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DIAMOND FOODS INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) Overview Diamond Foods, Inc. ("Diamond," the "Company," or "we") is an innovative packaged food company focused on building and energizing brands. We specialize in processing, marketing and distributing snack and nut products, including culinary, in-shell and ingredient nuts. In 2004, we complemented our heritage in the culinary nut market under the Diamond of California® brand by 22-------------------------------------------------------------------------------- Table of Contents launching a line of nut varieties under the Emerald®brand. In 2008, we acquired the Pop Secret® brand of microwave popcorn products, which provided us with increased scale in the snack market, supply chain economies of scale and cross promotional opportunities with our existing brands. In 2010, we acquired Kettle Foods, a leading premium potato chip company in the two largest potato chip markets in the world, the United States and the United Kingdom, which added the complementary premium Kettle Brand ® to our existing portfolio of brands in the snack market. In general, we sell directly to retailers, particularly large national grocery store and drug store chains, and indirectly through wholesale distributors to independent and small regional retail grocery store chains and convenience stores. We sell our products to global, national, regional and independent grocery, drug and convenience store chains, as well as to mass merchandisers, club stores, other retail channels and non-retail channels. Our business is seasonal. Demand for nut products, particularly in-shell nuts and to a lesser extent culinary nuts, is highest during the months of October, November and December. In sourcing walnuts, we contract directly with growers for their walnut crop. We typically receive walnuts during the period from September to November, and we pay for the crop throughout the year in accordance with our walnut purchase agreements with the growers. We typically receive pecans during the period from October to March, and we pay for our pecan receipts over such period. As a result of this seasonality, our personnel and working capital requirements and walnut inventories peak during the last four months of the calendar year. We experience seasonality in capacity utilization at our Stockton, California facility associated with the annual walnut harvest and seasonal in-shell and culinary product demand. Generally, we receive and pay for approximately 50% of the corn for popcorn in November, and approximately 50% in April. We contract for potatoes and oil annually and receive and pay for supply throughout the year. Generally, demand for potato chips is highest in the months of June, July and August in the United States, and November and December in the United Kingdom. Accordingly, the working capital requirement of our popcorn and potato chip product lines is less seasonal than that of the tree nut product lines. Results of Operations The Company's chief operating decision maker ("CODM") changed during the fourth quarter of fiscal 2012, and in the second quarter of fiscal 2013, there was a change in the information used by the CODM to make decisions about the allocation of resources and the assessment of performance. As a result, during the second quarter of fiscal 2013, the Company changed its operating and reportable segments. The Company previously had one operating segment and one reportable segment; it now aggregates its operating segments into two reportable segments, which are Snacks and Nuts. The Snacks reportable segment includes products sold under the Kettle U.S., Kettle U.K. and Pop Secret brands. The Nuts reportable segment includes products sold under the Emerald and Diamond of California brands. The Company evaluates the performance of its segments based on net sales and gross margin for each of the segments. Gross profit is calculated as net sales less all cost of sales. Our net sales and gross profit by segment for the periods identified below were as follows (in thousands): Three Months Ended Six Months Ended January 31, % Change from January 31, % Change from 2013 2012 2012 to 2013 2013 2012 2012 to 2013 Net sales Snacks $ 105,421 $ 98,356 7% $ 216,664 $ 209,258 4% Nuts 115,423 163,995 -30% 262,642 340,486 -23% Total $ 220,844 $ 262,351 -16% $ 479,306 $ 549,744 -13% Gross profit Snacks $ 34,836 $ 28,448 22% $ 73,129 $ 63,445 15% Nuts 15,733 13,474 17% 35,986 39,784 -10% Total $ 50,569 $ 41,922 21% $ 109,115 $ 103,229 6% For the three and six months ended January 31, 2013, Snack segment net sales increased to $105.4 million and $216.7 million from $98.4 million and $209.3 million, respectively, primarily driven by an increase in net price realization in both periods, on a 2% volume increase and relatively flat volume, for the three and six months ended January 31, 2013, respectively. For the three and six months ended January 31, 2013, Nuts segment net sales decreased to $115.4 million and $262.6 million from $164.0 million and $340.5 million, respectively, primarily driven by decreases in sales volume of 37.1% and 33.8%, for the three and six months ended January 31, 2013, respectively. The decline in volume was a result of lower walnut supply, and planned reductions in SKUs and promotional spending associated with the Emerald brand. 23 -------------------------------------------------------------------------------- Table of Contents Sales to our largest customer, Wal-Mart Stores, Inc. (which includes sales to both Sam's Club and Wal-Mart), represented approximately 17.3% and 18.4% of total net sales for the three and six months ended January 31, 2013, and 18.2% and 18.3% of total net sales for the three and six months ended January 31, 2012. Sales to our second largest customer, Costco Wholesale Corporation, represented less than 10% of total net sales for the three and six months ended January 31, 2013, and approximately 11.4% and 10.1% of total net sales for the three and six months ended January 31, 2012. No other customer accounted for 10% or more of our total net sales for those periods. The impact of foreign exchange on our net sales for the three and six months ended January 31, 2013 and 2012 was not significant. Gross profit. Snacks segment gross profit as a percentage of net sales was 33.0% and 33.8% for the three and six months ended January 31, 2013 and 28.9% and 30.3% for the three and six months ended January 31, 2012. The increases in Snack segment gross profit as a percentage of net sales for the three and six months ended January 31, 2013, reflects an increase in net price realization. Nuts segment gross profit as a percentage of net sales was 13.6% and 13.7% for the three and six months ended January 31, 2013, and 8.2% and 11.7% for the three and six months ended January 31, 2012. The increases in Nuts segment gross profit as a percentage of net sales for the three and six months ended January 31, 2013, reflects a focus on increasing net price realization, reducing lower performing SKUs, and cost savings initiatives. Selling, general and administrative. Selling, general and administrative expenses consist principally of salaries and benefits for sales and administrative personnel, brokerage, professional services, travel, non-manufacturing depreciation and facility costs. Selling, general and administrative expenses were $32.3 million and $70.4 million for the three and six months ended January 31, 2013, respectively, and $34.3 million and $63.8 million for the three and six months ended January 31, 2012, respectively. Selling, general and administrative expenses as a percentage of net sales were 14.6% and 14.7% for the three and six months ended January 31, 2013, respectively, and 13.1% and 11.6% for the three and six months ended January 31, 2012, respectively. Selling, general and administrative expenses decreased for the three months ended January 31, 2013 over the prior year period, primarily due to lower costs incurred as a result of the audit committee investigation and the reversal of certain previously recorded stock compensation expenses associated with former executives, offset by higher consulting services and audit fees, gain on sale of assets, and employee severance. Selling, general and administrative expenses increased for the six months ended January 31, 2013 over the prior year period primarily due to higher consulting services and audit fees. The increases in expenses as a percentage of net sales for the three and six months ended January 31, 2013, were primarily due to decreases in net sales for those periods. Advertising. Advertising expenses were $12.3 million and $21.3 million for the three and six months ended January 31, 2013, and $11.6 million and $24.4 million for the three and six months ended January 31, 2012. Advertising expenses as a percentage of net sales were 5.6% and 4.5% for the three and six months ended January 31, 2013 and 4.4% and 4.4% for the three and six months ended January 31, 2012. The increase in expenses for the three months ended January 31, 2013 was primarily due to increased advertising spending for Diamond of California related to the 100th anniversary and increased spending related to the continued support of Pop Secret. The decrease in expenses for the six months ended January 31, 2013, was primarily due to a shift in timing of advertising programs to later in fiscal 2013. Acquisition and integration related expenses. Acquisition and integration related expenses include items such as transaction related legal and consulting fees, as well as business and systems integration costs, which were primarily associated with the proposed Pringles merger. Acquisition and integration related expenses were nil for the three and six months ended January 31, 2013, and $12.1 million and $29.3 million for the three and six months ended January 31, 2012. Gain on warrant liability. Gain on warrant liability was $18.6 million and $11.1 million for the three and six months ended January 31, 2013, due to the change in stock price. There was no gain or loss for the three and six months ended January 31, 2012, as the warrant was issued as part of the Oaktree Capital Management L.P. ("Oaktree") transaction in the quarter ended July 31, 2012. For more information regarding the Oaktree transaction, please refer to "Liquidity and Capital Resources." Interest expense, net. Net interest expense was $14.2 million and $28.1 million for the three and six months ended January 31, 2013, and $6.5 million and $12.2 million for the three and six months ended January 31, 2012. The increases were primarily due to higher interest rates and the new Oaktree debt. Additionally, under the Third Amendment, as described below, the interest rates applicable under the Secured Credit Agreement were increased. Please refer to "Liquidity and Capital Resources." Income taxes. The effective tax rates for the three and six months ended January 31, 2013 were approximately 2.5% and 299%, respectively. The effective tax rate difference for the three and six months ended January 31, 2013, from the statutory rate of 35% is primarily due to the valuation allowance which was provided to reduce deferred tax assets to amounts considered recoverable. The negative impact the valuation allowance had on the rate was partially offset by the benefit of income generated in the United Kingdom at lower tax rates. 24-------------------------------------------------------------------------------- Table of Contents The effective tax rates for the three and six months ended January 31, 2012, were approximately 10.6% and 64.5%, respectively. The higher tax rate for the six months ended January 31, 2012, compared to the statutory rate of 35%, was related to a tax benefit of $17.0 million, which included three items. First, we had a discrete tax benefit of $5.5 million, resulting primarily from the conclusion of a tax ruling with the United Kingdom tax authorities and the associated reversal of our unrecognized tax benefit related to this event. Second, during the six months ended January 31, 2012, we incurred acquisition and integration related expenses resulting in a tax benefit of $11.0 million. Third, the forecasted annual tax rate applied to profit before tax and acquisition and integration related expenses, resulted in a tax benefit of $0.5 million. Proposed Pringles Merger Terminated On April 5, 2011, Diamond entered into a definitive agreement with The Procter & Gamble Company ("P&G") to merge P&G's Pringles business into the Company; on February 15, 2012, Diamond and P&G mutually agreed to terminate this proposed merger. No "break-up" fee or other fees were paid to P&G in connection with the termination, which included a mutual release. Liquidity and Capital Resources Our liquidity is dependent upon funds generated from operations and external sources of financing. Cash provided by operating activities was $60.2 million during the six months ended January 31, 2013, compared to $7.1 million cash used in operating activities for the six months ended January 31, 2012. The change from cash used in operating activities to cash provided by operating activities was primarily due to a decrease in net loss, decrease in inventory due to lower walnut supply and a decrease in trade receivables due to lower sales. Additionally there were non-cash reconciling items to net loss during the six months ended January 31, 2013, that did not occur in the six months ended January 31, 2012, such as gain on warrant and payment-in-kind interest on debt. Cash used in investing activities was $4.4 million during the six months ended January 31, 2013, compared to $18.2 million for the six months ended January 31, 2012. The lower cash used in investing activities was primarily due to the completion of our Beloit, Wisconsin plant expansion at the end of fiscal 2012. Cash used in financing activities was $54.4 million during the six months ended January 31, 2013, compared to $23.4 million cash provided by financing activities during the six months ended January 31, 2012, primarily due to decreased borrowings under the revolving credit facility. In February 2010, we entered into an agreement (the "Secured Credit Agreement") with a syndicate of lenders for a five-year $600 million secured credit facility (the "Secured Credit Facility"). We used the borrowings under the Secured Credit Facility to fund a portion of the Kettle Foods acquisition and to fund ongoing operations. Our Secured Credit Facility initially consisted of a $200 million revolving credit facility and a $400 million term loan. In March 2011, the syndicate of lenders approved our request for a $35 million increase in our revolving credit facility to $235 million, under the same terms. In August 2011, the syndicate of lenders approved our request for a $50 million increase in our revolving credit facility to $285 million, under the same terms. In May 2012, the revolving credit facility was reduced from $285 million to $255 million as part of the Third Amendment. As of January 31, 2013, the revolving credit facility had $255 million in capacity, of which $133 million was outstanding. The capacity under the revolving credit facility is scheduled to decrease to $230 million effective July 31, 2013, and to $180 million effective January 31, 2014. In May 2012, we made a $100 million pre-payment on the term loan facility as part of the Third Amendment. As of January 31, 2013, the term loan facility had $217 million in capacity, of which $217 million was outstanding. In addition, scheduled principal payments on the term loan facility are $0.9 million (due quarterly), with the remaining principal balance and any outstanding loans under the revolving credit facility to be repaid on February 25, 2015. Substantially all of our tangible and intangible assets are considered collateral security under the Secured Credit Facility. The Secured Credit Facility provides for customary affirmative and negative covenants and cross default provisions that may be triggered, if we fail to comply with obligations under our other credit facilities or indebtedness. As of January 31, 2013, we had obtained covenant relief under the Third Amendment and were in compliance with all applicable financial covenants. Beginning on October 31, 2013, our senior debt to Consolidated EBITDA ratio, as defined in the Third Amendment, will be limited to no more than 4.70 to 1.00 and our fixed charge coverage ratio to no less than 2.00 to 1.00. The senior debt to Consolidated EBITDA ratio covenant, as defined in the Third Amendment, will decline over four quarters to 3.25 to 1.00 in the quarter ending July 31, 2014. In December 2010, Kettle Foods obtained, and we guaranteed, a 10-year fixed rate loan (the "Guaranteed Loan") in the principal amount of $21.2 million, of which $11.6 million was outstanding as of January 31, 2013. Principal and interest payments are due monthly throughout the term of the loan. The Guaranteed Loan was used to purchase equipment for our Beloit, Wisconsin plant expansion. Borrowed funds were placed in an interest-bearing escrow account and were made available as expenditures were 25-------------------------------------------------------------------------------- Table of Contents approved for reimbursement. As the cash was used to purchase non-current assets, such restricted cash was classified as non-current on the balance sheet. In December 2012, the remaining balance within the escrow account was released back to the lender and was used to pay down the outstanding loan balance. Also, as part of this transaction, we paid a 4% prepayment penalty which was recorded in interest expense. The Guaranteed Loan provides for customary affirmative and negative covenants, which are similar to the covenants under the Secured Credit Facility. The financial covenants within the Guaranteed Loan were reset to match those in the Third Amendment. On March 21, 2012, we reached an agreement with our lenders to forbear from seeking any remedies under the Secured Credit Facility with respect to specified existing and anticipated non-compliance with the credit agreement and to amend our credit agreement ("Second Amendment"). Under the amended credit agreement, we had continued access to our existing revolving credit facility through a forbearance period (initially through June 18, 2012) subject to our compliance with the terms and conditions of the amended credit agreement. During the forbearance period, the interest rate on borrowings increased. The amended credit agreement required us to suspend dividend payments to stockholders. In addition, we paid a forbearance fee of 0.25% to our lenders. The forbearance period concluded on May 29, 2012, when we closed agreements to recapitalize our balance sheet with an investment by Oaktree. The Oaktree investment initially consisted of $225 million of newly-issued senior notes and warrant to purchase approximately 4.4 million shares of Diamond common stock. The senior notes will mature in 2020 and bear interest at 12% per year that may be paid-in-kind at our option for the first two years. Oaktree's warrant became exercisable at $10 per share on March 1, 2013. The Oaktree agreements provide that, if we secure a specified minimum supply of walnuts from the 2012 crop and achieve profitability targets for our nut businesses for the six-month period ended January 31, 2013, the warrant will be cancelled and Oaktree may exchange $75 million of the senior notes for convertible preferred stock of Diamond (the "Special Redemption"). The convertible preferred stock would have an initial conversion price of $20.75, which represents a 3.5% discount to the closing price of Diamond common stock on April 25, 2012, the date that we entered into our commitment with Oaktree. The convertible preferred stock would pay a 10% dividend that would be paid in-kind for the first two years. Based on the Company's operating results for the six months ended January 31, 2013, the Special Redemption did not occur. On May 22, 2012, we entered into the Waiver and the Third Amendment to its Secured Credit Facility ("Third Amendment"), which provided for a lower level of total bank debt, initially at $475 million, along with substantial covenant relief until October 31, 2013. At that time, these covenants will become applicable at revised levels set forth in the Third Amendment (initially 4.70 to 1.00 for the senior leverage ratio, declining over four quarters to 3.25 to 1.00 in the quarter ending July 31, 2014 and thereafter, and 2.00 to 1.00 for the fixed charge coverage ratio for each fiscal quarter). The Third Amendment includes a new covenant requiring that we have at least $20 million of cash, cash equivalents and revolving credit availability at all times, beginning February 1, 2013. Refer below for discussion on how we expect to meet the covenant. In addition, the Third Amendment required a $100 million pre-payment of the term loan facility, while reducing the remaining scheduled principal payments on the term loan facility from $10 million to $0.9 million. The Third Amendment also amended the definition of "Applicable Rate" under the Secured Credit Agreement (which sets the margin over LIBOR and the Base Rate at which loans under the Secured Credit Agreement bear interest). Under the Third Amendment, initially, Eurodollar rate loans will bear interest at 5.50% plus the LIBOR for the applicable loan period, and Base Rate loans will bear interest at 4.50% plus the highest of (i) the Federal Funds Rate plus 0.50%, (ii) the Prime Rate, or (iii) Eurodollar Rate plus 1.00%. The LIBOR rate is subject to a LIBOR floor, initially 1.25%. The Applicable Rate will decline, if and when we achieve specified reductions in our ratio of senior debt to Consolidated EBITDA, as defined in the Third Amendment. The Third Amendment also eliminates the requirement that proceeds of future equity issuances be applied to repay outstanding loans, and waives certain covenants that we were non-compliant with in connection with our restatement of our fiscal 2010 and fiscal 2011 consolidated financial statements. The Secured Credit Facility and the Securities Purchase Agreement, dated as of May 22, 2012, by and between Diamond and OCM PF/FF Adamantine Holdings, Ltd. (the "Oaktree SPA") provide for customary affirmative and negative covenants, and cross default provisions that may be triggered, if we fail to comply with obligations under our other credit facilities or indebtedness. The Secured Credit Facility and the Oaktree SPA included a covenant that restricts the amount of other indebtedness (including capital leases and purchase money obligations for fixed or capital assets), to no more than $25 million. The accounting treatment for the seven-year equipment lease for our Salem, Oregon plant (the "Kettle US Lease") and the five-year equipment lease for our Norfolk, UK plant (the "Kettle UK Lease") caused us to be in default of the covenants limiting other indebtedness. These defaults were waived, with respect to the Kettle UK Lease on July 27, 2012 ("Fourth Amendment"), and with respect to the Kettle US Lease on August 23, 2012 ("Fifth Amendment"). Additionally, the Secured Credit Facility and the Oaktree SPA were each amended to allow the Company to incur up to $31 million of capital leases and purchase money obligations for fixed or capital assets, which amount will be reduced from and after December 31, 2013 (a) to $25 million under the Secured Credit Facility and (b) to $27.5 million under the Oaktree SPA. 26-------------------------------------------------------------------------------- Table of Contents Working capital and stockholders' equity were $33.8 million and $328.6 million at January 31, 2013, compared to $61.6 million and $324.8 million at July 31, 2012, and $53.5 million and $402.1 million at January 31, 2012. The decrease in working capital from January 31, 2012 to January 31, 2013 was primarily due to a decrease in accounts receivable, inventory, current portion of long-term debt, accounts payable and accrued liabilities, and payable to growers of $25.8 million, $38.5 million, $35.9 million, and $44.7 million, and $43.1 million, respectively. In addition, the Company had a warrant liability under the Oaktree SPA of $35.7 million that did not exist as of January 31, 2012. We believe our cash and cash equivalents, cash expected to be provided from our operations, and borrowings available under our Secured Credit Facility, will be sufficient to fund our contractual commitments, repay obligations as required and fund our operational requirements for at least the next 12 months. Contractual Obligations and Commitments Contractual obligations and commitments at January 31, 2013, were as follows (in millions): Payments Due by Period Remainder FY 2014 FY 2016 Total FY 2013 -FY 2015 -FY 2017 Thereafter Revolving line of credit $ 132.7 $ - $ 132.7 $ - $ - Long-term obligations 514.1 2.9 220.0 5.0 286.2 Interest on long-term obligations (a) 236.7 7.6 63.3 68.8 97.0 Capital leases 10.9 1.1 4.5 4.6 0.7 Operating leases 26.6 2.9 8.7 5.3 9.7 Purchase commitments (b) 35.1 30.8 4.3 - - Pension liability 27.3 3.2 1.4 1.5 21.2 Long-term deferred tax liabilities (c) 127.9 - - - 127.9 Other long-term liabilities (d) 2.4 0.4 0.3 0.3 1.4 Total $ 1,113.7 $ 48.9 $ 435.2 $ 85.5 $ 544.1 (a) Amounts represent the expected cash interest payments on our long-term debt. Interest on our variable rate debt was forecasted using a LIBOR forward curve analysis as of January 31, 2013. (b) Commitments to purchase inventory and equipment. Excludes purchase commitments under walnut purchase agreements due to uncertainty of pricing and quantity. (c) Primarily relates to the intangible assets of Kettle Foods. (d) The liability for uncertain tax positions ($3.0 million at January 31, 2013, excluding associated interest and penalties) has been excluded from the contractual obligations table because a reasonably reliable estimate of the timing of future tax settlements cannot be determined. Effects of Inflation There has been no material change in our exposure to inflation from that discussed in our 2012 Annual Report on Form 10-K. Critical Accounting Policies Our consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of our assets, liabilities, revenues and expenses. We base our estimates on historical experience and various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates. Our critical accounting policies are set forth below. Revenue Recognition and Accounts Receivable. We recognize revenue when persuasive evidence of an arrangement exists, title and risk of loss has transferred to the buyer (based upon terms of shipment), price is fixed, delivery occurs and collection is reasonably assured. Revenues are recorded net of rebates, introductory or slotting payments, coupons, promotion and marketing allowances. The 27 -------------------------------------------------------------------------------- Table of Contents amount we accrue for promotion is based on an estimate of the level of performance of the trade promotion, which is dependent upon factors such as historical trends with similar promotions, expectations regarding customer and consumer participation and sales and payment trends with similar previously offered programs. Customers have the right to return certain products. Product returns are estimated based upon historical results and are reflected as a reduction in sales. Inventories. All inventories are accounted for on a lower of cost (first-in, first-out or weighted average) or market basis. We have entered into walnut purchase agreements with growers, under which they deliver their walnut crop to us during the fall harvest season, and pursuant to our walnut purchase agreements, we determine the price for this inventory after delivery and by the end of the fiscal year. This purchase price is determined by us based on our discretion provided in the agreements, taking into account market conditions, crop size, quality and nut varieties, among other relevant factors. Since the ultimate purchase price to be paid will be determined subsequent to receiving the walnut crop, we estimate the final purchase price for our interim financial statements. Those interim estimates may subsequently change due to changes in the factors described above and the effect of the change could be significant. Any such changes in estimates are accounted for in the period of change by adjusting inventory or cost of goods sold of the inventory sold. Property, Plant and Equipment. Property, plant and equipment are stated at cost. Depreciation and amortization are computed using the straight-line method over the estimated useful lives of assets ranging from 30 to 39 years for buildings and ranging from 3 to 15 years for equipment. Valuation of Long-lived and Intangible Assets and Goodwill. We periodically review long-lived assets and certain identifiable intangible assets for impairment in accordance with Accounting Standards Codification ("ASC") 360, "Property, Plant, and Equipment." Identifiable intangible assets with finite lives are amortized over their estimated useful lives of 20 years. Goodwill and intangible assets not subject to amortization are reviewed annually for impairment in accordance with ASC 350, "Intangibles - Goodwill and Other," or more often if there are indications of possible impairment. The analysis to determine whether or not an asset is impaired requires significant judgments that are dependent on internal forecasts, including estimated future cash flows, estimates of long-term growth rates for our business, the expected life over which cash flows will be realized and assumed royalty and discount rates. Changes in these estimates and assumptions could materially affect the determination of fair value and any impairment charge. While the fair value of these assets exceeds their carrying value based on our current estimates and assumptions, materially different estimates and assumptions in the future in response to changing economic conditions, changes in our business or for other reasons could result in the recognition of impairment losses. For assets to be held and used, including acquired intangible assets subject to amortization, we initiate our review whenever events or changes in circumstances indicate that the carrying amount of these assets may not be recoverable. Recoverability of an asset is measured by comparison of its carrying amount to the expected future undiscounted cash flows that the asset is expected to generate. Any impairment to be recognized is measured by the amount by which the carrying amount of the asset exceeds its fair value. Significant management judgment is required in this process. For brand intangible assets not subject to amortization, we test for impairment annually, or whenever events or changes in circumstances indicate that their carrying value may not be recoverable. In testing brand intangibles for impairment, we compare the fair value with the carrying value. The determination of fair value is based on a discounted cash flow analysis, using inputs such as forecasted future revenues attributable to the brand, assumed royalty rates and a risk-adjusted discount rate that approximates our estimated cost of capital. If the Company were to experience a decrease in forecasted future revenues attributable to the brands, this could indicate a potential impairment. If the carrying value exceeds the estimated fair value, the brand intangible asset is considered impaired, and an impairment loss will be recognized in an amount equal to the excess of the carrying value over the fair value of the brand intangible asset. At June 30, 2012, the brand intangible asset had a carrying value that was approximately 13.3% less than the fair value of the brand intangible asset. We perform our annual goodwill impairment test required by ASC 350 as of June 30th of each year. After our segment reporting changes goodwill impairment will now be tested at the reporting units which are the same as our operating segments. Goodwill impairment is indicated if the book value of the reporting unit exceeds its fair value. If the fair value of an evaluated reporting unit is less than its book value, the goodwill is written down to fair value, which is generally based on a discounted future cash flows analysis. Future business results could impact the evaluation of our goodwill and intangible assets. At January 31, 2012, the carrying value of goodwill and other intangible assets totaled approximately $845.6 million, compared to total assets of approximately $1,404.7 million and total shareholders' equity of approximately $402.1 million. At January 31, 2013, the carrying value of goodwill and other intangible assets totaled approximately $839.2 million, compared to total assets of approximately $1,275.0 million and total shareholders' equity of approximately $328.6 million. Goodwill was determined not to be impaired as of June 30, 2012. 28-------------------------------------------------------------------------------- Table of Contents As a result of the goodwill allocation process performed as part of the segment reporting changes, we have indications of fair value for our reporting units. The indicated fair values substantially exceed the carrying values for all reporting units except Kettle US and Kettle UK. The fair value exceeds the carrying value by a margin of less than 10% for Kettle US and Kettle UK. The indicated fair values were determined utilizing a blend of a discounted cash flow methodology and a guideline company methodology. Material assumptions within these models include the selected control premium, selected multiples, discount rates and forecasted cash flow projections. The fair values could be affected by changes in these assumptions. We cannot guarantee that a material impairment charge will not be recorded in the future. To the extent calculated fair values change such that they are lower than our reporting unit carrying values, or if other indicators of potential impairment are present, then we will be required to take further steps to determine if an impairment of goodwill has occurred and to calculate an impairment loss. Employee Benefits. We incur various employment-related benefit costs with respect to qualified and nonqualified pension and deferred compensation plans. Assumptions are made related to discount rates used to value certain liabilities, assumed rates of return on assets in the plans, compensation increases, employee turnover and mortality rates. Different assumptions could result in the recognition of differing amounts of expense over different periods of time. Derivative Financial Instruments. We account for the warrant issued as part of the Oaktree transaction as freestanding derivative financial instruments. We record derivative financial instruments at fair value in our consolidated balance sheet at the point the transaction is entered into and at the end of all subsequent reporting periods. On a quarterly basis, changes in the fair value of a derivative financial instrument are recorded in current period earnings. Income Taxes. We account for income taxes in accordance with ASC 740, "Income Taxes." This guidance requires that deferred tax assets and liabilities be recognized for the tax effect of temporary differences between the financial statement and tax basis of recorded assets and liabilities at current tax rates. This guidance also requires that deferred tax assets be reduced by a valuation allowance if it is more likely than not that some portion or all of the deferred tax assets will not be realized. The recoverability of deferred tax assets is based on both our historical and anticipated earnings levels and is reviewed periodically to determine if any additional valuation allowance is necessary when it is more likely than not that amounts will not be recovered. There are inherent uncertainties related to the interpretations of tax regulations in the jurisdictions in which we operate. We may take tax positions that management believes are supportable, but are potentially subject to successful challenge by the applicable taxing authority. We evaluate our tax positions and establish liabilities in accordance with the guidance on uncertainty in income taxes. We review these tax uncertainties in light of changing facts and circumstances, such as the progress of tax audits, and adjust them accordingly. Accounting for Stock-Based Compensation. We account for stock-based compensation arrangements, including stock option grants and restricted stock awards, in accordance with the provisions of ASC 718, "Compensation - Stock Compensation." Under this guidance, compensation cost is recognized based on the fair value of equity awards on the date of grant. The compensation cost is then amortized on a straight-line basis over the vesting period. We use the Black-Scholes option pricing model to determine the fair value of stock options at the date of grant. This model requires us to make assumptions such as expected term, volatility and forfeiture rates that determine the stock options' fair value. These key assumptions are based on historical information and judgment regarding market factors and trends. If actual results are not consistent with our assumptions and judgments used in estimating these factors, we may be required to increase or decrease compensation expense, which could be material to our results of operations. Recent Accounting Pronouncements See Note 2 of the Notes to Condensed Consolidated Financial Statements. |