2008-08-13 13:00:00
TORONTO, ONTARIO–(EMWNews – Aug. 13, 2008) –
NOT FOR RELEASE OVER US NEWSWIRE SERVICES
Attention Business/Financial Editors:
Menu Foods Income Fund (TSX:MEW.UN) announces its financial results for the second quarter ended June 30, 2008.
A conference call to review these results will take place tomorrow Thursday, August 14, 2008 at 8:30 a.m. EST (Toronto time). The conference call will be chaired by Paul Henderson, Menu’s President and Chief Executive Officer. Paul will be joined on the call by Mark Wiens, Menu’s Executive Vice-President and Chief Financial Officer.
To access the conference call in real time, please call 416-850-9150 or 1-866-809-4939. A replay will be available from approximately one hour after the end of the conference call until August 28, 2008 by dialing 416-915-1035 or 1-866-245-6755, using passcode 395906 followed by the number sign. A live audio webcast of the conference call is also available, it can be accessed by entering http://events.onlinebroadcasting.com/menufoods/081408/index.php on an Internet browser. A replay of the webcast will be available for one year, it can be accessed by entering http://events.onlinebroadcasting.com/menufoods/081408/index.php on an Internet browser.
Message to Unitholders
As we began 2008, we recognized that this would be a year of rebuilding for Menu. I am pleased to report that the good progress made against this objective in the first quarter of 2008 continued in the quarter ended June 30, 2008. It is particularly satisfying to note that volume within our continuing business is growing and that Menu earned a profit in this quarter.
While the 2007 recall is now largely behind us, its impact on our profitability and on our leverage ratios will be felt for some time to come. Given the covenants contained in our credit facilities and our goal of rebuilding the business, the Fund’s management and employees’ near-term focus will continue to be on cash flow generation and the day-to-day effective operation of the business. In the second quarter, we realized benefits of this approach, although to a reduced extent due to the influence of market-wide material cost increases.
Menu’s performance during the quarter ended June 30, 2008 was noteworthy for a number of reasons:
– The Fund earned a profit for the first time since the fourth quarter of 2006, generating net income of $0.7 million compared to a loss of $3.6 million for the same period in the prior year.
– Despite the significant increases in the costs of raw and packaging materials, delivery and operational expenses of the Fund’s production facilities, in general, the Fund achieved adjusted EBITDA of $5.0 million. This is in line with the $5.1 million earned in the first quarter of 2008 and up significantly from $2.0 million in the fourth quarter of 2007.
– The Fund followed the leading national brands; successfully implementing a price increase to private-label customers which had the effect of increasing sales by more than 2.5% during the quarter. While cost increases eroded all of the benefit of this price increase, its timely implementation allowed the Fund to earn adjusted EBITDA consistent with the prior quarter and more than sufficient to meet the covenants as set out by its Lenders.
– Volume from the Fund’s continuing business increased by 6.3% as compared to the first quarter of 2008. This increase followed an increase of 12.6% realized in the first quarter of 2008, as compared to the fourth quarter of 2007.
– Selling, general and administrative expenses continued to decrease; largely reflecting the expected benefits from the prior year’s restructuring efforts.
– Inventory levels were managed downward from levels at the end of the first quarter and are now more in line with the levels needed to support the Fund’s ongoing business.
Significant progress continues to be made in respect of the industry-wide Pet Food Multi-District litigation. On May 30, 2008, the United States District Court for the District of New Jersey and, on July 9, 2008, the Canadian courts provided preliminary approvals for the comprehensive cross border settlement agreement reached in respect of this litigation. Motions for final approval have been scheduled for October 14, 2008 in the United States and November 3, 2008 in Canada. The Fund is pleased with this negotiated settlement, which, if finally approved will provide restitution to the pet owners affected by the 2007 pet food recalls.
As we look ahead to the final half of 2008, we foresee continued cost escalation within cost of sales, which will more than offset the benefit of our second quarter price increase. The branded manufacturers of wet pet food have many of the same input costs as the Fund and we believe that they are experiencing cost escalations similar to our own. Early in the third quarter we confirmed that the national branded manufacturers have increased prices in Canada. Shortly thereafter, the Fund initiated a price increase to its Canadian private-label customers. Given this movement in Canada, we expect leading national branded manufacturers to initiate price increases in the United States in order for them to recover the cost increases experienced in that marketplace. When this happens the Fund expects to follow with a price increase of its own. However, until such time as we are able to pass those cost increases along to customers, the Fund expects that its gross margin and EBITDA will continue to be adversely impacted.
Once again, I want to thank our lenders, suppliers, customers, and our employees who are seeing us through these challenging times and have already helped Menu to strengthen its business foundation. I look forward to reporting to you again next quarter.
Paul Henderson
President & Chief Executive Officer
Menu Foods GenPar Limited
Administrator of Menu Foods Income Fund
Management’s Discussion and Analysis of Financial Results
(For the quarter ended June 30, 2008)
Presentation of Financial Information
The following discussion and analysis of the financial results of Menu Foods Income Fund (the “Fund”) is dated as of August 13, 2008 and is supplementary to and should be read in conjunction with the unaudited consolidated financial statements for the quarters ended June 30, 2008 and 2007.
The Fund is the indirect owner of Menu Foods Limited (“Menu”), the leading North American private label/contract manufacturer of wet pet food products. The Fund’s results include those of Menu, its subsidiaries, affiliates and the partnerships that conduct its day-to-day business.
Where applicable, financial information contained herein is prepared in accordance with Canadian generally accepted accounting principles (“GAAP”) and is reported in Canadian dollars.
Certain statements in this Management’s Discussion and Analysis of Financial Results are “forward-looking statements”, which reflect management’s expectations regarding the Fund and Menu’s future growth, results of operations, performance, business prospects and opportunities. Such forward-looking statements reflect management’s current beliefs and are based on information currently available to management. Many factors could cause results to differ materially from the results discussed in the forward-looking statements, including risks related to issues associated with the product recall, including litigation related matters; key customer performance; dependence on key suppliers; economic conditions; competition; regulatory matters/changes; foreign exchange rates and interest rates, cost increases and the pricing environment, among others. Although the forward-looking statements are based on what management believes to be reasonable assumptions, the Fund and Menu cannot assure investors that actual results will be consistent with these forward-looking statements. These forward-looking statements are made as of the date of this report, and neither the Fund nor Menu assumes any obligation to update or revise them to reflect new events or circumstances.
Overall Performance and Results of Operations
The following table highlights selected comparative results (all figures, except per unit amounts, expressed in thousands of Canadian dollars)
For the quarter For the six months
ended June 30, ended June 30,
2008 2007 2008 2007
$ $ $ $
Sales 60,330 47,244 115,911 111,750
Cost of sales 53,591 43,461 101,693 100,208
-----------------------------------------
Gross profit 6,739 3,783 14,218 11,542
Selling, general and administrative
expenses 4,582 5,561 9,440 11,927
-----------------------------------------
Income (loss) before the
undernoted 2,157 (1,778) 4,778 (385)
Product recall expenses - 1,914 - 41,029
Restructuring and related expenses 70 - 172 -
Financial expenses 1,347 1,853 6,046 5,135
-----------------------------------------
Income (loss) before income taxes
and non-controlling interest 740 (5,545) (1,440) (46,549)
-----------------------------------------
Current income taxes 5 20 29 (194)
Future income taxes - (94) - (14,295)
-----------------------------------------
Total income taxes 5 (74) 29 (14,489)
-----------------------------------------
Income (loss) before
non-controlling interest 735 (5,471) (1,469) (32,060)
Non-controlling interest of Class
B Exchangeable Units - (1,869) - (10,949)
-----------------------------------------
Net income (loss) for the period 735 (3,602) (1,469) (21,111)
-----------------------------------------
-----------------------------------------
Basic net income (loss) per Trust
Unit 0.036 (0.189) (0.072) (1.106)
Diluted net income (loss) per Unit 0.025 (0.189) (0.072) (1.106)
Diluted distributable cash per
Trust Unit and Class B Unit 0.110 (1.0567) 0.094 (1.0281)
Basic weighted average number of
Trust Units outstanding (000s) 20,362 19,087 20,362 19,084
Diluted weighted average number
of Units outstanding (000s) 28,989 28,984 28,985 29,091
Average US/Cdn exchange rate
per Bank of Canada 0.9901 0.9104 0.9928 0.8810
Operating Results for the Quarter Ended June 30, 2008
Beginning on March 16, 2007, the Fund announced a series of recalls of a portion of the dog and cat food it manufactured between November 8, 2006 and March 7, 2007 (the “recall”). The recall primarily related to “cuts and gravy” style pet food in cans and pouches manufactured and sold under private-label and contract-manufactured for some national brands.
The Fund’s investigation discovered that the timing of production associated with reported concerns and certain other events, coincided with the introduction of wheat gluten from a new supplier. Subsequent investigation has proven that the supplier’s wheat gluten had in fact been adulterated with melamine and related compounds. Menu was the first of a number of companies within the pet food industry to recall product adulterated with melamine and related compounds in connection with one of the largest recalls in the industry’s history. Menu, its competitors, its customers and consumers were all victims of a terrible fraud perpetuated on the pet food industry as a whole.
While a substantial portion of the expected costs of the recall were expensed by the Fund during the first quarter of 2007, since the recall happened so close to quarter-end, its impact on Menu’s sales and operations to March 31, 2007 was minimized. By contrast, while fewer recall-related expenses arose in the second quarter of 2007, significant impacts in terms of lost sales and higher operating costs were experienced as the Fund suspended shipments of most “cuts and gravy” products while the recall was in effect. Any comparative analysis between the second quarter of 2008 and the second quarter of 2007 needs to consider this and much of the explanation for variances between the quarters will be attributed to the recall.
As reported during 2007, the impact of the recall on sales and operating costs was greatest during the second quarter of the year. Many customers significantly reduced or suspended purchases from Menu during that time. By the third quarter of 2007 the Fund had resumed shipping to most of its private-label customers and, in fact, benefited from an increase in demand as customers who had been without product for several months refilled their ‘pipelines’. Sales in the fourth quarter of 2007 were considered to be more indicative of recurring volumes. Taking these factors into consideration, it is more meaningful to measure the change in sales and operating performance during 2008 against the fourth quarter of 2007.
Given the comments above, we will evaluate the results for the quarter ended June 30, 2008 in two ways:
1. relative to the trend in performance since the fourth quarter of 2007. It is this trend that is more relevant in evaluating how Menu has recovered from the impacts of the recall of 2007; and
2. relative to the quarter ended June 30, 2007. Since the recall accounts for much of the change in performance compared to 2007, and since this is an underlying explanation it is not repeated in the commentary.
Relative to the trend since the fourth quarter of 2007
For the quarter ended
June 30, 2008 March 31, 2008 December 31, 2007
$ $ $
Sales 60,330 55,581 55,001
Cost of sales 53,591 48,102 49,743
-----------------------------------------------------
Gross profit 6,739 7,479 5,258
Selling, general and
administrative
expenses 4,582 4,858 6,029
Financial expenses 1,347 4,699 3,887
-----------------------------------------------------
Income (loss)(1) 810 (2,078) (4,658)
-----------------------------------------------------
-----------------------------------------------------
Average US/Cdn
exchange rate 0.9901 0.9955 1.0184
-----------------------------------------------------
-----------------------------------------------------
(1) Income (loss) is before product recall expenses, restructuring and
related expenses, goodwill impairment, income taxes and non-controlling
interests and is not a recognized measure under GAAP
Quarter ended March 31, 2008 compared to the quarter ended December 31, 2007
Sales for the quarter ended March 31, 2008 were $55.6 million, up $0.6 million or 1.0% compared to the fourth quarter in 2007. This increase is attributable to:
1. Effect of Change in Sales Volume. A 3.4% decrease in volume resulting in a sales decrease of $1.7 million. Most of this decrease results from a 59.2% decline in volume sold to customers who had advised the Fund during 2007 that they would no longer be purchasing from Menu. The remaining volume to these customers will be lost throughout 2008 and into 2009. Volume to continuing customers increased by 12.6%.
2. Price and Cost Increases/Adjustments. The effect of pricing adjustments to pass through cost increases to Menu’s contract manufacturing customers, together with changes to sales mix and other variables, had the effect of increasing sales by $1.3 million.
3. Foreign Exchange Effect on Sales. The strengthening of the United States dollar relative to the Canadian dollar had the effect of increasing sales by $1.0 million relative to the fourth quarter in 2007.
Gross profit increased by $2.2 million or 42.2% during the quarter ended March 31, 2008 compared to the fourth quarter of 2007. This increase is attributable to:
1. Effect of Change in Sales Volume. As previously noted, total volume during the first quarter of 2008 decreased by 3.4%. This change in sales volume decreased gross profit by $0.3 million.
2. Price and Cost Increases/Adjustments. On a comparative basis to the fourth quarter in 2007, the increase in costs of certain inputs to production, including raw and packaging materials and labour and benefits, lead to higher cost of sales. However, as the Fund has returned to more normal levels of production during the quarter ended March 31, 2008 it began to realize more typical operating efficiencies and, accordingly, reduced factory overhead. The increased costs and other variables were more than offset by the selling price increases to contract-manufacturing customers and the improved operating efficiencies, increasing gross profit by $2.1 million.
3. Foreign Exchange Effect on Sales. The strengthening of the United States dollar relative to the Canadian dollar during the quarter had the effect of increasing sales by approximately $1.0 million and that translated into an increase in gross profit of $0.2 million for the quarter ended March 31, 2008.
4. Decrease in Amortization. The amortization of capital projects completed in the past year was more than offset by the effect of fully amortized assets, resulting in a decrease in total amortization. Furthermore, higher finished goods inventory levels resulted in more amortization being included in inventory as part of factory overhead costs rather than expensed as part of cost of sales. Taken together, this resulted in a decrease in amortization included in the cost of sales of $0.2 million versus the fourth quarter in 2007.
Selling, general and administrative expenses for the quarter ended March 31, 2008 decreased by $1.2 million compared to the fourth quarter in 2007. This improvement was largely attributed to savings resulting from the Fund’s restructuring initiatives announced on October 10, 2007 (including the sale of its production facility in North Sioux City, South Dakota), which became fully effective during the first quarter of 2008.
Financial expenses were $0.8 million higher during the quarter ended March 31, 2008 than in the fourth quarter of 2007. The Fund recorded a loss of $1.7 million on interest rate swaps during the first quarter of 2008 compared to a loss of $1.0 million in the fourth quarter last year. Excluding the effect of the accounting for the interest rate swaps, on a comparative basis, interest expense increased by $0.1 million during the quarter.
Quarter ended June 30, 2008 compared to the quarter ended March 31, 2008
Sales for the quarter ended June 30, 2008 were $60.3 million, up $4.7 million or 8.5% compared to the first quarter in 2008. This increase is attributable to:
1. Effect of Change in Sales Volume. A 4.2% increase in volume resulting in a sales increase of $2.7 million. Volume to continuing customers increased by 6.3% while volume sold to customers who had advised the Fund during 2007 that they would no longer be purchasing from Menu declined by 15.7%, continuing the trend noted in the first quarter of 2008.
2. Price and Cost Increases/Adjustments. The impact of the price increase to private-label customers that was implemented during the second quarter of 2008 and the effect of pricing adjustments to pass through cost increases to Menu’s contract-manufacturing customers, together with changes to sales mix and other variables, had the effect of increasing sales by $1.7 million.
3. Foreign Exchange Effect on Sales. The strengthening of the United States dollar relative to the Canadian dollar during the quarter had the effect of increasing sales by $0.3 million relative to the first quarter in 2008.
Gross profit decreased by $0.7 million or 9.9% during the quarter ended June 30, 2008 compared to the first quarter of 2008. This decrease is attributable to:
1. Effect of Change in Sales Volume. As previously noted, total volume during the second quarter of 2008 increased by 4.2%. This change in sales volume increased gross profit by $0.4 million.
2. Price and Cost Increases/Adjustments. On a comparative basis to the first quarter in 2008, the increase in costs of certain inputs to production, particularly raw and packaging materials, have led to higher cost of sales. Furthermore, in order to reduce inventories and bank indebtedness the Fund reduced production with a resultant impact on operating efficiencies and an increase in factory overhead per case. These increased costs and other variables were only partially offset by the price increase to private-label customers and the selling price increases to contract-manufacturing customers, decreasing gross profit by $0.7 million.
3. Foreign Exchange Effect on Sales. The strengthening of the United States dollar relative to the Canadian dollar during the quarter had the effect of increasing sales by approximately $0.3 million and that translated into a nominal increase in gross profit for the quarter ended June 30, 2008.
4. Increase in Amortization. The reduction in finished goods inventory levels during the quarter resulted in less amortization of capital assets being included in inventory as part of factory overhead costs, and more being expensed as part of cost of sales. This contrasts with the first quarter, during which finished goods inventory levels increased resulting in less amortization of capital assets being expensed to cost of sales and more being included in the cost of inventory. The net effect was an increase in the amortization associated with the cost of sales of $0.4 million versus the first quarter in 2008.
Selling, general and administrative expenses for the quarter ended June 30, 2008 decreased by $0.3 million compared to the first quarter in 2008. This decrease can be attributed to a number of small decreases across a variety of expense categories.
Financial expenses were $3.4 million lower during the quarter ended June 30, 2008 than in the first quarter of 2008. The Fund recorded a gain of $1.5 million on interest rate swaps during the second quarter of 2008 compared to a loss of $1.7 million in the first quarter this year. Excluding the effect of the accounting for the interest rate swaps, on a comparative basis, interest expense decreased by $0.2 million during the quarter.
Relative to the quarter ended June 30, 2007
Sales for the quarter ended June 30, 2008, were $60.3 million, up 27.7% or $13.1 million compared to the same quarter last year. This increase is attributable to:
1. Effect of Change in Sales Volume. A 34.9% increase in volume resulting in a sales increase of $16.2 million.
2. Price and Cost Increases/Adjustments. The impact of the price increase to private-label customers that was implemented during the second quarter of 2008 and the effect of pricing adjustments to pass through cost increases to Menu’s contract-manufacturing customers, together with changes to sales mix and other variables, had the effect of increasing sales by $3.1 million.
3. Foreign Exchange Effect on Sales. The strengthening of the Canadian dollar relative to the United States dollar had the effect of decreasing sales by $6.2 million relative to the second quarter of 2007.
Overall, volume (expressed in cases of 24 cans or pouches) was up 34.9% compared to the quarter ended June 30, 2007. Can volume, which represented 88.5% of Menu’s volume in the second quarter of 2008 (98.9% in 2007), grew by 20.8% (equating to an increase in total volume of 20.6%) while pouch volume, which represented 11.5% of total volume (1.1% in 2007), increased dramatically (equating to an increase in total volume of 14.3%) compared to the second quarter of 2007. Virtually all customers had suspended the purchase of the pouch format, which is exclusively in the “cuts and gravy” style of product, during the second quarter of 2007.
During 2007, the Fund was advised that customers whose volume represented approximately 37% of sales in 2006 and 33% of sales during the first quarter of 2007 would no longer be purchasing these products from Menu. This lost business primarily impacted 2007, but will affect 2008 and 2009 as well. For the quarters ended June 30, 2007 and 2008, respectively, volume to these customers declined to 33.4% and 18.4% of the levels achieved during the first quarter of 2007. Overall, for the quarters ended June 30, 2007 and 2008, respectively, these customers accounted for 18.6% and 7.6% of total volume for the quarter. Compared to the second quarter of 2007, during the quarter ended June 30, 2008, volume to these customers decreased 44.9% (equating to 8.2% of total volume). This decrease was more than offset by the 53.1% increase (equating to 43.3% of total volume) in volume to the Fund’s continuing customers.
Gross profit increased by $3.0 million (or 78.1%) for the quarter ended June 30, 2008, compared to the prior year. This increase is attributable to:
1. Effect of Change in Sales Volume. As previously noted, total volume for the second quarter increased by 34.9%. This change in sales volume increased gross profit by $1.8 million.
2. Price and Cost Increases/Adjustments. In February 2007, Menu followed a leading national brand manufacturer and announced a price increase on canned products sold to its United States private-label customers. This price increase was effective in the second quarter of 2007. During the first quarter of 2008, Menu again followed the leading national brands and announced a price increase to private-label customers that was implemented during the second quarter of 2008. While costs continue to rise, this price increase should enable Menu to recover some of the cost increases experienced since the last price increase to its private-label customers.
On a comparative basis to the same quarter in 2007, the increase in costs of certain inputs to production, including raw and packaging materials and labour and benefits, have led to higher cost of sales. During 2007 the dramatic decline in sales due to the recall translated to a significant reduction in production, which resulted in factory overhead associated with the Fund’s production facilities being allocated over a reduced number of cases, thereby increasing the cost of the Fund’s inventory, and in turn, its cost of sales as that inventory was sold. During the fourth quarter of 2007, the Fund restructured its operations in order to better align its costs to its ongoing business. This restructuring had the effect of reducing production costs during the second quarter of 2008 as compared to the same quarter of 2007. These reduced costs of manufacturing, together with the selling price increases referred to above, as well as selling price increases to contract-manufacturing customers, more than offset the increases in input and other costs thereby increasing gross profit by $2.3 million.
3. Foreign Exchange Effect on Sales. The strengthening of the Canadian dollar relative to the United States dollar during the quarter had the effect of reducing sales by approximately $6.2 million and that translated into a reduction in gross profit of $0.9 million for the quarter ended June 30, 2008.
4. Increase in Amortization. The amortization associated with the South Dakota facility, which was sold during the third quarter of 2007, together with the effect of fully amortized assets, the write down of capital assets and the customer relationship as part of last year’s restructuring by the Fund and the stronger Canadian dollar more than offset the additional amortization of capital projects completed in the past year, resulting in lower total amortization when compared to the second quarter of 2007. However, the reduction in finished goods inventory levels during the second quarter of 2008 has resulted in less amortization of capital assets being included in inventory as part of factory overhead costs, and more being expensed as part of cost of sales. This contrasts with the second quarter of 2007 during which finished goods inventory levels increased resulting in less amortization of capital assets being expensed as part of cost of sales. On a comparative basis the foregoing netted to an increase in the amortization associated with the cost of sales of $0.2 million versus the second quarter of 2007.
Selling, general and administrative expenses for the quarter ended June 30, 2008 decreased by $1.0 million compared to the prior year. Savings resulting from the Fund’s restructuring initiatives announced on October 10, 2007 (including the sale of its production facility in North Sioux City, South Dakota) accounted for the majority of the decrease. Amortization was $0.5 million less than in 2007, largely as a result of the reduction in amortization associated with fully amortized assets during the period exceeding amortization associated with newly acquired assets being put into service and as a result of the stronger Canadian dollar. Foreign exchange losses on the United States dollar exposure in working capital in Menu’s Canadian operations increased by about $1.0 million compared to last year.
As reported last year, as a consequence of the recall, the Fund had to restructure to better align costs with its ongoing business operations. The restructuring initiatives took several forms and under GAAP, depending upon their nature, were to be both accrued and expensed in 2007 or are to be expensed as incurred in future periods. A further $0.1 million in restructuring costs was expensed during the second quarter of 2008.
During the first quarter of 2007, management estimated that the total costs associated with the product recall would approximate $45 million. This estimate principally comprised product collection, write off and disposal costs of $36.5 million, lost margin on returned product of $2.9 million, $2.4 million to establish and operate a call centre to respond to customer concerns and $3.2 million in professional and associated fees necessary to manage through this difficult process. All but $3.0 million of these costs, which were expensed as incurred during 2007, were accrued in the first quarter of 2007. An additional $1.9 million (of the $3.0 million) in recall-related costs was expensed during the second quarter of 2007. The estimate for product recall costs was revised in the fourth quarter of 2007 and adjusted to $55 million.
Adjusted EBITDA for the quarter ended June 30, 2008 amounted to $5.0 million. In order to have any meaningful comparison to EBITDA in the second quarter of 2007 it is necessary to remove the impacts of the recall as described above. Adjusting for the $1.9 million in recall related costs in the second quarter of 2007 the foregoing resulted in an adjusted EBITDA (see Note A) of $1.4 million. On this basis, adjusted EBITDA during the second quarter of 2008 increased by $3.6 million (or 259.9%) compared to the same period in 2007.
The strengthening of the Canadian dollar, relative to the United States dollar, has reduced sales, gross margin, selling, general and administrative expenses, amortization, interest and EBITDA. Menu estimates that each change of $0.01 in the cost of the Canadian dollar changes EBITDA by approximately $0.095 million and Distributable Cash (see Note A) by approximately $0.070 million, on a quarterly basis. Menu estimates that the strengthening of the Canadian dollar during the second quarter of 2008 versus the same period in 2007 reduced EBITDA by approximately $0.8 million and Distributable Cash by approximately $0.6 million.
Amortization (which is included in cost of sales and selling, general and administrative expenses) in the second quarter of 2008 was $0.3 million lower than in 2007. This decrease is directly attributable to fully amortized assets, the sale of the South Dakota facility, the write down of idle assets and the customer relationship and the effects of the strengthening of the Canadian dollar relative to the United States dollar offset by the additional amortization in 2008 on the $3.8 million of capital expenditures made during the twelve-month period ended June 30, 2008 together with the full quarter amortization of the $0.8 million of capital expenditures made during the quarter ended June 30, 2007.
Financial expenses were $0.5 million lower during the quarter ended June 30, 2008 than in the second quarter of 2007. The Fund recorded a gain of $1.5 million on interest rate swaps during the second quarter of 2008 compared to a gain of $0.8 million in the same quarter last year. Excluding the effect of the accounting for interest rate swaps, interest expense increased by $0.2 million, reflecting both the higher interest rates and the higher amounts borrowed this year.
The Fund operates using a number of different legal structures (e.g., partnerships, trusts, corporations etc.) in a number of jurisdictions. Each of these structures and jurisdictions is subject to income tax at different rates.
Income before non-controlling interest of Class B Exchangeable Units (“Class B Units”) for the quarter ended June 30, 2008, was $0.7 million, compared to a loss of $5.5 million for the quarter ended June 30, 2007.
Operating Results for the Six Months Ended June 30, 2008
The various recalls initiated by the Fund during the first half of 2007 have had a significant impact on the Fund’s results for the six months ended June 30, 2007. In order to draw meaningful conclusions with respect to the Fund’s performance in the first half of 2007 and thereby permit a meaningful comparison to the first half of 2008, it is important to isolate the effects of the recalls from the ongoing business.
The following table further evaluates the results noted above:
For the six months ended June 30, 2007
2008 Total Recall Costs Excluding
Recall
$ $ $ $
Sales 115,911 111,750 (14,320) 126,070
Cost of sales 101,693 100,208 (11,435) 111,643
--------------------------------------------------
Gross profit 14,218 11,542 (2,885) 14,427
Selling, general and
administrative expenses 9,440 11,927 - 11,927
--------------------------------------------------
Income before the
undernoted 4,778 (385) (2,885) 2,500
Product recall expenses - 41,029 41,029 -
Restructuring and related
expenses 172 - - -
Financial expenses 6,046 5,135 - 5,135
--------------------------------------------------
Loss before income taxes
and non-controlling
interest (1,440) (46,549) (43,914) (2,635)
--------------------------------------------------
--------------------------------------------------
Sales for the six months ended June 30, 2008, were $115.9 million, up 3.7% or $4.2 million compared to the same period last year. This increase is attributable to:
1. Effect of Change in Sales Volume. A 1.1% decrease in volume resulting in a nominal change in sales primarily due to the impact of the recall, particularly during the second quarter in the comparative period. Upon announcing the recall in 2007, Menu and its customers suspended the sale and purchase, respectively, of the recalled products (primarily cuts and gravy style). Pouch sales were particularly affected with only minimal sales during the quarter ended June 30, 2007.
2. Foreign Exchange Effect on Sales. The strengthening of the Canadian dollar relative to the United States dollar during the six-month period had the effect of reducing sales by approximately $14.0 million. These decreased sales were partially offset by:
3. Effect of Product Recall. As a further consequence of the product recall, sales returns were received or accrued during the quarter ended March 31, 2007. There were no such returns during the six months ended June 30, 2008, resulting in increased sales on a comparative basis of $14.3 million.
4. Price and Cost Increases/Adjustments. The impact of the price increases since the end of the first quarter of 2007 and the effect of pricing adjustments to pass through cost increases to Menu’s contract manufacturing customers, together with changes to sales mix and other variables, had the effect of increasing sales by $3.9 million.
Overall, excluding actual returns arising from the product recall, volume (expressed in cases of 24 cans or pouches) was down 1.1% compared to the six months ended June 30, 2007. Can volume, which represented 87.5% of Menu’s volume in the first half of 2008 (85.8% in 2007), increased by 1.0% (equating to an increase in total volume of 0.9%). Conversely, pouch volume decreased over the same period in the prior year, since while all customers stopped purchasing this product during the second quarter of 2007, sales had been stronger during the first quarter of 2007. During the first six months of 2008, case sales of the pouch product, which represented 12.5% of total volume (14.2% in 2007), decreased by 13.4% (equating to a decrease in total volume of 1.9%) compared to the first six months of 2007.
During 2007, the Fund was advised that customers whose volume represented approximately 37% of sales in 2006 would no longer be purchasing these products from Menu. This lost business primarily impacted 2007, but will affect 2008 and 2009 as well. During the six months ended June 30, 2008, volume to these customers decreased 69.8% as compared to the six months ended June 30, 2007, which more than offset the 25.5% increase in volume to the Fund’s continuing customers. Over this same period the significance of these lost customers has decreased as well, with their volumes accounting for only 8.5% of total volume compared to 27.8% in 2007.
Gross profit increased by $2.7 million (or 23.2%) for the six months ended June 30, 2008, compared to the prior year. This increase is attributable to:
1. Effect of Change in Sales Volume. As previously noted, excluding actual returns arising from the product recall, total volume for the first half of the year decreased by 1.1%. This change in sales volume decreased gross profit by $0.2 million.
2. Product Recall Impacts. As noted above, due to the product recall, $14.3 million in sales returns were received or accrued during the quarter ended March 31, 2007. The gross profit associated with these returns amounted to $2.9 million.
3. Price and Cost Increases/Adjustments. In February 2007, Menu followed a leading national brand manufacturer and announced a price increase on canned products sold to its United States private-label customers. This price increase was effective in the second quarter of 2007. During the first quarter of 2008, Menu again followed the leading national brands and announced a price increase to private-label customers that was implemented during the second quarter of 2008. While costs continue to rise, this price increase should enable Menu to recover some of the cost increases experienced since the last price increase to its private-label customers.
On a comparative basis to the same period in 2007, the increase in costs of certain inputs to production, including raw and packaging materials and labour and benefits, have led to higher cost of sales. However, during 2007 and particularly during the second quarter of 2007, lower sales translated to lower levels of production, which necessitated that the factory overhead associated with the Fund’s production facilities had to be allocated over fewer cases, thereby increasing the cost of the Fund’s inventory, and in turn, its cost of sales as that inventory was sold. During the fourth quarter of 2007, the Fund restructured its operations in order to better align its costs to its ongoing business. This restructuring had the effect of reducing production costs during the first six months of 2008 as compared to the same period of 2007. These reduced costs of manufacturing, together with the selling price increases referred to above, as well as selling price increases to contract-manufacturing customers, more than offset the increases in input and other costs thereby increasing gross profit by $1.1 million.
4. Foreign Exchange Effect on Sales. The strengthening of the Canadian dollar relative to the United States dollar during the period had the effect of reducing sales by approximately $14.0 million and that translated into a reduction in gross profit of $2.2 million for the six months ended June 30, 2008.
5. Decrease in Amortization. The amortization associated with the South Dakota facility, which was sold during the third quarter of 2007, together with the effect of fully amortized assets, the write down of capital assets and the customer relationship as part of last year’s restructuring by the Fund, and the stronger Canadian dollar more than offset the additional amortization of capital projects completed in the past year, resulting in lower total amortization when compared to the first six months of 2007. Furthermore, the reduction in finished goods inventory levels during the first half of 2008 has resulted in less amortization of capital assets being included in inventory as part of factory overhead costs, and more being expensed as part of cost of sales This contrasts with the first half of 2007 during which finished goods inventory levels increased resulting in less amortization of capital assets being expensed to cost of sales. On a comparative basis the foregoing netted to a decrease in the amortization associated with the cost of sales of $1.1 million versus the first half of 2007.
Selling, general and administrative expenses for the six months ended June 30, 2008 decreased by $2.5 million compared to the prior year. Savings resulting from the Fund’s restructuring initiatives announced on October 10, 2007 (including the sale of its production facility in North Sioux City, South Dakota) accounted for the majority of the decrease. Amortization was $1.0 million less than in 2007, largely as a result of the reduction in amortization associated with fully-amortized assets during the period and resulting from the sale of the South Dakota facility exceeding amortization associated with newly acquired assets being put into service and as a result of the stronger Canadian dollar. Foreign exchange losses on the United States dollar exposure in working capital in Menu’s Canadian operations increased by about $1.4 million compared to last year. Bonus expense, which was negligible in 2007 due to the recall, increased by $0.2 million, compared to the first half of last year.
During the first quarter of 2007, management estimated that the total costs associated with the recall would approximate $45 million. This estimate principally comprised product collection, write off and disposal costs of $36.5 million, the lost margin on returned product of $2.9 million discussed above, $2.4 million to establish and operate a call centre to respond to consumer concerns and $3.2 million in professional and associated fees necessary to manage this difficult process. All but $1.1 million of these costs, had to be expensed as incurred under Canadian generally accepted accounting policies, were reflected in the results for the six months ended June 30, 2007. The estimate for product recall costs was revised in the fourth quarter of 2007 and adjusted to $55 million.
In order to have any meaningful discussion of EBITDA it is necessary to remove the impacts of the recall as described above. Adjusting for the $43.9 million in recall related costs, the foregoing resulted in an adjusted EBITDA (see Note A) of $9.8 million for the six months ended June 30, 2007. This compares to adjusted EBITDA of $10.1 million (adjusted for restructuring and related expenses) for the six months ended June 30, 2008, an increase of $0.3 million (or 3.1%) over the same period in 2007.
The strengthening of the Canadian dollar, relative to the United States dollar, has decreased sales, gross margin, selling, general and administrative expenses, amortization, interest and EBITDA. Menu estimates that each change of $0.01 in the cost of the Canadian dollar changes EBITDA by approximately $0.38 million and Distributable Cash (see Note A) by approximately $0.28 million, on an annual basis. Menu estimates that the strengthening of the Canadian dollar during the first half of 2008 versus the same period in 2007 reduced EBITDA by approximately $2.0 million and Distributable Cash by approximately $1.5 million. Subsequent to June 30, 2008 the United States dollar has strengthened relative to the Canadian dollar. Should this be sustained throughout the balance of the year there will be a reversal of the trends noted during the first half of 2008.
Amortization (which is included in cost of sales and SG&A expense) in the first six months of 2008 was $2.1 million less than in 2007. This decrease is directly attributable to fully amortized assets, the sale of the South Dakota facility, the write down of idle assets, the write down of the customer relationship, and the effects of the strengthening of the Canadian dollar relative to the United States dollar offset by the additional amortization in 2008 on the $3.8 million of capital expenditures made during the twelve-month period ended June 30, 2008 together with the full period amortization of the $2.6 million of capital expenditures made during the six months ended June 30, 2007.
Financial expenses were $0.9 million higher during the six months ended June 30, 2008 than in the first half of 2007. The Fund recorded a loss of $0.2 million on interest rate swaps during the first half of 2008 compared to a gain of $0.6 million in the same period last year. Excluding the effect of accounting for the interest rate swaps, interest expense increased by $0.9 million, reflecting both the higher interest rates and the higher amounts borrowed this year. Offsetting this comparative increase, the amendments to the Agreements with the Fund’s Lenders were such that under GAAP, for accounting purposes, they resulted in a settlement of the original senior secured notes facility. As a consequence, during the first half of 2007 it was necessary to write off $1.1 million in costs associated with the establishment of the original facility. This compares to the almost $0.3 million in amortization of deferred commitment fees reflected in the six months ended June 30, 2008 and this accounts for virtually all of the remaining comparative difference.
The Fund operates using a number of different legal structures (e.g., partnerships, trusts, corporations etc.) in a number of jurisdictions. Each of these structures and jurisdictions is subject to income tax at different rates. The effective tax rate can vary from quarter-to-quarter, depending on the taxing jurisdiction and the legal structure in which the income is earned. Since the Fund has approximately $69.5 million in available tax losses it is not expecting to pay any current income taxes for the foreseeable future.
Loss before non-controlling interest of Class B Exchangeable Units (“Class B Units”) for the six months ended June 30, 2008, was $1.5 million, compared to a loss of $32.1 million for the six months ended June 30, 2007.
Liquidity
During the six months ended June 30, 2008, the Fund generated cash flow from operations of $2.9 million. This amount was increased by $1.2 million as a result of changes in non-cash working capital items. The most significant of these changes related to accounts payable and prepaid expenses. Accounts payable were reduced by $0.6 million, primarily reflecting the payment timing of inventory and other purchases during the period. Inventory, which had grown by approximately $3.0 million during the first quarter of 2008, was reduced by $3.3 million during the second quarter as the Fund brought inventory levels into line with ongoing sales for a net decline of $0.3 million. Prepaid expenses were reduced by $0.9 million due primarily to the timing of prepaid items being incurred and amortized. The $0.2 million decrease in accounts receivable reflects the timing of sales during the second quarter of 2008.
No distributions were declared during the first half of 2008.
On May 14, 2007, the Fund reached an agreement with its Lenders to modify the terms of its existing credit facilities. This arrangement modified the terms governing the US$30 million bank and the non-revolving US$85 million senior secured notes facilities and increased the bank facility by US$20 million. On October 19, 2007 the Fund reached agreement with its Lenders to further modify the terms of its credit facilities given changes in estimated recall costs and the restructuring of the Fund’s operations. The available bank facility was reduced by US$2.5 million on each of September 30, 2007, October 19, 2007 and March 31, 2008 and was to be further reduced by US$2.5 million on June 30, 2008, September 30, 2008, December 31, 2008, March 31, 2009 and June 30, 2009 at which time the additional US$20 million facility will have been extinguished. During June 2008 the Fund agreed with its Lenders to defer the reductions due on June 30, 2008 and September 30, 2008 until December 31, 2008, at which time the reductions in respect of the last three quarters of 2008 will still aggregate to US$7.5 million. The Fund had drawn or committed US$32,196 ($32,830) of the US$42.5 million bank facility on June 30, 2008. Cash flow from operations, together with the remaining unutilized bank facilities, the expected proceeds from the sale of assets and working capital management, is expected to be sufficient to fund Menu’s normal, ongoing operating requirements and maintenance capital expenditures.
Various legal actions and investigations have been commenced against the Fund as a consequence of the product recall. It is possible that additional actions or investigations may arise in the future. The Fund expects to expend significant amounts and to devote considerable management time to these matters. It is not possible to predict the amount of such expenses, the resolution of any claims or investigations, or the extent to which these items will be paid by insurance. Furthermore, if the actual cost of the recall and restructuring exceed management’s estimates of $55 million and $5.4 million, respectively or if the degree to which business is re-established is unexpectedly low, the Fund may need to obtain additional credit facilities, although there can be no assurances that such facilities would be available.
Initiatives have been ongoing to reach a mediated settlement in respect of the purported class actions referenced above. On May 30, 2008, the United States District Court for the District of New Jersey preliminarily approved the comprehensive settlement agreement in the pet food multi-district litigation. The settlement agreement would resolve more than 100 class action lawsuits filed in the U.S. and Canadian courts. Similar motions for approval were subsequently granted by the Canadian courts. Motions for final approval of the settlement agreement have been scheduled in the U.S. District Court for October 14, 2008 and in various Canadian courts for November 3, 2008.
Capital Resources
During the six months ended June 30, 2008, Menu spent $2.0 million, net of the proceeds of sale, on capital assets. Capital expenditures, which the Fund defines as being of a maintenance nature for purposes of determining Distributable Cash, which totalled $1.3 million for the six months ended June 30, 2008, were financed from the cash flow of the business. These maintenance capital expenditures were over and above the $4.5 million (2007 – $6.4 million) for labour and parts expended by Menu for the ongoing repairs and maintenance of its plants that have been expensed as part of cost of sales. Capital expenditures of a growth nature totalled $1.0 million for the six months ended June 30, 2008.
Outstanding Units
The following table highlights the number of units outstanding:
Class B
Trust Units Exchangeable
Units
December 31, 2005 17,766,159 11,133,655
Conversion of Class B Units during the year 1,236,431 (1,236,431)
Options exercised during the year 74,683 --
------------------------------
December 31, 2006 19,077,273 9,897,224
Conversion of Class B Units during the year 1,274,635 (1,274,635)
Options exercised during the year 9,746 --
------------------------------
December 31, 2007 and June 30, 2008 20,361,654 8,622,589
------------------------------
During the year ended December 31, 2007, 390,156 unit options with an exercise price of $7.34 were granted to 47 employees; 18,390 unit options with an exercise price of $3.00 were granted to one employee; 1,189,300 unit options with an exercise price of $1.82 were granted to 70 employees; and 21,000 unit options with an exercise price of $0.92 were granted to one employee. These options vest in equal annual amounts over three years and will expire 39 months after the day they were granted. During the year ended December 31, 2007, 219,416 unit options with an exercise price of $4.56; 21,000 unit options with an exercise price of $5.00; 21,000 unit options with an exercise price of $6.20; 6,000 unit options with an exercise price of $6.55; and 87,588 unit options with an exercise price of $7.34 were forfeited. During the year ended December 31, 2007, 9,746 options with an exercise price of $4.56 were exercised by one employee.
On June 30, 2008, the Fund agreed to issue 1 million five-year Trust Unit warrants in the Fund as part of the settlement of certain claims against the Fund relating to the recall. The Trust Unit warrants will be issued on August 22, 2008 at fair market value.
Controls and Procedures
Multilateral Instrument No. 52-109 (“MI 52-109”) requires the Fund’s Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”) to make certain certifications related to the information contained in the Fund’s annual filings. Specifically, the CEO and CFO must acknowledge that they are responsible for establishing and maintaining disclosure controls and procedures and internal controls over financial reporting for the Fund. In addition, in respect of:
(a) Disclosure Controls and Procedures
The CEO and CFO must certify that they have designed the disclosure controls and procedures, or caused them to be designed under their supervision, to provide reasonable assurance that material information relating to the Fund, including its consolidated subsidiaries, is made known to them in a timely manner.
As at June 30, 2008, the Fund’s management, under the supervision of, and with the participation of the CEO and CFO, evaluated the design of the disclosure controls and procedures. Based on this evaluation, the CEO and CFO have concluded that as at June 30, 2008, the Fund’s disclosure controls and procedures were appropriately designed.
Consistent with the concept of reasonable assurance, the Fund recognizes that the relative cost of maintaining these controls and procedures should not exceed their expected benefits. As such, the Fund’s disclosure controls and procedures can only provide reasonable, and not absolute, assurance that the objectives of such controls and procedures are met.
(b) Internal Controls over Financial Reporting
The CEO and CFO must certify that they have designed such internal controls over financial reporting, or caused them to be designed under their supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with GAAP.
Consistent with the concept of reasonable assurance, the Fund recognizes that the relative cost of maintaining these controls should not exceed their expected benefits. As such, the Fund’s internal controls over financial reporting can only provide reasonable, and not absolute, assurance that the objectives of such controls are met.
No material changes were made to the design of the internal controls over financial reporting during the three-month period ended June 30, 2008.
Recent Canadian accounting pronouncements issued and not yet adopted
The Accounting Standards Board has adopted a strategic plan that will have GAAP converge with International Financial Reporting Standards (“IFRS”) effective January 2011. The Fund will commence its planning and transition from GAAP to IFRS during 2008.
Outlook
Product Recall and Litigation
On March 16, 2007, the Fund announced the recall of a portion of the dog and cat food it manufactured between December 3, 2006 and March 6, 2007. This recall was primarily related to “cuts and gravy” style pet food in cans and pouches manufactured at two of the Fund’s United States facilities. These products were both manufactured and sold under private-label and were contract-manufactured for some national brands.
On March 24, 2007, the Fund instituted a withdrawal of all varieties of recalled pet food, regardless of the dates, to reduce the risk that any recalled product might remain on the retailer’s shelves. On April 5, 2007, Menu expanded the recall to include certain products manufactured by its Emporia, Kansas plant between November 8, 2006 and December 2, 2006. This was necessary to align the Fund’s recall with that of the supplier of the adulterated ingredient. On April 10, 2007, Menu expanded the recall to include some limited production from its Streetsville, Ontario facility. Finally, on April 17, 2007, May 2, 2007 and May 22, 2007, the Fund made some further refinements to the list of recalled products.
Throughout this period of time, the Fund worked closely with regulatory authorities and its customers to learn as much as it could about the cause for the recall. It was ultimately determined that the contaminated ingredient was wheat gluten adulterated with melamine and related compounds. This ingredient was imported from China by a broker in the United States. Subsequent to Menu’s recall a number of other significant companies in the pet food industry, who had also purchased wheat gluten from this same broker, followed suit and instituted recalls of their own. As it transpired, the Fund, the pet food industry, our customers and consumers were all victims of a fraud of monumental proportions.
The Fund estimates that, based on currently available information, the direct costs associated with this recall, which will be financed from a combination of internally generated cash flow, proceeds from asset sales and bank credit facilities, will approximate $55 million, which had a significant impact on the results for the year ended December 31, 2007.
On May 14, 2007 the Fund reached an agreement with its Lenders to increase the amount available under the bank facility and on May 14, 2007 and again on October 19, 2007 to modify the terms of its existing facility. Management expects that the direct and indirect costs of the recall will lead to a further utilization of available credit facilities by the Fund. The amended agreements increase the rates of interest paid by the Fund. Both of these changes are expected to increase the Fund’s financial expenses going forward.
Lawsuits have been initiated against the Fund and certain of its subsidiaries in the United States and in Canada, which seek to recover damages on behalf of the named plaintiffs and a purported class of pet owners. Furthermore, the U.S. Food and Drug Administration is conducting an investigation into the situation. The United States Attorney for the Western District of Missouri, based in Kansas City, has informed Menu that it is the target of a criminal investigation for possible violations of the U.S. Federal Food, Drug and Cosmetic Act. It is possible that additional actions or investigations may arise in the future. The Fund expects to expend significant amounts and devote considerable management time to these matters. The Fund cannot predict the amount of such expenses, the resolution of any claims or investigations, the extent to which these items will be paid by the Fund’s insurers, or whether the Fund will have sufficient resources to pay any or all of these items.
Initiatives have been ongoing to reach a mediated settlement in respect of the purported class actions referenced above. On May 30, 2008, the United States District Court for the District of New Jersey preliminarily approved the comprehensive settlement agreement in the pet food multi-district litigation. The settlement agreement would resolve more than 100 class action lawsuits filed in the U.S. and Canadian courts. Similar motions for approval were subsequently granted by the Canadian courts. Motions for final approval of the settlement agreement have been scheduled in the U.S. District Court for October 14, 2008 and in various Canadian courts for November 3, 2008.
The settlement agreement creates a settlement fund of US$24 million that will allow a potential recovery of up to 100% of all economic damages incurred by pet owners, subject to certain limitations. The settlement fund, administered by a neutral claims administrator, will be available to persons in the United States and Canada who purchased or obtained, or whose pets used or consumed, recalled pet food. Pursuant to the settlement agreement, the settlement fund will be funded by the defendants, including Menu Foods Income Fund and its
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For more information, please contact Menu Foods GenPar Limited |
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