10-Q 1 spectrum305.txt 10-Q SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q (Mark One) [X] QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2005. [ ] TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM ____________ TO _____________ Commission File No. 333-22997 SPECTRUM ORGANIC PRODUCTS, INC. ---------------------------------------- (Exact name of Registrant as specified in its Charter) California 94-3076294 ------------------------ ---------------------- (State of incorporation) (I.R.S. Employer Identification Number) 5341 Old Redwood Highway, Suite 400 Petaluma, California 94954 707-778-8900 ----------------------------------- --------------------------- (Address of executive offices) (Issuer's telephone number) Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes |X| No | | Indicate by check mark whether the Registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes | | No |X| APPLICABLE ONLY TO ISSUERS INVOLVED IN BANKRUPTCY PROCEEDINGS DURING THE PRECEEDING FIVE YEARS: Indicate by check mark whether the Registrant filed all documents and reports required to be filed by Section 12, 13 or 15(d) of the Exchange Act after the distribution of securities under a plan conformed by a court. Yes | | No | | APPLICABLE ONLY TO CORPORATE ISSUERS: State the number of shares outstanding of each of the issuer's classes of common equity, as of the latest practicable date: Common Stock, no par value, 46,444,693 shares issued and outstanding as of May 6, 2005. Transitional Small Business Disclosure Format: Yes | | No |X|
PART I - FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS ---------------------------- SPECTRUM ORGANIC PRODUCTS, INC. BALANCE SHEETS ASSETS (Unaudited) March 31, December 31, 2005 2004 ------------ ------------ Current Assets: Cash $ 13,800 $ 11,000 Accounts receivable, net 4,700,200 3,799,800 Inventories, net 8,564,600 9,564,800 Deferred income taxes - current 610,200 630,000 Prepaid expenses and other current assets 269,900 141,400 ------------ ------------ Total Current Assets 14,158,700 14,147,000 Property and Equipment, net 3,929,400 3,990,200 Other Assets: Deferred income taxes - long-term 1,529,500 1,529,500 Intangible assets, net 584,300 584,800 Other assets 251,300 251,200 ------------ ------------ Total Assets $ 20,453,200 $ 20,502,700 ============ ============ LIABILITIES AND STOCKHOLDERS' EQUITY Current Liabilities: Bank overdraft $ 200,900 $ 843,300 Line of credit 7,103,700 6,984,400 Accounts payable, trade 4,029,900 4,033,800 Accrued expenses 1,474,600 854,100 Current maturities of term notes payable and capital lease obligations 509,900 514,600 Current maturities of notes payable, related parties 169,500 228,200 ------------ ------------ Total Current Liabilities 13,488,500 13,458,400 Notes payable and capitalized lease obligations, less current maturities 1,250,000 1,375,000 Notes payable, related parties, less current maturities 332,400 326,200 Deferred rent 33,600 37,000 ------------ ------------ Total Liabilities 15,104,500 15,196,600 ------------ ------------ Commitments and Contingencies (Note 7) Stockholders' Equity: Preferred stock, 5,000,000 shares authorized, no shares issued or outstanding -- -- Common stock, no par value, 60,000,000 shares authorized, 46,444,693 and 46,405,943 issued and outstanding at March 31, 2005 and December 31, 2004, respectively 9,644,300 9,631,400 Accumulated deficit (4,295,600) (4,325,300) ------------ ------------ Total Stockholders' Equity 5,348,700 5,306,100 ------------ ------------ Total Liabilities and Stockholders' Equity $ 20,453,200 $ 20,502,700 ============ ============ See accompanying notes to financial statements. 2 SPECTRUM ORGANIC PRODUCTS, INC. STATEMENTS OF OPERATIONS (Unaudited) Three Months Ended March 31, March 31, 2005 2004 ------------ ------------ Net Sales $ 13,243,000 $ 12,733,100 Cost of Goods Sold 10,050,600 9,830,400 ------------ ------------ Gross Profit 3,192,400 2,902,700 ------------ ------------ Operating Expenses: Sales and Marketing 2,036,600 1,981,900 General and Administrative 972,200 1,029,400 ------------ ------------ Total Operating Expenses 3,008,800 3,011,300 ------------ ------------ Income (Loss) from Operations 183,600 (108,600) Other Income (Expense): Interest Expense (133,900) (74,000) Other, net -- 1,000 ------------ ------------ Income (Loss) Before Taxes 49,700 (181,600) (Provision) Benefit for Income Taxes (19,900) 72,600 ------------ ------------ Net Income (Loss) $ 29,800 $ (109,000) ============ ============ Basic and Fully Diluted Income (Loss) Per Share $ 0.00 $ (0.00) ============ ============ Basic Weighted Average Shares Outstanding 46,423,596 46,275,557 ============ ============ Fully Diluted Weighted Average Shares Outstanding 47,198,965 46,275,557 ============ ============ See accompanying notes to financial statements. 3 SPECTRUM ORGANIC PRODUCTS, INC. STATEMENTS OF CASH FLOWS (Unaudited) Three Months Ended March 31, March 31, 2005 2004 Cash Flows from Operating Activities: ----------- ----------- Net Income (Loss) $ 29,800 $ (109,000) Adjustments to Reconcile Net Income (Loss) to Net Cash Provided by Operating Activities: Depreciation and amortization expense 157,400 148,200 Provision for inventory obsolescence 42,500 18,700 Provision for uncollectible receivables 16,000 18,800 Imputed interest on note payable, related party 6,200 5,000 Revaluation of derivative financial instruments 35,300 -- Changes in Assets and Liabilities: Accounts receivable (916,500) (251,400) Inventories 957,700 1,246,700 Other assets (108,800) (160,000) Accounts payable 724,700 557,100 Other liabilities (146,800) (491,400) ----------- ----------- Net Cash Provided by Operating Activities 797,500 982,700 ----------- ----------- Cash Flows from Investing Activities: Purchase of property and equipment (96,100) (440,300) ----------- ----------- Net Cash Used in Investing Activities (96,100) (440,300) ----------- ----------- Cash Flows from Financing Activities: Decrease in bank overdraft (642,400) (513,800) Proceeds from line of credit 5,825,400 5,483,300 Repayment of line of credit (5,706,000) (5,168,700) Repayment of notes payable, related parties (58,800) (70,100) Repayment of term notes payable (125,000) (62,500) Repayment of capitalized lease obligations (4,700) (13,100) Proceeds from exercise of stock options 12,900 13,600 ----------- ----------- Net Cash Used in Financing Activities (698,600) (331,300) ----------- ----------- Net Increase in Cash 2,800 211,100 Cash, beginning of the year 11,000 7,300 ----------- ----------- Cash, end of the period $ 13,800 $ 218,400 =========== =========== Supplemental Disclosure of Cash Flow Information: Cash paid for income taxes $ -- $ 16,000 Cash paid for interest $ 127,000 $ 67,700 See accompanying notes to financial statements. 4
SPECTRUM ORGANIC PRODUCTS, INC. NOTES TO FINANCIAL STATEMENTS 1. Basis of Presentation: These are unaudited interim financial statements and include all adjustments that, in the opinion of Management, are necessary in order to make the financial statements not misleading. The financial statements have been prepared in accordance with the instructions to Form 10-Q and do not include certain disclosures required by accounting principles generally accepted in the United States of America. Accordingly, the statements should be read in conjunction with Spectrum Organic Products, Inc.'s financial statements and notes thereto included in the Company's Annual Report on Form 10-K for the year ended December 31, 2004. Operating results for the three-month period ended March 31, 2005 are not necessarily indicative of the results that may be expected for the entire year ending December 31, 2005 or future periods. Certain reclassifications have been made to the prior year unaudited interim financial statements to be consistent with the presentation at March 31, 2005. These reclassifications had no impact on net income or retained earnings. 2. Nature of Operations and Business Segments: Spectrum Organic Products, Inc. ("Spectrum", the "Registrant" or the "Company") is a California corporation that competes primarily in three business segments: natural and organic foods sold under the Spectrum Naturals(R) brand, essential fatty acid nutritional supplements sold under the Spectrum Essentials(R) brand, and industrial ingredients for use by other manufacturers sold under the Spectrum Ingredients name. The vast majority of the Company's products are oil-based and the Company has positioned itself as "The Good Fats Company." Within the natural and organic foods segment, the Company's products include olive oils and other culinary oils, salad dressings, condiments and butter-substitutes such as Spectrum Organic Margarine(R) and Spectrum Spread(R). All of the Company's culinary products feature healthy fats, contain no hydrogenated or trans fats and are offered in a variety of sizes and flavors in both organic and conventional, non-GMO offerings. Within the nutritional supplement segment, the Company's products include organic flax oils, evening primrose oil, borage oil, Norwegian fish oil and other essential fatty acids in both liquid and capsule forms. The Spectrum Essentials(R) products are cold-pressed, nutritionally rich sources of Omega-3 and Omega-6 essential fatty acids and are also offered in a variety of sizes and styles. The Spectrum Ingredients(R) (formerly known as Spectrum Commodities, Inc.) segment includes organic and conventional non-GMO culinary oils, organic vinegar, condiments and nutritional oils offered to other manufacturers for use in their products. In addition, they bring incremental purchasing power to the Company resulting in higher margins for the consumer branded products. Also included in this segment are private label products sold to major retailers. 5 Operating data is captured by segment to the gross profit level. However, operating statement data below gross profit and balance sheet data have not been disaggregated and captured by business segment since the information is presently unavailable to the Company's chief operating decision maker. Accordingly, the following segment information is currently captured by the Company: Three Months Ended March 31, 2005 2004 % Change ----------- ----------- -------- Net Sales: Spectrum Naturals(R) $ 6,041,800 $ 5,817,600 +4% Spectrum Essentials(R) 2,772,700 2,668,800 +4% Spectrum Ingredients/Private Label 4,428,500 4,246,700 +4% ----------- ----------- ---- Total Net Sales $13,243,000 $12,733,100 +4% =========== =========== ==== Gross Profit: Spectrum Naturals(R) $ 1,345,400 $ 1,404,700 -4% Spectrum Essentials(R) 1,289,000 1,066,200 +21% Spectrum Ingredients/Private Label 558,000 431,800 +29% ----------- ----------- ---- Total Gross Profit $ 3,192,400 $ 2,902,700 +10% =========== =========== ==== 3. Derivative Financial Instruments: In January 2005 the Company began to utilize foreign currency forward contracts to minimize the volatility of foreign currency cash flows resulting from changes in exchange rates. Foreign currency forward contracts are entered into for firmly committed or anticipated raw material purchases. The use of these contracts enables the Company to reduce its exposure to foreign currency exchange rate movements since the gains and losses on the contracts substantially offset the gains and losses on the transactions being hedged. As of March 31, 2005 the Company had outstanding foreign currency forward contracts to purchase 1,034,100 euros at an average contractual exchange rate of $1.33 per euro. Included in cost of sales for the three months ended March 31, 2005 was an expense of $35,300 which represented the difference between the fair value of the forward contracts versus the contractual amount. 4. Industrial Accident: On February 4, 2004 the Company pleaded no contest to two misdemeanor counts of violations under California Labor Code Section 6425, violation of a regulation issued by the California Occupational Health and Safety Administration ("CAL-OSHA"), requiring employers to provide, maintain and ensure employees use required confined space equipment. The plea arose in connection with a tragic industrial accident on April 25, 2002 that resulted in the death of two of the Company's employees. Under the Terms of Settlement and Probation entered into with the plea, the Company will pay a fine of $150,000 in three annual installments of $50,000 each on June 30, 2004, 2005 and 2006. In addition the Company paid $150,000 in restitution to the California District Attorneys Association Workers Safety Training Account to assist in the prosecution of worker safety cases in the State of California. The Company also reimbursed costs of $25,000 each to the Petaluma Police Department, the Petaluma Fire Department and the Sonoma County District Attorney's Office. Finally, an additional fine of $250,000 under California Labor Code Section 6425 was suspended conditioned upon the Company's compliance with the terms of court supervised probation for three years. Accordingly, the Company accrued an expense of $375,000 during the year ended December 31, 2003 to cover the net present value of the above payments, plus attorney's fees. Total payments made during the year ended December 31, 2004 in connection with the plea were $275,000. 6 CAL-OSHA completed their investigation of the accident and issued their report and notice of proposed penalties on October 18, 2002. Their report included nine citations for safety violations with total proposed penalties of $137,900. There were no willful citations and the CAL-OSHA report acknowledged that all the safety violations had been 100% abated prior to the report's issuance. The Company filed a formal appeal and executed a verbal settlement agreement with CAL-OSHA on December 17, 2004 which calls for the Company to pay penalties totaling $70,500 to close the CAL-OSHA appeal. At the date of this report, the Company was awaiting the receipt of an Order from the CAL-OSHA Appeals Board, at which time the Company will remit the $70,500 to close this matter. The dependents of both deceased employees filed appeals with the Workers' Compensation Appeals Board of California for serious and willful misconduct penalties against Spectrum. On May 25, 2004 the Company settled one of the appeals for $35,000 which was paid on June 3, 2004 and charged against the industrial accident reserve. The remaining workers compensation appeal is for an additional death benefit equal to 50% of the eventual death benefit to be paid by the Company's workers' compensation insurance carrier at the time of the accident. That amount would be payable by the Company to the dependents of the deceased worker if the dependents successfully establish that the Company was guilty of serious and willful misconduct by allowing unsafe working conditions to exist. If actually litigated, the workers compensation appeal is an all-or-nothing proposition under which the Company will either be liable for 50% of the eventual insurance death benefit or nothing. Based on the advice of counsel, the Company expects the remaining workers compensation appeal to be settled rather than litigated. Management believes the remaining reserve of $190,400 as of March 31, 2005 will be approximately adequate to cover the present value of the remaining two installments under the CLCS 6425 fine of $50,000 each, the settlement of the CAL-OSHA appeal for $70,500, and the remaining workers compensation appeal. 5. Inventories: Inventories consisted of the following: March 31, December 31, 2005 2004 ----------- ----------- Finished goods $ 6,975,900 $ 7,590,100 Raw materials 1,699,200 2,170,200 Deposits on inventory 222,500 154,500 ----------- ----------- Total Inventories 8,897,600 9,914,800 Less: Reserve for obsolete inventory (333,000) (350,000) ----------- ----------- Net Inventories $ 8,564,600 $ 9,564,800 =========== =========== 7 Deposits on inventory primarily represent flaxseed paid for prior to its receipt at the Company's production facility. 6. Stock-based Compensation: Statement of Financial Accounting Standards ("SFAS") No. 123R, "Share Based Payment" ("SFAS 123R") issued in December 2004 will require the Company to record an expense associated with stock option grants, based on the fair value method, in the Company's statements of operations for fiscal year 2006. Meanwhile, as currently permitted under SFAS 123, the Company has chosen to continue to account for employee stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25"). Accordingly, compensation expense for employee stock options is measured as the excess, if any, of the fair market price of the Company's stock at the date of grant over the amount an employee must pay to acquire the stock. Options granted to non-employees are recorded over the service period at the estimated fair value of the option granted. All stock options issued to employees have an exercise price not less than the fair market value of the Company's common stock on the date of grant. Under these circumstances, in accordance with the accounting for such options utilizing the intrinsic value method prescribed in APB 25, there is no related compensation expense recorded in the Company's financial statements. Had compensation cost for stock-based compensation been determined based on the fair value of the options at the grant dates consistent with SFAS 123, the Company's net income or loss and net income or loss per share for the three months ended March 31, 2005 and 2004 would have been adjusted to the pro-forma amounts presented below: Three months ended March 31, 2005 2004 -------- --------- Net income (loss) as reported $ 29,800 $(109,000) Less: Total compensation expense under fair value method for all stock-based awards, net of related tax effects (95,300) (70,300) -------- --------- Pro-forma net income (loss) $(65,500) $(179,300) ======== ========= Basic and diluted income (loss) per share: As reported $ 0.00 $ (0.00) Pro-forma $ (0.00) $ (0.00) The fair value of the option grants for 2005 was estimated on the date of grant utilizing the Black-Scholes option pricing model, with the following assumptions: expected life of five years, risk-free interest rate of 3.0%, no dividend yield and volatility of 65%. The weighted average fair value of the option grants during the first quarter of 2005 was $0.29 per share. The fair value of the option grants for 2004 was estimated on the date of grant utilizing the Black-Scholes option pricing model, with the following assumptions: expected life of five years, risk-free interest rate of 2.0%, no dividend yield and volatility of 95%. The weighted average fair value of the option grants during the first quarter of 2004 was $0.61 per share. 8 7. Commitments and Contingencies: Pending Litigation - Proposition 65 Complaint On November 26, 2003 the Company was notified by attorneys for the Environmental Law Foundation (the "ELF") that the Spectrum Naturals(R) Organic Balsamic Vinegar contains lead in excess of the allowable quantities under the Safe Drinking Water and Toxic Enforcement Act of 1986, also known as Proposition 65. The ELF is a California non-profit organization that represents itself as dedicated to the preservation of human health and the environment. ELF's attorneys filed a Complaint for Civil Penalties, Statutory, Equitable and Injunctive Relief (the "Complaint") against Cost Plus, Inc., Safeway, Inc., Trader Joe's Company, Williams-Sonoma, Inc., Whole Foods, Inc. and unspecified defendants one through 100 in the Superior Court of the State of California on May 20, 2003 alleging violation of Proposition 65 for the sale of various products that contain lead in excess of the allowable limits without the required warning label. ELF's attorneys later notified Spectrum and dozens of other retailers, importers and manufacturers of vinegar that they would be included as one of the 100 unspecified defendants in the Complaint. While lead has been shown to cause cancer and reproductive toxicity in humans, the Proposition 65 consumption quantity defined as no significant risk level for cancer was set at 15 micrograms per day. Lead is a naturally occurring element in some wine and balsamic vinegars. Based on the Company's tests, a person would need to consume somewhere between 1.3-2.6 cups (270-630ml) daily of the Company's various vinegar products to reach the Proposition 65 lead level. The small lead content in vinegar occurs naturally in the soil and is absorbed by the grapes used to make vinegar. The level of lead in vinegar is not affected by the manufacturing process and, therefore, is not subject to regulation under Proposition 65. The Spectrum Naturals(R) brand was built on the premise of providing consumers with organic healthy oils and condiments. Management does not believe the consumption of its various vinegar products as condiments or salad dressings poses any increased risk for cancer or reproductive toxicity. The Company joined a Joint Defense Group in February 2004 which was established by attorneys representing several of the defendants in the Complaint. Total attorney's fees incurred by the Company as a member of the Joint Defense Group since its inception were $15,300. Management believes the Complaint will eventually be settled for an insignificant sum. Accordingly, no provision for loss has been recorded at March 31, 2005. Court Supervised Probation In connection with the industrial accident on April 25, 2002 the Company entered a plea on February 4, 2004 of no contest to two misdemeanor counts of violations under CLCS 6425, violation of a regulation issued by the California Occupational Health and Safety Administration requiring employers to provide, maintain and ensure employees use required confined space equipment. Under the Terms of Settlement and Probation entered into with the plea, the Company received a suspended fine of $250,000 conditioned upon the Company's compliance with the terms of court supervised probation for three years. The probation terms require that the Company submit to a warrant-less search of its premises during business 9 hours by any local or state law enforcement, safety or health officer; and that the Company shall be of good conduct and obey all laws, particularly those laws relating to worker safety and health. Should the Company fail to honor the probation terms, the suspended fine of $250,000 may be reimposed by the Sonoma County District Attorney. Contingent Guarantee The Company was a guarantor in the amount of $25,000 for that portion of the outstanding borrowings under a line of credit for the Olive Press, LLC a third party that the Company held an investment in of $15,000 at March 31, 2005. In the event of a default by the Olive Press of its obligations under its line of credit, Spectrum would be liable for an amount not to exceed $25,000. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS ------------------------------------------------------------------------------- Introduction: The following discussion should be read in conjunction with the financial statements and related notes and other information included in this report. The financial results reported herein are not necessarily indicative of the financial results that may be achieved by the Company in any future period. The Company's operating results could vary from period to period as a result of a number of factors. These factors include, but are not limited to, the purchasing patterns of significant customers, the timing of new product introductions by the Company and its competitors, the amount of slotting fees, new product development and advertising expenses incurred by the Company, variations in sales by distribution channel, fluctuations in market prices and availability of raw materials, competitive pricing policies and situations that the Company cannot foresee. These factors could cause the Company's performance to differ from investor expectations, resulting in volatility in the price of the common stock. Investors should carefully consider the following information as well as other information contained in this report. Information included in this report contains "forward-looking statements" which can be identified by the use of forward-looking terminology such as "believes," "expects," "may," "should" or "anticipates" or the negative thereof or other variations thereon or comparable terminology, or by discussions of strategy. No assurance can be given that the future results covered by the forward-looking statements will be achieved. The following matters constitute cautionary statements identifying important factors with respect to such forward-looking statements, including certain risks and uncertainties that could cause actual results to vary materially from the future results covered in such forward-looking statements. Other factors could also cause actual results to vary materially from the future results covered in such forward-looking statements. Overview: Spectrum Organic Products, Inc. ("Spectrum", the "Company", or the "Registrant") competes primarily in three segments: natural and organic foods sold under the Spectrum Naturals(R) brand, nutritional supplements sold under the Spectrum Essentials(R) brand, and industrial ingredients sold by the Spectrum Ingredients sales force for use by other manufacturers. The vast majority of the Company's products are oil-based and the Company has positioned itself as "The Good Fats Company." 10 Within the Spectrum Naturals(R) brand, the Company's products include olive oils and other culinary oils, salad dressings, condiments and butter-substitutes such as Spectrum Organic Margarine(R) and Spectrum Spread(R). All of the Company's culinary products feature healthy oils, contain no hydrogenated fats and are offered in a variety of sizes and flavors in both organic and conventional offerings. Within the Spectrum Essentials(R) brand, the Company's products include organic flax oil, borage oil, Norwegian fish oil and other essential fatty acids in both liquid and capsule forms. The Spectrum Essentials(R) products are cold-pressed, nutritionally rich sources of Omega-3 and Omega-6 essential fatty acids and are also offered in a variety of sizes and styles. The Spectrum Ingredients (formerly known as Spectrum Commodities, Inc.) sales force offers organic culinary oils, vinegar and nutritional oils to other manufacturers for use in their products. In addition, they bring incremental purchasing power to the Company resulting in higher margins for the consumer branded product lines. Also included in this segment are private label products sold to major retailers. Critical Accounting Policies and Estimates: The following discussion and analysis of the Company's financial condition and results of operations is based upon the Company's financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. The Company bases its estimates on historical experience and various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for the carrying values of assets and liabilities that are not readily apparent from other sources. On an on-going basis, the Company re-evaluates all of its estimates, including those related to accounts receivable allowances, inventory reserves, the industrial accident reserve and the deferred tax asset valuation allowance. Actual results may differ materially from these estimates under different assumptions or conditions and as additional information becomes available in future periods. The Company believes the following are the more significant judgments and estimates used in the preparation of its financial statements: Accounts Receivable Allowances - The Company provides allowances against accounts receivable for estimated bad debts, returns and deductions by customers for trade promotions and programs. These allowances are based upon the Company's historical experience with bad debt write-offs and customer deductions, customer creditworthiness, payment trends and general economic conditions. Allowances for bad debts and customer deductions were $516,000 at March 31, 2005 on gross trade accounts receivable of $5,181,100. While this estimate is one of the more significant estimates the Company makes in the preparation of its financial statements, management does not consider it to be highly uncertain. Inventory Reserves - The Company establishes reserves for obsolete, excess and slow-moving inventories in order to properly value its inventory at the lower of cost or market. The reserve estimates are based upon historical inventory usage, spoilage, current market conditions, and anticipated future demand. Reserves for obsolete inventories were $333,000 at March 31, 2005 on total gross inventories of $8,897,600. While this estimate is one of the more significant estimates the Company makes in the preparation of its financial statements, management does not consider it to be highly uncertain. 11 Deferred Tax Asset Valuation Allowance - As of March 31, 2005 the Company had net deferred tax assets of $2,139,700 primarily resulting from net operating loss carryforwards ("NOLs"), which consisted of $5,735,000 of Federal NOLs that expire at various times through 2021, and $3,833,000 of state NOLs that expire at various times through 2011. The majority of the NOLs originated from the pre-merger operations of OFPI. As a result of OFPI's acquisition by SNI, OFPI experienced an ownership change in excess of 50% for federal and state income tax purposes. Therefore, an annual limitation is placed by the taxing authorities on the Company's right to realize the benefit of the pre-merger NOLs. Management continues to believe that it is more likely than not that the Company will continue to report sufficient taxable income in the foreseeable future, allowing utilization of 100% of its deferred tax assets. Management will continue to evaluate the Company's deferred tax assets in the future to determine whether a deferred tax asset reserve should be reinstated at some future point. Industrial Accident Reserve - The Company has an industrial accident reserve to cover future payments anticipated as a result of the industrial accident in 2002. As of March 31, 2005 the balance remaining in the industrial accident reserve was $190,400 which covers the present value of the remaining two installment payments of $50,000 each under the Terms of Settlement and Probation entered into on February 4, 2004 with the Sonoma County District Attorney's Office, and the settlement of the appeal filed by the Company with CAL-OSHA regarding their citations and fines for $70,500. That will leave approximately $30,000 in the reserve to cover the one remaining unsettled issue with regards to the industrial accident, plus related attorney's fees. The remaining unsettled issue is an appeal filed by dependents of one of the deceased employees with the Workers Compensation Appeals Board of California for an additional death benefit equal to 50% of the eventual death benefit to be paid by the Company's workers' compensation insurance carrier at the time of the accident. That amount would be payable by the Company to the dependents of the deceased employee if the dependents successfully establish that the Company was guilty of serious and willful misconduct by allowing unsafe working conditions to exist. If actually litigated, the workers compensation appeal is an all-or-nothing proposition under which the Company will either be liable for 50% of the eventual insurance death benefit or nothing. Based on the advice of counsel, the Company expects the remaining workers compensation appeal to be settled rather than litigated. However, management considers the remaining unsettled workers compensation appeal to be uncertain since expenses in excess of the remaining reserve could be incurred regardless of whether the workers compensation appeal is litigated or settled. -------------------------------------------------------------------------------- Results of Operations for the Three Month Periods Ending March 31, 2005 and March 31, 2004 -------------------------------------------------------------------------------- Summary Discussion: In general, the Company continued to grow its business at a moderate rate during the first quarter of 2005. Overall net sales growth was 4% as the Company continued to benefit from increased consumer awareness of the importance of healthy oils to overall health and nutrition. Additionally, small and medium sized food manufacturers continued their push to eliminate partially hydrogenated oils from their products which drove the Spectrum Ingredients industrial sales higher. 12 The Company reported net income for the quarter of $29,800 which was an improvement over the prior year's net loss of $109,000. The improved profitability was primarily attributable to higher gross profit in the Spectrum Essentials segment as flaxseed costs returned to their historic norms during the latter half of 2004. Also contributing to the improved results in 2005 was higher gross profit in the Spectrum Ingredients/Private Label segment as a result of a new supply relationship for private label organic flax oil with a major specialty retailer. Management believes that Earnings Before Interest, Taxes, Depreciation and Amortization ("EBITDA") is an important measure of the Company's operating performance. Management incentive compensation is earned, in part, based on the achievement of EBITDA targets that are established and approved by the Company's Board of Directors prior to the beginning of the year. For the three months ended March 31, 2005 EBITDA was $341,000 compared to $40,600 for the prior year, an increase of $300,400. The improved performance in 2005 is discussed in detail below, but was primarily attributable to increased gross profit. While Management believes that EBITDA is a useful measure of the Company's financial performance, it should not be construed as an alternative to income from operations, net income or cash flows from operating activities as determined in accordance with accounting principles generally accepted in the United States of America. Furthermore, the Company's calculation of EBITDA may be different from the calculation used by other companies, thereby limiting comparability. The Company's calculations to arrive at EBITDA are detailed in the following table: Three Months Ended March 31, 2005 2004 --------- --------- Net income (loss) $ 29,800 $(109,000) Add back: Provision (benefit) for income taxes 19,900 (72,600) Interest expense 133,900 74,000 Depreciation and amortization 157,400 148,200 --------- --------- EBITDA $ 341,000 $ 40,600 ========= ========= The following is Managements' discussion and analysis of the significant line items within the financial statements and the reasons behind the trends and variances versus the prior year. Revenues: Spectrum's net sales for the three months ended March 31, 2005 were $13,243,000 compared to $12,733,100 for 2004, an increase of $509,900 or 4%. The increase is detailed by segment in the following table: 13 Three Months Ended March 31, 2005 2004 % Change ----------- ----------- -------- Spectrum Naturals(R) Culinary Products $ 6,041,800 $ 5,817,600 +4% Spectrum Essentials(R) Nutritional Supplements 2,772,700 2,668,800 +4% Spectrum Ingredients/Private Label 4,428,500 4,246,700 +4% ----------- ----------- --- Total Net Sales $13,243,000 $12,733,100 +4% =========== =========== === Within the Spectrum Naturals(R) culinary products, sales were significantly higher than prior year in packaged oils (+12%), olive oils (+8%) and packaged vinegar (+28%). Partially offsetting those product lines were lower sales in salad dressings (-37%), foodservice oils (-6%), and foodservice mayonnaise (-9%). In general the Company's culinary oils continued to benefit from increased consumer awareness of the importance of healthy fats in one's diet. The Company implemented price increases on certain culinary products effective February 1, 2005 and the prior year first quarter sales were positively impacted by certain customers buying forward in advance of a price increase taken on April 1, 2004. Spectrum Essentials(R) nutritional supplement sales increased 4% versus the prior year, primarily on the strength of increased sales of liquid supplement products (+8%) and coconut oil sold as a health and beauty aid (+104%). Partially offsetting those product lines were lower sales of encapsulated products, which were off 4% versus prior year. The Spectrum Ingredients/Private Label sales were also up 4% versus the prior year primarily as a result of a new relationship with a major specialty retailer for the supply of private label organic flax oil. Partially offsetting that was lower sales in industrial culinary oils, which were off 3% versus the prior year, largely due to supply constraints for canola oil. Cost of Goods Sold: The Company's cost of goods sold for the three months ended March 31, 2005 was $10,050,600 versus $9,830,400 for the prior year, an increase of 2%. The increase was primarily volume-related with respect to the Spectrum Ingredients/Private Label segment and both volume and rate driven in the Spectrum Naturals(R) and Spectrum Essentials(R) segments, as detailed in the following table: Three Months Ended March 31, 2005 2004 % Change ----------- ----------- -------- Spectrum Naturals(R) Culinary Products $ 4,696,400 $ 4,412,900 +6% Spectrum Essentials(R) Nutritional Supplements 1,483,700 1,602,600 -7% Spectrum Ingredients/Private Label 3,870,500 3,814,900 +1% ----------- ----------- --- Total Cost of Goods Sold $10,050,600 $ 9,830,400 +2% =========== =========== === Cost of goods sold as a percent of net sales decreased to 75.9% in 2005 versus 77.2% in 2004. The decrease was primarily due to reduced flaxseed costs in 2005 versus 2004. During 2004 the remaining high cost flaxseed imported from China during the drought in Canada and the northern plains states was crushed and sold. Partially offsetting the favorable flaxseed costs were unfavorable costs in olive oil and canola oil, primarily as a result of the weak dollar versus the euro and the Canadian dollar. 14 Gross Profit: Gross profit for the three months ended March 31, 2005 was $3,192,400 versus $2,902,700 for the prior year, an increase of 10%. The increase was primarily attributable to 4% sales growth in all three segments and the raw material cost changes described above. The following table discloses gross profit by segment: Three Months Ended March 31, 2005 2004 % Change ---------- ---------- -------- Spectrum Naturals(R) Culinary Products $1,345,400 $1,404,700 -4% Spectrum Essentials(R) Nutritional Supplements 1,289,000 1,066,200 +21% Spectrum Ingredients/Private Label 558,000 431,800 +29% ---------- ---------- ---- Total Gross Profit $3,192,400 $2,902,700 +10% ========== ========== ==== Gross profit as a percent of net sales (gross margin) was 24.1% for 2005 versus 22.8% for 2004, primarily as a result of the decreased flaxseed costs in 2005 and the addition of a new relationship with a major specialty retailer for private label organic flax oil. Sales and Marketing Expenses: The Company's sales and marketing expenses for the three months ended March 31, 2005 were $2,036,600 or 15.4% of net sales, versus $1,981,900 or 15.6% of net sales for the prior year. The increase in spending of $54,700 is detailed in the following table which reconciles sales and marketing spending for the first quarter of 2005 versus 2004, and discloses the significant variances by spending category: Total sales and marketing expenses, first quarter 2004 $ 1,981,900 Increased sponsorships 93,400 Increased compensation and benefits 70,000 Increased market research & development 28,500 Decreased broker commissions (88,900) Decreased advertising (40,300) Decreased website development expenses (33,900) All other, net 25,900 ----------- Total sales and marketing expenses, first quarter 2005 $ 2,036,600 =========== The increased sponsorships was primarily attributable to the Company's involvement with Dr. Andrew Weil and his annual nutrition conference at the University of Arizona. The increased compensation and benefits was primarily associated with increased staffing in the sales and marketing departments. The Company recently hired two new sales professionals to improve sales execution on the Spectrum Essentials segment. The increased research and development was primarily associated with new product development. The decrease in broker commissions was primarily due to changes effected in 2005 to the broker incentive plan. The decrease in advertising was primarily attributable to heavy spending during the prior year for the launch of the Company's new "I am Spectrum" advertising campaign which did not need to be repeated in 2005. Finally, the decrease in the website development expenses was a return to normal levels versus the prior year during which the website was completely redesigned and repopulated with data. 15 General and Administrative Expenses: The Company's general and administrative expenses for the three months ended March 31, 2005 were $972,200 or 7.1% of net sales, versus $1,029,400 or 8.1% of net sales for the prior year. The decrease in spending of $57,200 is detailed in the following table which reconciles general and administrative spending for the first quarter of 2005 versus 2004, and discloses significant variances by spending category: Total general and admin. expenses, first quarter 2004 $ 1,029,400 Increased professional fees 57,100 Decreased relocation expenses (48,400) Decreased rent expenses (24,800) All other, net (41,100) ----------- Total general and admin. expenses, first quarter 2005 $ 972,200 =========== The increased professional fees were primarily associated with increased consulting and accounting services. The decreased relocation expenses were primarily associated with project management and consulting incurred during 2004 in conjunction with the Company's relocation of its manufacturing facility to Cherokee, Iowa. The decreased rent expenses were primarily associated with rent no longer incurred for the Company's previous office space in the Petaluma production facility, which was closed in November 2004. Interest Expense: The Company's interest expense for the three months ended March 31, 2005 was $133,900 versus $74,000 for the prior year. The increase of $59,900 or 81% is detailed in the following table which reconciles interest expense for the first quarter of 2005 versus 2004, and discloses the significant variances by type of debt: Total interest expense, first quarter 2004 $ 74,000 Increased interest on revolving line of credit 52,500 Increased interest on bank term notes payable 11,500 All other, net (4,100) --------- Total interest expense, first quarter 2005 $ 133,900 ========= The increased interest on the revolving line of credit was due to higher average borrowings in 2005 to support the increased level of operations and higher interest rates during 2005 versus 2004. The Company's weighted average effective interest rate under the line of credit was 5.2% in 2005 versus 3.5% in 2004. The increased interest on the bank term notes payable was the result of additional principal drawdowns against the Company's variable-rate term debt during 2004 and increases in the prime rate versus the prior year. Provision for Income Taxes: The Company recorded a provision for income taxes of $19,900 for the three months ended March 31, 2005 versus a net benefit for income taxes of $72,600 for the prior year. The accrual for both years was estimated at 40% of the Company's income or loss before taxes, which was the Company's estimated effective tax rate. 16 Seasonality: Historically, the Company has experienced little seasonal fluctuation in revenues. With regards to product purchasing, the Company will seasonally contract for certain raw materials for the entire year at harvest time or at planting time. These purchases take place annually from early spring to mid-summer and are effected to reduce the risk of price swings due to demand fluctuations. These annual purchases can create overages and shortages in inventory. Liquidity and Capital Resources: On June 4, 2004 the Company entered into the First Amendment to its Credit Facility with Comerica Bank ("Comerica") which extended the maturity date of the Credit Facility to June 30, 2006. The Amendment also increased the revolving line of credit up to a maximum of $9,000,000, and extended the drawdown period under the capital expenditure term loan of $1,000,000 by six months to December 31, 2004. The Credit Facility is secured by substantially all assets of the Company and enables the Company to borrow below prime, using a LIBOR rate option. As of March 31, 2005 the Company had $6,000,000 of its outstanding borrowings under the revolving line of credit locked in at a fixed weighted average LIBOR interest rate of 5.35%. The Company could not operate its business without the Credit Facility with Comerica or one similar to it. The Credit Facility calls for continued satisfaction of various financial covenants for 2005 and beyond related to profitability levels, debt service coverage, and the ratio of total liabilities to tangible net worth. As of March 31, 2005 the Company was in technical default of the liabilities to tangible net worth ratio due to the expenses associated with the manufacturing facility relocation incurred during 2004. Comerica has granted the Company a waiver for the covenant violation. At March 31, 2005 the Company had working capital of $670,200 which reflected a decrease of $366,700 versus the prior year. The decrease was primarily attributable to increased borrowings outstanding under the line of credit to finance the manufacturing facility relocation during 2004 and the higher levels of operations in general. During 2005 the Company generated $797,500 in cash from operating activities, compared to $982,700 in 2004. The cash generated for both years was primarily due to reductions in inventory levels as the Company sold off inventories built during the prior year's fourth quarter. Cash used in investing activities was $96,100 in 2005 compared to $440,300 in 2004. For both years the cash was primarily invested in the new production facility in Iowa. The greater spending during the prior year occurred during the initial construction phase of the project. Cash used in financing activities was $698,600 in 2005 compared to $331,300 in 2004. The cash used for both years was primarily for principal payments against long-term debt, partially offset by increased borrowing under the revolving line of credit. Management believes that future cash flows from operations and available borrowing capacity under the revolving line of credit should provide adequate funds to meet the Company's estimated cash requirements for the foreseeable future. Available borrowing capacity under the revolving line of credit was $1,305,200 and $1,852,400 at March 31, 2005 and 2004, respectively. 17 The Company does not utilize off-balance sheet financing arrangements. There were no transactions with special purpose entities that give the Company access to assets or additional financing or carry debt that is secured by the Company. New Applicable Accounting Pronouncements: In December 2004, the Financial Accounting Standards Board ("FASB") issued SFAS 123R, "Share-Based Payment," a revision of SFAS No. 123, "Accounting for Stock-Based Compensation" and superseding APB Opinion No. 25, "Accounting for Stock Issued to Employees." SFAS 123R requires the Company to expense grants made under the Company's stock option program. That cost will be recognized over the vesting period of the stock option grants. SFAS 123R is effective for fiscal years beginning after June 15, 2005. Upon adoption of SFAS 123R, amounts previously disclosed under SFAS No. 123 will be recorded in the Company's statement of operations. The Company is evaluating the alternatives allowed under the standard, which the Company is required to adopt effective for its fiscal year 2006. In November 2004, the FASB issued SFAS No. 151, "Inventory Costs," an amendment to ARB No. 43, Chapter 4, "Inventory Pricing." SFAS No. 151 is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. The Company believes there will be no material effect on its financial statements upon adoption of this standard. During 2004 the FASB published a revision to Interpretation 46 ("46R") to clarify some of the provisions of FASB Interpretation No. 46, "Consolidation of Variable Interest Entities", and to exempt certain entities from its requirements. The additional guidance is being issued in response to input received from constituents regarding certain issues arising in implementing Interpretation 46. Under the new guidance, special effective date provisions apply to enterprises that have fully or partially applied Interpretation 46 prior to issuance of this revised Interpretation. Otherwise, application of Interpretation 46R (or Interpretation 46) is required in financial statements of public entities that have interests in structures that are commonly referred to as special-purpose entities for periods ending after December 15, 2003. Application by public entities, other than small business issuers, for all other types of variable interest entities is required in financial statements for periods ending after March 15, 2004. Application by small business issuers to variable interest entities other than special-purpose entities and by nonpublic entities to all types of variable interest entities is required at various dates in 2004 and 2005. In some instances, enterprises have the option of applying or continuing to apply Interpretation 46 for a short period of time before applying this revised Interpretation. The Company believes that adoption of Interpretation 46R (or Interpretation 46) will have no effect on its financial statements. In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity" ("SFAS 150"). SFAS 150 provides new rules on the accounting for certain financial instruments that, under previous guidance, would be accounted for as equity. It requires that an issuer classify a financial instrument that is within its scope as a liability. Such financial instruments include mandatorily redeemable shares, instruments that require the issuer to buy back some of its shares in exchange for cash or other assets, or obligations that can be settled with shares, the monetary value of which is fixed. SFAS 150 shall be effective for financial instruments entered into or modified after May 31, 2003 and otherwise shall be effective at the beginning of the first interim period beginning after June 15, 2003. However certain modifications and FASB Staff Positions relating to SFAS 150 are being deliberated. The adoption of SFAS 150 has no effect on the Company's financial statements. 18 Related Party Transactions and Other Relationships: There were no significant transactions with related parties during the three months ended March 31, 2005. However, there were cross-memberships between members of the Company's Board of Directors and the boards of certain key wholesalers and retailers within the industry, as follows: Mr. Thomas B. Simone is one of the Company's external Directors and also serves on the Board of United Natural Foods, Inc. ("UNFI"). UNFI is the Company's largest customer, representing approximately 42% of the Company's net sales for the year ended December 31, 2004. Dr. John B. Elstrott is one of the Company's external Directors and also serves on the Board of Whole Foods Market, Inc. Whole Foods is the largest retailer in the natural products industry; however, sales made by the Company directly to Whole Foods were insignificant. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK ------------------------------------------------------------------ Exchange Rates: The Company is exposed to market risk from changes in foreign currency exchange rates and interest rates that could impact its results of operations and financial position. The Company manages its exposure to these risks through financing activities and foreign currency forward contracts, when deemed appropriate. The Company utilizes foreign currency forward contracts as risk management tools and not for speculative purposes. Spectrum's risk management objective is to minimize the volatility on its cash flows by identifying the forecasted transactions exposed to these risks and hedging them appropriately. In January 2005 the Company began utilizing foreign currency forward contracts to minimize the volatility of foreign currency cash flows resulting from changes in exchange rates. Foreign currency forward contracts are entered into for firmly committed or anticipated raw material purchases. The intent of these contracts is to reduce the Company's exposure to foreign currency exchange rate movements, with any gains or losses on the contracts designed to offset any gains or losses on the transactions being hedged. As of March 31, 2005 the Company's primary foreign currency exchange rate exposures were the euro and Canadian dollar. Forward contracts to hedge anticipated euro purchases during 2005 were entered into beginning in January 2005. The table below provides information about the Company's foreign currency forward contracts outstanding as of March 31, 2005. All foreign currency contracts were for euros and are expected to mature during 2005. Contracted Amounts Fair Value ------------------ ---------- Foreign Currency Forward Contracts: (Pay euros / receive U.S. $) Euros (euro)1,034,100 Average Contractual Exchange Rate $1.33 U.S. Dollars $1,375,300 $1,340,000 19 Included in cost of sales for the three months ended March 31, 2005 was an expense of $35,300 to value the foreign currency forward contracts at the euro/U.S. dollar spot rate of $1.296 at March 31, 2005. Interest Rates: Throughout the course of its fiscal year, the Company utilizes a variable interest rate line of credit at various borrowing levels. For the three months ended March 31, 2005 the average outstanding balance under the line of credit was approximately $7,261,300 with a weighted average effective interest rate of 5.2% per annum. For the three months ended March 31, 2004 the average outstanding balance under the line of credit was approximately $4,746,500 with a weighted average effective interest rate of 3.5% per annum. The increased average borrowing levels in 2005 reflect the funds necessary to finance the increased inventory levels and increased level of operations in general. The line of credit agreement calls for the interest rate to float at the prime rate or LIBOR plus 2.25%, at the Company's option. Certain other debt items are also sensitive to changes in interest rates. The following table summarizes future cash flows and related weighted average interest rates by expected maturity date for long-term debt outstanding as of March 31, 2005, excluding capital lease obligations (dollars in thousands):
Expected Future Principal Payments (Periods Ended December 31) 2005 2006 2007 2008 2009 2010 Total Fair Value ---- ---- ---- ---- ---- ---- ----- ---------- Long Term Debt: Fixed Rate $169.4 -- -- -- -- -- $ 169.4 $ 169.4 Avg. Int. Rate 9.2% -- -- -- -- -- 9.2% Variable Rate $375.0 $500.0 $500.0 $375.0 -- -- $1,750.0 $1,750.0 Avg. Int. Rate var. var. var. var. -- -- var. Imputed Rate -- -- -- -- -- $513.3 $ 513.3 $ 332.4 Avg. Int. Rate -- -- -- -- -- 6.5% 6.5%
The fair value of all long-term debt is equal to the sum of the expected future principal payments with the exception of the non-interest bearing note payable due in one lump sum of $513,300 on December 31, 2010. Interest has been imputed on that note at an effective rate of 6.5% per annum, leaving a fair value at March 31, 2005 of $332,400. Purchase Commitments: In the ordinary course of its business the Company enters into commitments to purchase raw materials over a period of time, generally six months to one year, at contracted prices. At March 31, 2005 these future commitments approximated fair value because they were not at prices in excess of current market, nor in quantities in excess of normal requirements. The Company does not utilize derivative contracts either to hedge existing risks or for speculative purposes. Other Risks: The Company is subject to a wide variety of other risks in the ordinary course of its business. Some of the more significant of these risks include heavy concentrations of sales with a few key customers; heavy concentrations of raw material supply with a few key suppliers; heavy reliance on several key processors for its dressings, condiments and butter substitutes; reliance on one processor for bottling of its oils as well as warehousing and distribution of its finished case goods; regulation by various federal, state and local agencies 20 with regards to the manufacture, handling, storage and safety of food products; regulation of its manufacturing facilities for cleanliness and employee safety; and regulation by various agencies with regards to the labeling and certification of organic and kosher foods. The Company is also subject to competition from other food companies, the risk of crop shortages due to weather or other factors, and is dependant on the continued demand for healthy oils and nutritional supplements by consumers. Item 4. DISCLOSURE CONTROLS AND PROCEDURES ------------------------------------------ The Company's Chief Executive Officer and Chief Financial Officer have evaluated the effectiveness of both the design and the operation of its disclosure controls and procedures and have found them to be adequate. The Company has formed a Disclosure Review Committee (the "DRC") which consists of various senior managers from each functional area of the Company. The DRC considers the materiality of new information and reports to the Company's Chief Financial Officer. There were no material changes in the Company's internal control system during the three months ended March 31, 2005. Management is not aware of any material weaknesses in the Company's internal control system. 21 PART II - OTHER INFORMATION Item 1. Legal Proceedings ------------------------- Industrial Accident On February 4, 2004 the Company pleaded no contest to two misdemeanor counts of violations under California Labor Code Section 6425 ("CLCS 6425"), violation of a regulation issued by the California Occupational Health and Safety Administration ("CAL-OSHA"), requiring employers to provide, maintain and ensure employees use required confined space equipment. The plea arose in connection with a tragic production accident on April 25, 2002 that resulted in the death of two of the Company's employees. Under the Terms of Settlement and Probation entered into with the plea, the Company agreed to pay a fine under CLCS 6425 of $150,000 in three annual installments of $50,000 each on June 1, 2004, 2005 and 2006. In addition the Company paid $150,000 in restitution to the California District Attorneys Association Workers Safety Training Account to assist in the prosecution of worker safety cases in the State of California. The Company also reimbursed costs of $25,000 each to the Petaluma Police Department, the Petaluma Fire Department and the Sonoma County District Attorney's Office. Finally, an additional fine of $250,000 under CLCS 6425 was suspended conditioned upon the Company's compliance with the terms of court supervised probation for three years. Accordingly, the Company accrued an expense of $375,000 during the year ended December 31, 2003 to cover the net present value of the above payments, plus attorney's fees. Total payments made during the year ended December 31, 2004 in connection with the plea were $275,000. CAL-OSHA completed their investigation of the accident and issued their report and notice of proposed penalties on October 18, 2002. Their report included nine citations for safety violations with total proposed penalties of $137,900. There were no willful citations and the CAL-OSHA report acknowledged that all the safety violations had been 100% abated prior to the report's issuance. The Company filed a formal appeal with CAL-OSHA and reached a verbal settlement agreement with CAL-OSHA on December 17, 2004 which calls for the Company to pay penalties totaling $70,500 to close the CAL-OSHA appeal. At the date of this report, the Company was awaiting receipt of an Order from the CAL-OSHA Appeals Board, at which time the Company will remit the $70,500 to close this matter. The dependents of both deceased employees filed appeals with the Workers' Compensation Appeals Board of California for serious and willful misconduct penalties against Spectrum. On May 25, 2004 the Company settled one of the appeals for $35,000 which was paid on June 3, 2004 and charged against the industrial accident reserve. The remaining workers compensation appeal is for an additional death benefit equal to 50% of the eventual death benefit to be paid by the Company's workers' compensation insurance carrier at the time of the accident. That amount would be payable by the Company to the dependents of the deceased worker if the dependents successfully establish that the Company was guilty of serious and willful misconduct by allowing unsafe working conditions to exist. If actually litigated, the workers compensation appeal is an all-or-nothing proposition under which the Company will either be liable for 50% of the eventual insurance death benefit or nothing. Based on the advice of counsel, the Company expects the remaining workers compensation appeal to be settled rather than litigated. Management believes the remaining reserve of $190,400 as of March 31, 2005 will be approximately adequate to cover the present value of the remaining two installments under the CLCS 6425 fine of $50,000 each, the settlement of the CAL-OSHA appeal for $70,500, and the remaining workers compensation appeal. 22 Proposition 65 Complaint On November 26, 2003 the Company was notified by attorneys for the Environmental Law Foundation (the "ELF") that the Spectrum Naturals(R) Organic Balsamic Vinegar contains lead in excess of the allowable quantities under the Safe Drinking Water and Toxic Enforcement Act of 1986, also known as Proposition 65. The ELF is a California non-profit organization that represents itself as dedicated to the preservation of human health and the environment. ELF's attorneys filed a Complaint for Civil Penalties, Statutory, Equitable and Injunctive Relief (the "Complaint") against Cost Plus, Inc., Safeway, Inc., Trader Joe's Company, Williams-Sonoma, Inc., Whole Foods, Inc. and unspecified defendants one through 100 in the Superior Court of the State of California on May 20, 2003 alleging violation of Proposition 65 for the sale of various products that contain lead in excess of the allowable limits without the required warning label. ELF's attorneys later notified Spectrum and dozens of other retailers, importers and manufacturers of vinegar that they would be included as one of the 100 unspecified defendants included in the Complaint. While lead has been shown to cause cancer and reproductive toxicity in humans, the Proposition 65 consumption quantity defined as no significant risk level for cancer was set at 15 micrograms per day. Lead is a naturally occurring element in all vinegars. Based on the Company's tests, a person would need to consume somewhere between 1.3-2.6 cups (270-630ml) daily of the Company's various vinegar products to reach the Proposition 65 lead level. The small lead content in vinegar occurs naturally in the soil and is absorbed by the grapes used to make vinegar. The level of lead in vinegar is not affected by the manufacturing process and, therefore, is not subject to regulation under Proposition 65. The Spectrum Naturals(R) brand was built on the premise of providing consumers with organic healthy oils and condiments. Management does not believe the consumption of its various vinegar products as condiments or salad dressings poses any increased risk for cancer or reproductive toxicity. The Company joined a Joint Defense Group in February 2004 which was established by attorneys representing several of the defendants in the Complaint. Total attorney's fees incurred by the Company as a member of the Joint Defense Group since its inception were $15,300. Management believes the Complaint will eventually be settled for an insignificant sum. Accordingly, no provision for loss or future attorney's fees has been recorded at March 31, 2005. Item 2. Changes in Securities and Use of Proceeds ------------------------------------------------- During the three months ended March 31, 2005 the Company issued 38,750 shares of its common stock for the exercise of incentive stock options. Total proceeds received by the Company were $12,900 which were applied against the outstanding borrowings under the Company's line of credit. 23 The Company has not in the past nor does it intend to pay cash dividends on its common stock in the future. The Company intends to retain earnings, if any, for use in the operation and expansion of its business. Item 3. Defaults Upon Senior Securities --------------------------------------- As of March 31, 2005 the Company was in technical default of one of the financial covenants called for under the Credit Agreement with Comerica. That covenant called for a maximum ratio of total liabilities to tangible net worth ratio of 2.75 to one. Due to the expenses incurred during 2004 in connection with the manufacturing facility relocation, which included a non-cash reduction of $1,156,600 to the Company's tangible net worth, the Company continued to be in technical default of that covenant as of March 31, 2005. As a result of the technical default, Comerica has certain rights under the Credit Agreement including the right to raise the interest rates on the Company's indebtedness to Comerica by 3% per annum. Comerica has granted the Company a waiver of its rights as a result of this covenant violation. Item 4. Submission of Matters to a Vote of Security Holders ----------------------------------------------------------- None. Item 5. Other Information ------------------------- None. Item 6. Exhibits and Reports on Form 8-K ---------------------------------------- (a) Exhibits: 31.12 Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31.13 Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 32.12 Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 32.13 Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. (b) Reports on Form 8-K during the quarter ended March 31, 2005 The Company filed a Current Report on Form 8-K on March 8, 2005 disclosing the Company's final audited financial position and results of operations as of and for the year ended December 31, 2004. 24 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Date: May 6, 2005 SPECTRUM ORGANIC PRODUCTS, INC. By: /s/ Robert B. Fowles ---------------------------------------- Robert B. Fowles Duly Authorized Officer & Chief Financial Officer 25