SCHAWK INC - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations

(Edgar Glimpses Via Acquire Media NewsEdge) Cautionary Statement Regarding Forward-Looking Information Certain statements contained herein and in "Item 1. Business" that relate to the Company's beliefs or expectations as to future events are not statements of historical fact and are forward-looking statements within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act. The Company intends any such statements to be covered by the safe harbor provisions for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995. Although the Company believes that the assumptions upon which such forward-looking statements are based are reasonable within the bounds of its knowledge of its industry, business and operations, it can give no assurance the assumptions will prove to have been correct and undue reliance should not be placed on such statements. Important factors that could cause actual results to differ materially and adversely from the Company's expectations and beliefs include, among other things, the strength of the United States economy in general and, specifically, market conditions for the consumer products industry in the U.S. and abroad; the level of demand for the Company's services; unfavorable foreign exchange fluctuations; changes in or weak consumer confidence and consumer spending; loss of key management and operational personnel; the ability of the Company to implement its business strategy and cost reduction plans and to realize anticipated cost savings; the ability of the Company to comply with the financial covenants contained in its debt agreements and obtain waivers or amendments in the event of non-compliance; the ability of the Company to maintain an effective system of disclosure and internal controls and the discovery of any future control deficiencies or weaknesses, which may require substantial costs and resources to rectify; the stability of state, federal and foreign tax laws; the ability of the Company to identify and capitalize on industry trends and technological advances in the imaging industry; higher than expected costs associated with compliance with legal and regulatory requirements; higher than anticipated costs or lower than anticipated benefits associated with the Company's ongoing information technology and business process improvement initiative or unanticipated costs or difficulties associated with integrating acquired operations; any impairment charges due to declines in the value of the Company's fixed and intangible assets, including goodwill; the stability of political conditions in foreign countries in which the Company has production capabilities; terrorist attacks and the U.S. response to such attacks; as well as other factors detailed in the Company's filings with the Securities and Exchange Commission. The Company assumes no obligation to update publicly any of these statements in light of future events.

20-------------------------------------------------------------------------------- Table of Contents Executive Overview Marketing, promotional and advertising spending by consumer products companies and retailers drives a majority of the Company's revenues. The markets served are primarily consumer products, pharmaceutical, entertainment and retail. The Company's principal business in this area involves producing graphic images for various applications.

Generally, the Company or a third party creates an image and then the image is manipulated to enhance the color and to prepare it for print. The applications vary from consumer product packaging, including food and beverage packaging images, to retail advertisements in newspapers, including freestanding inserts (FSIs), magazine advertisements and the internet. The graphics process is generally the same regardless of the application. The following steps in the graphics process must take place to produce a final image: · Strategic Analysis · Planning and Messaging · Conceptual Design · Content Creation · File Building · Retouching · Art Production · Pre-Media The Company's involvement with a client's project may involve all of the above steps or just one of the steps, depending on the client's needs. Each client assignment, or ''job,'' is a custom job in that the image being produced is unique, even if it only involves a small change from an existing image, such as adding a ''low fat'' banner on a food package. Essentially, such changes equal new revenue for Schawk. The Company is paid for its graphic imaging work regardless of the success or failure of the food product, the promotion or the ad campaign.

Historically, a substantial majority of the Company's revenues have been derived from providing graphic services for consumer product packaging applications.

Packaging changes occur with regular frequency and lack of advance notice, and client turn-around requirements are tight, thereby creating little backlog.

There are regular promotions throughout the year that create revenue opportunities for the Company, such as: Valentine's Day, Easter, Fourth of July, Back-to-School, Halloween, Thanksgiving and Christmas. In addition, there are event-driven promotions that occur regularly, such as: the Super Bowl, Grammy Awards, World Series, Indianapolis 500 and the Olympics. Changing regulatory requirements also necessitate new packaging from time to time, as do the number of health related ''banners'' that are added to food and beverage packaging, such as ''heart healthy,'' ''low in carbohydrates,'' ''enriched with essential vitamins,'' ''low in saturated fat'' and ''caffeine free.'' All of these items require new product packaging designs or changes in existing designs, in each case creating additional opportunities for revenue. Graphic services for the consumer products packaging industry generally involve higher margins due to the substantial expertise necessary to meet consumer products companies' precise specifications and to quickly, consistently and efficiently bring their products to market, as well as due to the complexity and variety of packaging materials, shapes and sizes, custom colors and storage conditions.

Through several acquisitions in 2004 and 2005, the Company increased the percentage of its revenue derived from providing graphics services to advertising and retail clients and added to its service offering graphic services to the entertainment market. These clients typically require high volume, commodity-oriented premedia graphic services. Graphic services for these clients typically yield relatively lower margins due to the lower degree of complexity in providing such services, and the number and size of companies in the industry capable of providing such services.

In 2012, approximately 7.8 percent of the Company's total revenues came from its largest single client. While the Company seeks to build long-term client relationships, revenues from any particular client can fluctuate from period to period due to the client's purchasing patterns. Any termination of or significant reduction in the Company business relationship with any of its principal clients could have a material adverse effect on its business, financial condition and results of operations.

During 2013, the Company expects to continue to implement operational and work force alignment actions, including continuing to focus on realigning the Company's management and organizational structure to provide, among other things, greater consistency and more common approaches to the services the Company provides to its clients. While the Company anticipates these actions will benefit the Company and its clients, changes to its organizational structure also may result in increased or unanticipated short-term costs due to the realignment of responsibilities, roles and personnel functions.

21-------------------------------------------------------------------------------- Table of Contents Recent Acquisitions The Company has grown its business through a combination of internal growth and acquisitions. Schawk has completed approximately 60 acquisitions since 1965. The Company's recent acquisitions have significantly expanded its service offerings and its geographic presence, making it the only independent premedia firm with substantial operations in the Americas, Europe, Asia and Australia. As a result of these acquisitions, the Company is able to offer a broader range of services to its clients. Its expanded geographic presence also allows us to better serve its multinational clients' demands for global brand consistency.

Lipson Associates, Inc. and Laga, Inc. Effective October 19, 2011, the Company acquired substantially all of the assets of Lipson Associates, Inc. and Laga, Inc., which does business as Brandimage - Desgrippes & Laga ("Brandimage") and the assumption of certain trade account and business related liabilities.

Brandimage provides services that seek to engage and enhance the brand experience, including brand positioning and strategy, product development and structural design, package design and environmental design. Brandimage operates in Chicago, Cincinnati, Paris, Brussels, Shanghai, Seoul and Hong Kong.

Brandimage operates in conjunction with Schawk's current brand development capabilities, which are performed under its Anthem Worldwide brand. The net assets and results of operations of Brandimage are included in the Consolidated Financial Statements as of October 19, 2011 in the Americas, Europe and Asia Pacific operating segments. The purchase price was $24.6 million, consisting of $27.0 million paid in cash at closing, less $2.4 million received for a net working capital adjustment.

Real Branding LLC. Effective November 10, 2010, the Company acquired Real Branding LLC ("Real Branding"), a United States - based digital marketing agency. Real Branding provides digital marketing services to consumer product and entertainment clients through its locations in San Francisco and New York.

The net assets and results of operations of Real Branding are included in the Consolidated Financial Statements as of November 10, 2010 in the Americas operating segment. This business was acquired to strengthen the Company's ability to offer integrated strategic, creative and executional services across digital consumer touchpoints. The purchase price was $9.6 million, which included $3.4 million originally recorded as an estimated liability to the sellers for contingent consideration based on performance of the business for the years 2011 through 2014. The Company has determined, based on actual performance and current future projections, that no contingent consideration will be payable for any of the years covered by the acquisition agreement.

Untitled London Limited. Effective September 17, 2010, the Company acquired the operating assets of Untitled London Limited, a United Kingdom-based agency that provides strategic, creative and technical services for digital marketing. The net assets and results of operations of Untitled London Limited are included in the Consolidated Financial Statements in the Europe operating segment, effective September 17, 2010. This business was acquired to expand the Company's digital marketing capabilities in Europe. The purchase price was approximately $0.9 million.

Brandmark International Holding B.V. Effective December 31, 2008, the Company acquired 100 percent of the outstanding stock of Brandmark International Holding B.V., a Netherlands-based brand identity and creative design firm. Brandmark provides services to consumer products companies through its locations in Hilversum, the Netherlands and London, United Kingdom. The net assets of Brandmark are included in the Consolidated Financial Statements as of December 31, 2008, in the Europe operating segment. The purchase price was $10.5 million, subject to contingent additional purchase consideration of up to $0.7 million if a specified target of earnings before interest and taxes was achieved for the fiscal year ended March 31, 2009. During 2010, the Company and the former owners of Brandmark settled the contingent additional purchase consideration for a minimal amount.

Marque Brand Consultants Pty Ltd. Effective May 31, 2008, the Company acquired 100 percent of the outstanding stock of Marque Brand Consultants Pty Ltd, an Australia-based brand strategy and creative design firm that provides services to consumer products companies. The net assets and results of operations of Marque are included in the Consolidated Financial Statements in the Asia Pacific operating segment beginning June 1, 2008. The purchase price was $2.5 million and was subject to adjustment if certain thresholds of net sales and earnings before interest and taxes were exceeded for calendar years 2008 and 2009. The Company paid $0.2 million and $0.4 million as purchase price adjustments for the years ended December 31, 2008 and December 31, 2009, respectively.

22-------------------------------------------------------------------------------- Table of Contents Financial Results Overview Net sales increased $5.4 million or 1.2 percent for the year ended December 31, 2012 to $460.7 million from $455.3 million for 2011. The sales increase in 2012 compared to the prior year reflects an increase in sales from the Company's consumer products packaging accounts partially offset by a decrease in sales from the Company's advertising and retail and entertainment accounts. The sales increase in 2012 attributable to the increase in sales from acquisitions during 2012 compared to 2011 was $22.5 million, or 4.9 percent of total sales.

Excluding the impact of acquisitions, revenue would have decreased by $17.1 million or 3.8 percent. Sales in 2012 compared to the prior year were negatively impacted by changes in foreign currency translation rates of approximately $3.1 million, as the U.S. dollar increased in value relative to the local currencies of certain of the Company's non-U.S. subsidiaries. Net sales increased in the Europe and Asia Pacific segments in 2012 compared to the prior year, but were partially offset by a small decrease in sales in the Americas segment of $0.2 million, or 0.1 percent. The Europe segment increased by $8.5 million, or 11.3 percent and the Asia Pacific segment increased by $5.2 million, or 15.5 percent.

The Company's inventories, composed principally of the cost of unbilled client services, decreased by $2.6 million at December 31, 2012 compared to December 31, 2011.

Cost of sales was $303.5 million, or 65.9 percent of sales, in 2012, an increase of $10.5 million, or 3.6 percent, from $293.0 million, or 64.4 percent of sales, in 2011. The increase in cost of sales during 2012 compared to 2011 was mainly due to an increase in labor costs reflecting the Company's recent acquisitions and expansion of client service offerings.

Gross profit decreased by $5.0 million or 3.1 percent in 2012 to $157.3 million from $162.3 million in 2011. The decline in gross profit in 2012 compared to the prior year is attributable to the increased cost of sales year-over-year as mentioned above, partially offset by a small increase in net sales. Gross profit in the Americas operating segment decreased by $8.5 million or 6.9 percent.

Gross profit in the Europe operating segment increased by $2.5 million or 9.9 percent and increased in the Asia Pacific operating segment by $1.0 million or 6.6 percent.

The Company recorded an operating loss of $30.7 million in 2012 compared to an operating profit of $27.3 million in 2011, a decrease of $58.0 million. A significant portion of the operating loss in 2012 is attributable to a charge of $31.5 million related to the Company's decision to withdraw from a multiemployer pension plan, compared to pension plan withdrawal liability charges of $1.8 million recorded in 2011, an increase in expense year-over-year of $29.6 million. The remainder of the operating loss in 2012 compared to the prior year's operating income was due to lower gross profit in 2012 compared to the prior year as well as increases in expenses as further described below: Selling, general and administrative expenses increased $10.8 million, or 8.8 percent, in 2012 to $132.8 million from $122.0 million in 2011. Included in selling, general and administrative expenses for 2011 is a credit to income of approximately $3.3 million for a reduction in estimated contingent consideration payable related to the Company's 2010 acquisition of Real Branding compared to a credit to income of approximately $0.2 million in 2012 for the reversal of the remaining estimated contingent consideration payable for this acquisition. Also included in selling, general and administrative expenses for 2011 is a credit to income of approximately $0.8 million for the settlement of a lawsuit related to enforcement of a non-compete agreement with the former owner of a business acquired by the Company. In addition, selling, general and administrative expenses for 2011 were reduced by approximately $1.0 million related to reserve reductions for certain of the Company's vacant leased properties, for which changed circumstances required revisions in the estimates of future expenses related to the leases. This compares to an expense of approximately $0.5 million in 2012 for reserve increases for certain of the Company's vacant leased properties, for which changed circumstances required revisions in the estimates of future expenses related to the leases. Also included in selling, general and administrative expenses for 2011 is a credit to income of approximately $0.8 million for a reduction in an employment tax reserve related to an acquisition completed in 2008 and for which the statute of limitations has partially expired. This compares to a credit to income of approximately $0.4 million in 2012 for a further reduction in this employment tax reserve due to additional statute of limitations lapses. Excluding the effect of these credits to income in each respective year, the increase in selling, general and administrative expenses in 2012 compared to 2011 is principally due to increases in employee-related costs.

Business and systems integration expenses related to the Company's information technology and business process improvement initiative increased $3.6 million to $12.1 million in 2012 from $8.5 million in 2011. Acquisition integration and restructuring expenses, related to the Company's cost reduction and capacity utilization initiatives, were $5.4 million in 2012 compared to $1.5 million in 2011. In addition, the Company recorded $4.4 million for impairment of long-lived assets in 2012, of which $3.8 million related to customer relationship intangible assets at Company locations being restructured where projected cash flows did not support the carrying value of the assets and $0.6 million for fixed assets, principally for real estate that was written down to its estimated market value. In 2011, there were impairment charges of less than $0.1 million. The Company recorded a net loss of $1.8 million on foreign exchange exposures in 2012 as compared to a net loss of $1.1 million in 2011.

The Company recorded an income tax benefit of $10.8 million in 2012 compared to an income tax expense of $1.5 million in the prior year. The effective tax rate was 31.5 percent for 2012 compared to an effective tax rate of 6.8 percent in 2011.

In 2012, the Company recorded a net loss of $23.4 million, or $0.90 per diluted share, as compared to net income of $20.6 million, or $0.79 per diluted share, in 2011. The decrease in profitability, year-over-year, is principally due to increased expenses related to the Company's multiemployer pension plan withdrawal liability, information technology and business process improvement initiatives, the ongoing acquisition integration and restructuring efforts and the impairment of long-lived assets recorded in 2012, coupled with relatively flat sales compared to the prior year.

23-------------------------------------------------------------------------------- Table of Contents Goodwill impairment The Company's intangible assets not subject to amortization consist entirely of goodwill. The Company performs a goodwill impairment test annually, or when events or changes in business circumstances indicate that the carrying value may not be recoverable. The Company performs its annual impairment test as of October 1 each year.

The Company performed the required goodwill impairment tests for 2012 and 2011 as of October 1, 2012 and October 1, 2011, respectively. The Company allocated its goodwill on a geographic basis to its operating segments, which were determined to be reporting units for goodwill impairment testing. Using projections of operating cash flow for each reporting unit, the Company performed a step one assessment of the fair value of each reporting unit as compared to the carrying value of each reporting unit. The step one impairment analysis indicated no impairment of the goodwill for either year.

Cost reduction and capacity utilization actions Beginning in 2008 and continuing to-date, the Company incurred restructuring costs for employee terminations, obligations for future lease payments, fixed asset impairments, and other associated costs as part of its previously announced plan to reduce costs through a consolidation and realignment of its work force and facilities. The total expense recorded for 2012 was $5.4 million and is presented as Acquisition integration and restructuring expense in the Consolidated Statements of Comprehensive Income (Loss).

The expense for the years 2008 through 2012 and the cumulative expense since the cost reduction program's inception was recorded in the following operating segments: Asia (in millions) Americas Europe Pacific Corporate Total Year ended December 31, 2012 $ 4.4 $ 0.9 $ 0.1 $ -- $ 5.4 Year ended December 31, 2011 0.8 0.6 -- 0.1 1.5 Year ended December 31, 2010 1.3 0.5 -- 0.5 2.3 Year ended December 31, 2009 3.6 1.4 1.0 0.4 6.4 Year ended December 31, 2008 5.7 3.6 0.2 0.9 10.4 Cumulative since program inception $ 15.8 $ 7.0 $ 1.3 $ 1.9 $ 26.0 It is estimated that cost savings resulting from the 2012 cost reduction actions was approximately $5.5 million for 2012 and will be approximately $16.6 million for 2013. Cost savings resulting from the 2011 cost reduction actions is estimated to have been approximately $2.0 million for 2011 and $5.0 million annually over the subsequent two-year period. Cost savings resulting from the 2010 cost reduction actions is estimated to have been approximately $4.9 million for 2010 and $10.9 million annually over the subsequent two-year period. Cost savings resulting from the 2009 cost reduction actions is estimated to have been approximately $8.9 million during 2009 and $15.6 million annually over the subsequent two-year period. Cost savings resulting from the 2008 cost reduction actions is estimated to have been approximately $7.4 million during 2008 and $21.9 million annually over the subsequent two-year period.

Multiemployer pension withdrawal expense The Company has eight bargaining units in the United States that participate in the GCC/IBT National Pension Plan pursuant to a number of collective bargaining agreements. In December 2012, the Schawk Board of Directors authorized management to enter into good faith negotiations with the local bargaining units to effect a complete withdrawal from the pension plan. The decision to exit the plan was made in order to mitigate potentially greater financial exposure to the Company in the future under the plan, which is significantly underfunded, and to facilitate the consideration of future changes to the Company's operations in the United States. Based on an analysis prepared by an independent actuary, the Company recorded an estimated liability for its withdrawal from the pension plan of $31.7 million, which is the present value of the estimated future payments required for withdrawal. The payments are expected to total approximately $41.2 million, payable $2.1 million per year over a 20 year period, with the payments expected to commence on or about May 1, 2014. These payments were discounted at a risk free rate of 2.54 percent. The expense associated with the pension withdrawal liability is reflected in Multiemployer pension withdrawal expense on the Consolidated Statements of Comprehensive Income (Loss). The liability is included in Other long-term liabilities on the Consolidated Balance Sheets as of December 31, 2012.

In 2011, the Company decided to terminate participation in the San Francisco Lithographers Pension Trust and provided notification that it would no longer be making contributions to the plan. Under the Employee Retirement Income Security Act of 1974, the Company's decision triggered a withdrawal liability. The Company recorded an estimated liability of $1.8 million as of December 31, 2011 to reflect this obligation. The expense associated with the pension withdrawal liability is reflected in Multiemployer pension withdrawal expense on the Consolidated Statements of Comprehensive Income (Loss). The liability, which is included in Accrued expenses on the Consolidated Balance Sheets as of December 31, 2011, was settled during 2012 with a cash payment of $1.6 million.

24-------------------------------------------------------------------------------- Table of Contents Impairment of long-lived assets The following table summarizes the impairment of long-lived assets by asset category for the periods presented in this Form 10-K: Year Ended December 31, (in millions) 2012 2011 2010 Intangible assets, other than goodwill $ 3.8 $ -- $ -- Land and buildings 0.5 -- -- Other fixed assets 0.1 -- 0.7 Total $ 4.4 $ -- $ 0.7 For the year ended December 31, 2012, impairment charges of $4.4 million are included in Impairment of long-lived assets on the Consolidated Statements of Comprehensive Income (Loss). The impairment of long-lived assets includes $3.8 million related to impairments of intangible assets and $0.6 million related to impairment of fixed assets. The intangible asset impairment charges are for customer relationship intangible assets at Company locations currently being restructured for which projected cash flows do not support the carrying values.

The fixed asset impairment charges are comprised of $0.5 million related to Company-owned real estate which was written down to its estimated market value in anticipation of a sale expected to close in 2013 and $0.1 million related to production equipment.

In addition, for the year ended December 31, 2012, impairment charges of $0.2 million are included in Acquisition integration and restructuring expenses on the Consolidated Statements of Comprehensive Income (Loss). These impairment charges relate to building improvements at Company facilities that are being combined with other operating facilities or shut-down and relate to the Company's ongoing restructuring and cost reduction initiatives.

During 2011, charges of less than $0.1 million were recorded for impairment of long-lived assets. In addition, there were $0.3 million of impairments, primarily for leasehold improvements related to the Company's cost reduction and capacity utilization initiatives which are included in Acquisition integration and restructuring expenses on the Consolidated Statements of Comprehensive Income (Loss).

During 2010, certain newly purchased and installed production equipment sustained water damage and became no longer operable. The Company recorded an impairment charge in 2010 in the amount of $0.7 million, the net book value of the damaged equipment, which is included in Impairment of long-lived assets in the Consolidated Statements of Comprehensive Income (Loss). The Company maintains insurance coverage for property loss, business interruption, and directors and officers liability and records insurance recoveries in the period in which the insurance carrier validates the claim and confirms the amount of reimbursement to be paid. The loss sustained for the water-damaged production equipment was recovered by an insurance settlement during 2010, which was recorded as a reduction of Selling, general and administrative expenses on the Consolidated Statements of Comprehensive Income (Loss). See Item 8, Note 6 - Impairment of Long-lived Assets and Insurance Recoveries for additional information regarding this and other insurance recoveries.

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