OPERATIONS DATA:
Net Sales(1)............................ $94,425 $89,622 $90,365 $92,162 $91,938
Net income (loss)(2).................... 5,485 (1,364) (3,200) 1,595 1,007
Net income (loss) applicable to common
shares(2)........................... 3,904 (8,109) (9,205) (3,766) (3,744)
Basic earnings per common share:
Income (loss)....................... $7.39 $(15.35) $(15.35) $(7.13) $(7.09)
Extraordinary loss.................. -- -- (1.61) -- --
Cumulative effect of change in accounting
principle........................ -- -- (0.47) -- --
----------- ----------- ----------- ----------- -----------
Net income (loss) applicable to common shares $ 7.39 $(15.35) $(17.43) $(7.13) $(7.09)
=========== =========== =========== =========== ===========
Diluted earnings per common share:
Income (loss)....................... $ 5.87 $(15.35) $(15.35) $(7.13) $(7.09)
Extraordinary loss.................. -- -- (1.61) -- --
Cumulative effect of change in accounting
principle........................ -- -- (0.47) -- --
----------- ----------- ----------- ----------- -----------
Net income (loss) applicable to common
shares.............................. $5.87 ($15.35) ($17.43) ($ 7.13) ($ 7.09)
=========== =========== =========== =========== ===========
BALANCE SHEET DATA (AT END OF PERIOD):
Total assets............................ $213,594 $216,663 $227,757 $243,603 $260,307
=========== =========== =========== =========== ===========
Total debt, including current
maturities........................... 160,500 167,500 180,000 195,864 215,586
=========== =========== =========== =========== ===========
Mandatorily redeemable preferred
stock................................. 57,805 57,443 50,698 44,693 39,332
=========== =========== =========== =========== ===========
(1) During 2002, the Company adopted EITF No. 00-14, "Accounting for Certain
Sales Incentives" and EITF 00-25, "Vendor Income Statement
Characterization of Consideration Paid to a Reseller of the Vendor's
Products". As a result of this adoption, certain expenses have been
reclassified from selling, general and administrative to net sales for the
years ended 2001, 2000, 1999 and 1998. Net sales for 2001, 2000, 1999 and
1998 have been reduced by $4,126, $2,780, $2,299 and $1,143, respectively,
from previously reported amounts. The adoption of EITF 00-14 and EITF
00-25 had no impact on the Company's net income for any of these periods.
(2) Net income (loss) and net income (loss) attributable to common shares for
the year ended December 31, 2000 includes an extraordinary loss of $850
(net of income tax benefit of $521) related to the write-off of deferred
financing costs upon the refinancing of the Company's term loan and a
cumulative effect of change in accounting principle of $251 (net of income
tax benefit of $153) as a result of the adoption of Staff Accounting
Bulletin No. 101, "Revenue Recognition in Financial Statements".
20
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
GENERAL
The Company is the third largest manufacturer and marketer
of loose leaf chewing tobacco in the United States and the largest importer and
distributor in the United States of premium cigarette papers and related
products. The Company also contracts for the manufacture of and distributes
Make-Your-Own ("MYO") smoking tobaccos and related products. The Company has two
significant wholly owned subsidiaries through which it operates: NTC, which
operates the Company's smokeless tobacco business and NAOC, which operates the
Company's premium cigarette paper and MYO cigarette business.
The Company generates revenues from the sale of its
products primarily to wholesale distributors who in turn resell them to retail
operations. The Company's net sales, which include federal exercise taxes,
consists of gross sales, net of cash discounts, returns, and selling and
marketing allowances.
The Company's principal operating expenses include cost of
sales, which includes the cost of raw materials used to manufacture its
products; the cost of finished products, which are purchased goods; direct
labor; federal excise taxes; manufacturing overhead; and selling, general and
administrative expenses, which includes sales and marketing related expenses,
legal expenses and compensation expenses, including benefits costs of salaried
personnel. In 2002, the Company ceased the amortization of goodwill in
accordance with FASB Statement 142, "Goodwill and Other Intangible Assets
("Statement 142") and consequently, beginning in 2002, amortization of goodwill
no longer constitutes one of the Company's principal operating expenses. The
Company's other principal expenses include interest expense and deferred
financing costs and other expenses, the last of which has arisen during the last
several years and has during the last two years primarily represented the legal,
investigative and related costs associated with the Texas and California
Infringing Products Litigations instituted by the Company against alleged
counterfeiters of ZIG-ZAG premium cigarette papers.
The following factors have affected the Company's results
over the past three years.
o The existence of counterfeit cigarette papers bearing the
ZIG-ZAG trademark. From 1999-2002, management believes the
Company lost in excess of $10 million of net sales and incurred
approximately $7 million in expenses relating to the litigation
and investigation of counterfeiting claims and to brand
promotions intended to offset damage done to the legitimate
distribution channels. Management believes that the inflow and
sale of counterfeit products has been substantially reduced as a
result of the actions taken by the Company during this period.
o The impact of increased manufactured cigarette prices.
Management believes such price increases have resulted in higher
MYO cigarette sales. In 2002, a number of states increased their
excise taxes on cigarettes. Management expects this trend to
continue in 2003 and beyond as more states seek additional
sources of revenue to combat significant budget deficits.
o The continuing downward trend of loose leaf chewing tobacco.
This is a result of an aging consumer base coupled with an
increasing trend of consumers switching to moist snuff due to
changing demographics. Management believes that the switch to
moist snuff has been caused, in part, by the recent availability
of discount moist snuff products being priced at the same levels
or lower than loose leaf products. However, management believes
21
that the current rate of switching has slowed significantly as
those consumers who found the moist snuff product more
attractive have already switched, leaving a loyal base of higher
use consumers in the loose leaf category. Historically,
increased prices for loose leaf products have largely offset
this downward trend in consumption. Management expects this
pricing trend to continue and, as a result, the Company expects
that this segment's contribution to the Company's earnings will
remain relatively constant and stable for the foreseeable
future.
The Company changed its incentive distribution program for
ZIG-ZAG premium cigarette papers, effective January 1, 2003, from a triannual
promotion to an everyday low price. This change is expected to cause buying
patterns to shift from peaks during the three promotional periods to a more even
pattern throughout the entire year, which ultimately will have a positive impact
premium cigarette paper margins due to less promotional spending. However, the
Company expects that it will take its distribution channels time to adjust to
the new program. This may result in slower sales activity for the first six to
nine months of 2003. Management believes given, the maturity of this market, the
balancing of supply and demand, the continuing recovery from the counterfeiting
activity described above, and the expected results to be achieved by expanding
and reorganizing its sales force, the Company's 2003 results in the premium
cigarette paper area will exceed those of 2002.
RESULTS OF OPERATIONS
SUMMARY
The table and discussion set forth below relates to the
consolidated results of operations and financial condition of the Company for
the years ended December 31, 2002, 2001 and 2000.
Year Ended December 31,
------------------------------------------------------------------------------------
2002 2001 2000
------------------------- ----------------------- -----------------------
(amounts in thousands)
Net sales............................... $ 94,425 100.0% $89,622 100.0% $90,365 100.0%
Cost of sales........................... 40,973 43.4 37,697 42.1 37,797 41.8
--------- --------- --------- --------- --------- ---------
Gross profit............................ 53,452 56.6 51,925 57.9 52,568 58.2
Selling, general and
administrative expenses.............. 24,065 25.5 23,372 26.1 23,586 26.3
Amortization of goodwill................ -- -- 5,490 6.1 5,490 6.1
--------- --------- --------- --------- --------- ---------
Operating income........................ 29,387 31.1 23,063 25.7 23,492 26.2
Interest expense, net, and deferred
financing costs....................... 18,744 19.9 19,742 22.0 22,261 24.8
Other expense........................... 1,944 2.1 2,642 2.9 1,801 2.0
--------- --------- --------- --------- --------- ---------
Income (loss) from continuing operations
before income tax expense............ 8,699 9.2 679 0.8 (570) (0.6)
Income tax expense...................... 3,214 3.4 2,043 2.3 1,529 1.7
--------- --------- --------- --------- --------- ---------
Income (loss) before extraordinary
loss and cumulative effect of
change in accounting principle....... 5,485 5.8 (1,364) (1.5) (2,099) (2.3)
Extraordinary loss...................... -- -- -- -- (850) (0.9)
Cumulative effect of change in
accounting principle................. -- -- -- -- (251) (0.3)
--------- --------- --------- --------- --------- ---------
Net income (loss)....................... $ 5,485 5.8% $(1,364) (1.5%) $(3,200) (3.6%)
========= ========= ========= ========= ========= =========
22
ADJUSTED EBITDA
Adjusted EBITDA represents net income plus interest, taxes,
depreciation, amortization and certain other charges and expenses as detailed in
the reconciliation below. Adjusted EBITDA is presented because it is a key
financial measure used by management to (i) assess the Company's ability to
service its debt and meet its capital expenditure requirements, (ii) determine
the Company' compliance with the terms of its debt instruments, (iii) internally
measure the Company's operating performance and (iv) determine the Company's
incentive compensation programs. Adjusted EBITDA is not a measure determined in
accordance with generally accepted accounting principles ("GAAP") and should not
be considered as an alternative to, or more meaningful than, net income (loss)
(as determined in accordance with GAAP), as a measure of the Company's operating
results or cash flows (as determined in accordance with GAAP) or as a measure of
the Company's liquidity. The Company's computation of Adjusted EBITDA may not be
the same as similarly titled measures presented by other companies. The table
set forth below is a reconciliation of the Company's net income (loss) to
Adjusted EBITDA for the last three fiscal years:
Year Ended December 31,
----------------------------------------------
2002 2001 2000
-------------- -------------- ----------------
(amounts in thousands)
Net income (loss) before payment of
preferred stock dividends............ $ 5,485 $ (1,364) $ (3,200)
Interest expense, net and amortization
of deferred financing fees......... 18,744 19,742 22,261
Income tax expense................... 3,214 2,043 1,529
Depreciation......................... 701 637 1,067
Amortization of goodwill............. -- 5,490 5,490
Other (income) expense............... 1,944 2,642 1,801
Unfunded pension obligation.......... 19 513 201
LIFO adjustment...................... 3,877 2,682 2,434
Stock option compensation expense.... 576 33 33
Postretirement expense............... 558 615 465
Cumulative effective of accounting
change............................ -- -- 251
Extraordinary loss, net of income
tax benefit....................... -- -- 850
--------- --------- ---------
Adjusted EBITDA......................... $35,118 $33,033 $33,182
========= ========= =========
COMPARISON OF YEAR ENDED DECEMBER 31, 2002 TO YEAR ENDED DECEMBER 31, 2001
Net Sales. For 2002, net sales were $94.4 million, an
increase of $4.8 million or 5.4% from the prior year. Net sales of the smokeless
tobacco segment decreased from $38.6 million to $35.7 million or 7.5% from the
prior year reflecting, in part, a 9.4% volume decrease. This was partially
offset by an approximate 5.0% price increase during 2002. Net sales continued to
be adversely impacted by competitive pressures, including increased discounting
from other loose leaf competitors, growth of the moist snuff value brands and
increased discounting activity by moist snuff manufacturers.
Net sales of the MYO segment increased from $51.0 million
to $58.7 million or 15.1% from the prior year. This was due to increases of $5.7
million in sales of the expanded MYO smoking tobacco and related products line,
which in management's opinion resulted from increases in prices and taxes of
manufactured cigarettes; $3.1 million in premium cigarette papers, due to a
continuing recovery from the counterfeiting activity; and $0.9 million in sales
23
to Canada, due to increased sales of premium cigarette papers. All of these
positive factors were partially offset by an increase in customer incentives,
both to expand the distribution in the MYO area and to enhance recovery from
counterfeiting activity. The Company attributes its continuing recovery from
counterfeiting activity to the litigation instituted by the Company against
alleged counterfeiters as discussed under Part I, Item 3. "Legal Proceedings"
above.
Gross Profits. For 2002, gross profit increased 2.9% to
$53.5 million from $51.9 million for the prior year while the gross profit
percentage decreased to 56.6% from 57.9%. Gross profit of the smokeless tobacco
segment decreased to $16.5 million in 2002 from $17.1 million for the prior
year, or 3.4%, due to the net sales reduction; however, the gross profit
percentage increased to 46.1% of net sales in 2002 from 44.1% of net sales for
the prior year. The primary reason for this was the reduction of the non-cash
LIFO inventory adjustment to $2.1 million in 2002 from $2.9 million for the
prior year. Disregarding this adjustment, the gross profit percentage still
increased by 0.3% to 51.9% of net sales in 2002 from 51.6% for the prior year.
Gross profit of the MYO segment increased 6.1% to $37.0 million from $34.9
million due to the continued growth in the smoking tobacco and related products
area of this segment as a result of the net sales increase described above. The
gross profit percentage decreased from 68.4% of net sales to 63.0% of net sales
due primarily to product mix (greater growth in lower margin products) and to
the increase in the non-cash LIFO inventory adjustment of $2.0 million.
Disregarding this adjustment, the gross profit percentage decreased to 66.1% of
net sales from 68.4% for the prior year, again, as the MYO smoking tobacco and
related products margin is less than that of premium cigarette papers.
Currency. Currency movements and suppliers' price increases
relating to premium cigarette papers, cigarette tubes and cigarette injector
machines are the primary factors affecting cost of sales. Those products are
purchased from Bollore on terms of net 45 days and are payable in Euros. Thus,
NAOC bears certain foreign exchange risks for its inventory purchases. To
minimize this risk, NAOC may choose to utilize short-term forward currency
contracts, through which NAOC secures Euros in order to provide payment for its
monthly purchases of inventory. For 2002, though currency rates were generally
not favorable to the U.S. dollar in comparison to the Euro, the Company's
inventory position benefited economically by utilizing prior short-term forward
currency contracts. For 2003, as the Euro has remained strong against the U.S.
dollar, the Company projects that its currency strategy will result in an
increase in cost of goods sold; however, this increase will be exceeded by a
reduction in promotional spending associated with the new everyday low price
program. Given management's view of the currency market, no contracts are
presently being utilized.
Selling, General and Administrative Expenses. Selling,
general and administrative expenses for 2002 increased 3.0% to $24.1 million
from the prior year's $23.4 million. This increase was due primarily to
compensation expenses related to hiring additional staff in connection with the
re-organization of the Company's sales force.
Amortization of Goodwill. Amortization of goodwill was
eliminated for 2002 compared to an expense of $5.5 million for the corresponding
period of the prior year. Effective January 1, 2002, the Company ceased
amortizing goodwill in accordance with FASB Statement 142.
Net Interest Expense and Deferred Financing Costs. Interest
expense and deferred financing costs decreased to $18.7 million in 2002 from
$19.7 million for the prior year. This decrease was the result of a lower
average term loan balance coupled with a low average interest rate environment.
Other Expense. Other expense decreased to $1.9 million in
2002 from $2.6 million for the prior year. Other expense consists primarily of
legal, investigative and related expenses with respect to the Texas and
24
California Infringing Products Litigations involving ZIG-ZAG premium cigarette
papers which are described above under "Legal Proceedings."
Income Tax Expense. Income tax expense increased to $3.2
million in 2002 from $2.0 million for the prior year as a result of the increase
in taxable income from the prior year.
Net Income (Loss). Due to the factors described above, the
Company earned net income of $5.5 million for 2002 compared to the prior year's
net loss of $1.4 million.
COMPARISON OF YEAR ENDED DECEMBER 31, 2001 TO YEAR ENDED DECEMBER 31, 2000
Net Sales. For 2001, net sales were $89.6 million, a
decrease of $0.7 million or 0.8% from the prior year. Sales of the smokeless
tobacco segment decreased to $38.6 million from $39.4 million or 1.9% from the
prior year reflecting, in part, a 4.8% volume decrease, which was significantly
offset by price increases during 2001. Net sales continued to be adversely
impacted by competitive pressures, including increased discounting from other
loose leaf competitors, growth of the moist snuff value brands and increased
discounting activity from moist snuff manufacturers.
Sales of the MYO segment were relatively flat to the prior
year. Even though there was an increase of $2.2 million in sales of the expanded
MYO smoking tobacco and related products line, this was partially offset by a
planned decrease of $1.0 million in sales to Canada in an effort to balance
inventory positions to projected sales levels. This was achieved, although
ZIG-ZAG's Canadian volume for the year at the consumer level increased 6.0%. In
addition, the Company believes that its U.S. sales of ZIG-ZAG premium cigarette
papers in the MYO segment were materially and adversely affected by the
counterfeiting activity that is the subject of the Texas and California
Infringing Products Litigations, described above under "Legal Proceedings". The
Company believes, based on information submitted as part of the legal process,
that net sales of its ZIG-ZAG premium cigarette papers were reduced by a minimum
of $6.5 million. In management's opinion, this had a material and adverse effect
on the Company's sales.
Gross Profits. For 2001, gross profit decreased $0.7
million or 1.3% to $51.9 million from the prior year and the gross profit
percentage decreased to 57.9% from 58.2%. Gross profit and gross profit
percentage of the smokeless tobacco segment decreased to $17.1 million or 44.1%
of net sales in 2001 from $18.1 million or 45.8% of net sales for the prior
year. The increase in the non-cash LIFO inventory adjustment accounted for $0.8
million or 88.9% of the decline. Gross profit of the MYO segment increased 1.0%
to $34.9 million from $34.5 million due to the continued growth in the smoking
tobacco and related products area of this segment, despite the adverse impact of
the counterfeiting activity described above. Gross profit percentage increased
from 67.7% of net sales to 68.4% of net sales due to the benefit of a favorable
currency strategy and to a decrease in the non-cash LIFO inventory adjustment of
$0.6 million.
Currency. Currency movements and suppliers' price increases
are the primary adjustment factors for changes in costs of goods sold. Cigarette
papers are purchased from Bollore on terms of net 45 days and are payable in
Euros. Thus, NAOC bears certain foreign exchange risks for its inventory
purchases. To minimize this risk, NAOC may utilize short-term forward currency
contracts, through which NAOC secures Euros in order to provide payment for its
monthly purchases of inventory. For 2001, currency rates were generally less
favorable to the U.S. dollar in comparison to the Euro. However, the Company was
able to benefit thorough its prior use of short-term forward currency contracts.
As a component of its risk management process, the Company continually reassess
its currency strategy. At year end, the Company had no outstanding contracts.
25
Selling, General and Administrative Expenses. Selling,
general and administrative expenses for 2001 decreased 0.9% to $23.4 million
from the prior year's $23.6 million. This decrease was due primarily to a
reduction in legal/litigation expense.
Amortization of Goodwill. Amortization of goodwill was
unchanged at $5.5 million from the prior year.
Net Interest Expense and Deferred Financing Costs. Interest
expense and financing costs decreased to $19.7 million in 2001 from $22.3
million for the prior year. This decrease was the result of a lower average term
loan balance coupled with a lower average interest rate environment.
Other Expense (Income). Other expense increased to $2.6
million in 2001 from $1.8 million for the prior year. Other expense in 2001
represents legal, investigative and related expenses with respect to the Texas
and California Infringing Products Litigations involving ZIG-ZAG premium
cigarette papers which are described above under "Legal Proceedings." Other
expense in 2002 represented legal fees and other costs associated with a
proposed sale of the smokeless tobacco segment which was terminated in December
2000.
Income Tax Expense. Income tax expense increased to $2.0
million in 2001 from $1.5 million for the prior year as a result of the increase
in taxable income from the prior year.
Extraordinary Loss. The Company recorded an extraordinary
loss of $0.9 million (net of income tax benefit of $0.5 million) for 2000
related to the write-off of deferred financing costs associated with the initial
acquisition financing in June 1997 and the subsequent refinancing of the
Company's term loan on December 29, 2000.
Cumulative Effect of Change in Accounting Principle. The
Company recorded a cumulative effect of change in accounting principle of $0.3
million (net of income tax benefit of $0.1 million) for 2000, as a result of the
adoption of Staff Accounting Bulletin No. 101, "Revenue Recognition in Financial
Statements".
Net Loss. Due to the factors described above, the Company
reduced its net loss to $1.4 million for 2001 compared to the prior year's net
loss of $3.2 million.
LIQUIDITY AND CAPITAL REQUIREMENTS
The Company's principal uses for cash are for working
capital, capital expenditures, debt service and its annual escrow account
deposit. The Company's principal sources of cash are from operating cash flows
and from borrowings under its senior secured credit facility. In addition, the
Company will require additional cash to complete the pending acquisition of the
Star Cigarette Assets which it expects to fund from debt and equity financing
sources.
Working capital was $32.3 million at December 31, 2002
compared to $23.1 million at December 31, 2001. This increase was primarily the
result of a reduction of $12.5 million in the current portion of long term debt,
an increase of $2.0 million in accounts receivables and an increase of $1.8
million in other current assets which were offset by an increase of $5.5 million
in the revolving credit portion of the senior secured credit facility, a
decrease of $3.2 million in inventory and a decrease of $1.0 million in accrued
liabilities. The Company funds its working capital requirements through its
operating cash flows and, if needed, bank borrowings. As of December 31, 2002,
the Company had an undrawn availability of $13.5 million under the revolving
credit portion of its senior secured credit facility.
26
On February 18, 2003, the Company entered into an asset
purchase agreement to purchase substantially all of the assets of Star
Scientific, Inc. relating to the manufacturing, marketing and distribution of
four discount cigarette brands in the United States for approximately $80
million in cash. The Company intends to finance this acquisition by offering
debt and/or equity securities. The ability to do so will depend, among other
things, on the financial performance of the Company and the availability of
funds from debt and equity financing sources. Although the Company believes it
will be able to effect such a financing, there can be no assurance that such a
financing will be obtained.
During 2002, the Company spent $625,000 in capital
expenditures. Given its current operation, the Company believes that its annual
capital expenditure requirements for 2003 will be approximately $2.0 million,
primarily for testing equipment for its research and development activities, to
expand the Company's distribution activity in Louisville which is expected to
reduce operating expenses, and for equipment to enhance and expand its
information technology capabilities. Management believes that it will be able to
fund its capital expenditure requirements.
The senior secured credit facility was initially made
available under a Loan Agreement (the "Loan Agreement"), dated December 31,
2000, with Bank One, Kentucky, N.A. as Agent (the "Agent"), and the banks named
therein. The Loan Agreement initially provided for a $25 million term loan and a
$10 million revolving credit facility. Both the term loan and the revolving
credit facility matured on December 31, 2002, at which time the term loan was
paid in full. On December 31, 2002, the Company entered into an Amended Loan
Agreement (the "Amended Loan Agreement") with Bank One pursuant to which the
revolving credit facility was increased to $20 million and extended to December
31, 2003. All terms of the original Loan Agreement remain in place except for
the replacement of a fixed charge coverage covenant with an interest coverage
covenant. The Company's obligations under the Amended Loan Agreement are
guaranteed by NTC, NAOC and National Tobacco Finance Corporation. In addition,
the Company's obligations are secured by all of the Company's assets and the
Company's equity in its subsidiaries. The interest rate on borrowings under the
Amended Loan Agreement may be either based on LIBOR or the prime rate as
announced by the Agent from time to time. As of December 31, 2002, the interest
rate on borrowings under the Amended Loan Agreement was 3.77%. In addition, the
Company must pay a quarterly commitment fee of 0.5% per annum of the unused
portion of the revolving credit facility. The Company intends to replace the
existing senior secured credit facility with a new senior secured credit
facility in connection with the pending acquisition of the Star Cigarette Assets
which is expected to close during the second quarter of 2003.
On June 25, 1997, the Company issued $155.0 million of 11%
Senior Notes 2004 (the "Senior Notes"). The Senior Notes mature and are payable
on June 15, 2004. The Senior Notes bear interest at 11% per annum, payable
semiannually on June 15 and December 15. At the present time, the Company
projects that it will not have sufficient funds to effect such repayment in the
absence of a refinancing. The Company intends to refinance this debt in
connection with the pending acquisition of the Star Cigarette Assets which is
expected to close during the second quarter of 2003 and, in any event, in
advance of the maturity of the Senior Notes. The ability to do so will depend,
among other things, on the financial performance of the Company and the
availability of funds from debt and equity financing sources. Although the
Company believes it will be able to effect such a refinancing, there can be no
assurance that such a refinancing will be obtained.
The Amended Loan Agreement and the Senior Notes limit the
incurrence of additional indebtedness, dividends, transactions with affiliates,
asset sales, mergers, prepayments of indebtedness and liens and encumbrances. At
December 31, 2002, the Company was in compliance with all provisions of the Loan
Agreement and the indenture governing the Senior Notes.
27
On July 29, 2002, the Company successfully completed a
consent solicitation (the "Consent Solicitation") from registered holders of its
12% Senior Exchange Payment-in-Kind Preferred Stock, par value $0.01 per share
("Preferred Stock"), for certain amendments to the certificate of incorporation
of the Company relating to the terms of the Preferred Stock. As a result of
amendments to the Company's certificate of incorporation resulting from the
Consent Solicitation, among other things, dividends on the Company's Preferred
Stock are payable either in cash or through the issuance of additional shares of
Preferred Stock. The Company's future ability to make dividend payments in cash
will depend upon the availability of funds and whether the Company has satisfied
the "restricted payments" provision under the indenture governing the Senior
Notes. That provision has been and is currently satisfied. Additionally, the
Company has sufficient authorized and unissued shares of Preferred Stock to make
its dividend payments through the issuance of additional shares. For the
dividend payments on September 15, 2002, and December 15, 2002, the Company
chose to make this payment in kind. The Company intends to redeem the Preferred
Stock in connection with the pending acquisition of the Star Cigarette Assets
which is expected to close during the second quarter of 2003. The ability to do
so will depend, among other things, upon the financial performance of the
Company and the availability of funds from debt and equity financing sources.
Although the Company believes it will be able to effect such a redemption, there
can be no assurance that such a redemption will occur.
Pursuant to the U.S. Distribution Agreement (one of the
Distribution Agreements, as more fully discussed in Item 1. Business), the
Company is committed to purchase a minimum number of booklets of premium
cigarette papers annually to avoid the termination of that agreement. This level
of purchases has been significantly exceeded since the 1997 Acquisition and
management believes that the Company will be able to significantly exceed this
requirement for the foreseeable future. The agreement has also established the
purchase price for ZIG-ZAG premium cigarette papers through 2004, subject to
certain adjustments to reflect increases in the U.S. consumer price index and to
account for material currency fluctuations. The Distribution Agreements provide
that, in order to assure each of the parties commercially reasonable profits in
light of inflationary trends and currency translation factors, prior to December
31, 2004 and each fifth-year anniversary of such date, the parties will enter
into good faith negotiations to agree on an index and currency adjustment
formula to replace the index and formula currently in effect. If the parties are
unable to agree, the dispute is to be submitted to binding arbitration.
28
The following schedule summarizes the Company's contractual
cash obligations excluding interest at December 31, 2002:
Payments Due By Period
----------------------
(in thousands)
Contractual Cash Obligations Total Less than 1 year 1-3 years 4-5 years After 5 years
----------------------------- ----- ---------------- --------- --------- -------------
(excluding interest)
Senior Notes - Principal $155,000 $ -- $155,000 $ -- --
Loan Agreement - Principal 5,500 5,500 -- -- --
Operating Leases 1,711 757 951 3 --
-------- -------- -------- ------ -----
Total Contractual Cash Obligations $162,211 $ 6,257 $155,951 $ 3 $ -
======== ======== ======== ====== =====
As discussed in "Item. 1 Business - State Attorney General
Settlement Agreements," in order to be in compliance with the MSA and subsequent
states' statutes, the Company is required to fund an escrow account with each of
the settling states based on the number of cigarettes or cigarette equivalents,
i.e., the pounds of MYO smoking tobacco, sold in such state. Funding of the
escrow deposit by the Company in 2002 was $0.6 million in respect of sales of
MYO smoking products in 2001. The Company estimates the total payments will be
$1 million in 2003 due to an increase of sales of MYO smoking products in 2002.
The Company believes that its operating cash flows,
together with its revolving credit facility, should be adequate to satisfy its
reasonably foreseeable operating capital requirements. Additionally, the
financing of the acquisition of the Star Cigarette Assets and the refinancing of
the Senior Notes and Preferred Stock, will depend upon the Company's ability to
access funds from debt and equity sources.
INFLATION
The Company believes that any effect of inflation at
current levels will be minimal. Historically, the Company has been able to
increase prices at a rate equal to or greater than that of inflation and
believes that it will continue to be able to do so for the foreseeable future.
In addition, the Company has been able to maintain a relatively stable variable
cost structure for its products due, in part, to its successful procurement and
reformulation activities with regard to its tobacco products and, in part, to
its existing contractual agreement for the purchase of its premium cigarette
papers.
CRITICAL ACCOUNTING POLICIES
The Company believes the accounting policies below
represent its critical accounting policies due to the estimation process
involved in each. See Note 2, in the Consolidated Financial Statements, for a
detailed discussion of the Company's accounting policies.
Revenue Recognition - The Company recognizes revenues and
the related costs upon the transfer of title and risk of loss to the customer.
Goodwill - Upon adopting Statement 142 on January 1, 2002,
the Company ceased amortizing goodwill. Statement 142 required completion of the
first step of the transitional impairment test by June 30, 2002. In completing
the transitional impairment test for fiscal 2002, the Company reported that it
had incurred no impairment.
29
Taxes - The Company has not provided a valuation allowance
to reduce its net deferred income tax assets since it is "more likely than not"
to be able to realize these benefits before they expire. If the Company should
determine that it would not be able to realize all or part of its net deferred
income tax assets in the future, an adjustment to the deferred income tax assets
would be charged to earnings in the period such determination was made.
Contingencies - Note 17 of the Consolidated Financial
Statements discusses various litigation matters that impact the Company. No loss
or gain contingencies have been recorded for these matters because Management
believes that it is not probable that a loss has been incurred or an asset
realized. Future events may result in different conclusions, which could have a
material impact, either positively or negatively, on the results of operations
or financial condition of the Company.
Inventory/LIFO Adjustment - Inventories are stated at the
lower of cost or market. Cost is determined on the last-in, first-out (LIFO)
method. Leaf tobacco is presented in current assets in accordance with standard
industry practice, notwithstanding the fact that such tobaccos are carried
longer than one year for the purpose of curing.
Stock Options - The Company measures stock compensation
costs related to stock options on the fair value method which is the preferred
method under the provisions of Statement of Financial Accounting Standards
(SFAS) No. 123, "Accounting for Stock-Based Compensation". The fair value based
method requires compensation cost for stock options to be recognized based on
the fair value of stock options granted.
Pension and Postretirement Benefits Obligations - Pension
and postretirement benefits obligations accounting is intended to reflect the
recognition of future benefit costs over covered employees' approximate service
periods based on the terms of the plans and the investment and funding decisions
made by the Company. The Company is required to make assumptions regarding such
variables as the expected long-term rate of return on plan assets and the
discount rate applied to determine service costs and interest cost to arrive at
pension income or expense for the year. As of December 31, 2002 and 2001, the
Company used expected long-term rates of return on pension plan assets of 8.5%.
The postretirement plan has no assets. The Company analyzed the rates of returns
on assets used and determined that this rate is reasonable based upon the plans'
historical performance relative to the overall markets and mix of assets. The
Company will continue to assess the expected long-term rate of return on plan
assets assumptions for each plan based on relevant market conditions and will
make adjustments to the assumptions as appropriate. As of December 31, 2002 and
2001, the Company used discount rates of 6.75% and 7.25%, respectively, for both
the pension and postretirement plans. The decrease in the discount rate used in
the current year correlates with a decline in interest rates on noncallable,
high quality bonds over the past year. The Company bases its discount rate used
on Moody's Aa bond index plus an adjustment upward to the next quarter
percentage point. See Note 11 to the Consolidated Financial Statements for the
full list of assumptions for the pension and postretirement plans.
RECENT ACCOUNTING PRONOUNCEMENTS
During 2001, the Emerging Issues Task Force issued: (1)
EITF No. 00-14, "Accounting for Certain Sales Incentives", addressing the
recognition, measurement and statement of earnings classification of certain
sales incentives and (2) EITF No. 00-25, "Vendor Income Statement
Characterization of Consideration Paid to a Reseller of the Vendor's Products",
addressing the statement of earnings classification of consideration from a
vendor to an entity that purchases the vendor's products for resale. The Company
adopted EITF 00-14 and EITF 00-25 in the first quarter of 2002. As a result of
this adoption, certain expenses have been reclassified from selling, general and
administrative expenses to allowances in determining net sales and to cost of
30
goods sold for each of the years ended December 31, 2001 and 2000. Due to
adopting EITF 00-14 and EITF 00-25, for each of the years ended December 31,
2001 and 2000, net sales decreased by $4.126 million and $2.780 million,
respectively, cost of goods sold increased by $3.963 million and $4.108 million,
respectively, and selling, general and administrative expenses were reduced by
$8.089 million and $6.888 million, respectively, from the previously reported
figures. The adoption of EITF 00-14 and EITF 00-25 had no impact on the
Company's net income for either of these periods.
In June 2001, FASB issued Statement No. 141, "Business
Combinations" ("Statement 141") and Statement 142. Statement 141 requires that
all business combinations initiated after June 30, 2001 be accounted for using
the purchase method as use of the pooling-of interest method is no longer
permitted. Statement 142 requires that goodwill no longer be amortized to
earnings, but instead be reviewed at least annually for impairment using a
two-step process. The first step is a test for potential impairment, and the
second measures the amount of impairment, if any. Impairment losses that arise
from completing a transitional impairment test during 2002 are to be reported as
the cumulative effect of a change in accounting principle as of the beginning of
the year. Subsequent impairments, if any, will be classified as an operating
expense. In addition, Statement 142 specifies the types of acquired intangible
assets that are required to be recognized and reported separately from goodwill.
Upon adopting Statement 142 on January 1, 2002, the Company
ceased amortizing goodwill. Statement 142 required completion of the first step
of the transitional impairment test by June 30, 2002. In completing the
transitional impairment test for fiscal 2002, the Company reported that it had
incurred no impairment.
In August 2001, the FASB issued Statement No. 143,
"Accounting for Asset Retirement Obligations" ("SFAS 143"). SFAS 143 requires
that obligations associated with the retirement of a tangible long-lived asset
be recorded as a liability when those obligations are incurred, with the amount
of the liability initially measured at fair value. Upon initially recognizing a
liability for an asset-retirement obligation ("ARO"), an entity must capitalize
the cost by recognizing an increase in the carrying amount of the related long
lived asset. Over time, the liability is accreted to its present value each
period, and the capitalized cost is depreciated over the useful life of the
related asset. Upon settlement of the liability, an entity either settles the
obligation for its recorded amount or incurs a gain or loss upon settlement.
SFAS 143 will be effective for financial statements for fiscal years beginning
after June 15, 2002. The Company will adopt the provisions of SFAS 143 in fiscal
2003. SFAS 143 will not have an impact on the Company's financial statements.
On January 1, 2002, the Company adopted FASB Statement No.
144, "Accounting for the Impairment or Disposal of Long-Lived Assets"
("Statement 144"). Statement 144 develops a single accounting model for
long-lived assets to be disposed of by sale, and addresses significant
implementation issues related to previous guidance. Statement 144 requires that
long-lived assets to be disposed of by sale be measured at the lower of their
carrying amount or fair value less cost to sell, whether reported in continuing
operations or in discontinued operations. Statem