UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-QSB
(Mark One)
|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended October 31, 2006
or
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT
For the transition period from ___________ to ___________
Commission File Number 001-31756
Argan, Inc.
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(Exact Name of Small Business Issuer as Specified in Its Charter)
Delaware 13-1947195
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(State or other Jurisdiction of Incorporation (I.R.S. Employer
or Organization) Identification No.)
One Church Street, Suite 401, Rockville MD 20850
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(Address of Principal Executive Offices)
(301) 315-0027
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(Issuer's Telephone Number, Including Area Code)
Former address: One Church Street, Suite 302, Rockville MD 20850
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(Former Name, Former Address and Former Fiscal Year,
if Changed Since Last Report)
Check whether the issuer (1) filed all reports required to be filed by
Section 13 or 15 (d) of the Exchange Act during the past twelve 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 a shell company (as
defined in Rule 12b-2) of the Exchange Act).
Yes |_| No |X|
Common Stock, par value $.15 per share, outstanding at December 8, 2006:
11,094,012.
Transitional Small Business Disclosure Format (Check One):
Yes |_| No |X|
ARGAN, INC.
INDEX
Page No.
PART I. FINANCIAL INFORMATION............................................... 3
Item 1. Financial Statements (unaudited).................................... 3
Condensed Consolidated Balance Sheets -
October 31, 2006 and January 31, 2006............................. 3
Condensed Consolidated Statements of Operations
for the Three and Nine Months Ended October 31, 2006 and 2005..... 4
Condensed Consolidated Statements of Cash Flows
for the Nine Months Ended October 31, 2006 and 2005.............. 5
Notes to Condensed Consolidated Financial Statements................ 6
Item 2. Management's Discussion and Analysis or Plan of Operation........... 19
Item 3. Controls and Procedures............................................. 31
PART II. OTHER INFORMATION................................................... 32
Item 1. Legal Proceedings................................................... 32
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds......... 32
Item 3. Defaults Upon Senior Securities..................................... 32
Item 4. Submission of Matters to a Vote of Security Holders................. 32
Item 5. Other Information................................................... 32
Item 6. Exhibits............................................................ 32
SIGNATURES................................................................... 33
================================================================================
2
PART 1. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
ARGAN, INC.
Condensed Consolidated Balance Sheets
(Unaudited)
October 31, January 31,
2006 2006
-------------- --------------
ASSETS
CURRENT ASSETS:
Cash and cash equivalents $ 233,000 $ 5,000
Accounts receivable, net of allowance for doubtful accounts
of $147,000 at 10/31/2006 and $50,000 at 1/31/2006 4,726,000 3,351,000
Receivable from affiliated entity 139,000 157,000
Escrowed cash 300,000 300,000
Estimated earnings in excess of billings 705,000 675,000
Inventories, net of reserves of $63,000 at 10/31/2006 and
$95,000 at 1/31/06 2,202,000 3,410,000
Prepaid expenses and other current assets 686,000 458,000
-------------- --------------
TOTAL CURRENT ASSETS 8,991,000 8,356,000
Property and equipment, net of accumulated depreciation of
$2,138,000 at 10/31/2006 and $1,418,000 at 1/31/2006 3,313,000 3,324,000
Issuance cost for subordinated debt -- 257,000
Other assets 155,000 46,000
Contractual customer relationships, net 1,517,000 1,894,000
Trade name 224,000 224,000
Proprietary formulas, net 382,000 726,000
Non-compete agreement, net 1,020,000 1,290,000
Goodwill 7,505,000 7,505,000
-------------- --------------
TOTAL ASSETS $ 23,107,000 $ 23,622,000
============== ==============
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable $ 3,223,000 $ 3,205,000
Due to affiliates 11,000 121,000
Accrued expenses 2,470,000 1,801,000
Billings in excess of cost and earnings 3,000 --
Deferred income tax liability -- 49,000
Line of credit 1,288,000 1,243,000
Current portion of long-term debt 591,000 421,000
-------------- --------------
TOTAL CURRENT LIABILITIES 7,586,000 6,840,000
Deferred income tax liability 1,176,000 1,618,000
Other liabilities 19,000 10,000
Long-term debt 1,028,000 176,000
Subordinated note due former owner of Vitarich Laboratories, Inc. -- 3,292,000
-------------- --------------
TOTAL LIABILITIES 9,809,000 11,936,000
-------------- --------------
STOCKHOLDERS' EQUITY
Preferred stock, par value $.10 per share; 500,000 shares
authorized; no shares issued and outstanding -- --
Common stock, par value $.15 per share;
12,000,000 shares authorized; 4,577,243 and 3,817,243 shares
issued at 10/31/2006 and 1/31/2006 and 4,574,010 and 3,814,010
shares outstanding at 10/31/2006 and 1/31/2006 686,000 572,000
Warrants outstanding 849,000 849,000
Additional paid-in capital 27,269,000 25,336,000
Accumulated other comprehensive loss (7,000) --
Accumulated deficit (15,466,000) (15,038,000)
Treasury stock at cost; 3,233 shares at 10/31/2006 and 1/31/2006 (33,000) (33,000)
-------------- --------------
TOTAL STOCKHOLDERS' EQUITY 13,298,000 11,686,000
-------------- --------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 23,107,000 $ 23,622,000
============== ==============
See accompanying notes.
3
ARGAN, INC.
Condensed Consolidated Statements of Operations
(Unaudited)
Three months ended October 31, Nine months ended October 31,
2006 2005 2006 2005
-------------- -------------- -------------- --------------
Net sales
Nutraceutical products $ 5,248,000 $ 4,085,000 $ 16,288,000 $ 13,337,000
Telecom infrastructure services 4,361,000 3,048,000 10,843,000 7,804,000
-------------- -------------- -------------- --------------
Net Sales 9,609,000 7,133,000 27,131,000 21,141,000
Cost of sales
Nutraceutical products 4,235,000 3,185,000 12,561,000 10,227,000
Telecom infrastructure services 3,506,000 2,285,000 8,507,000 6,100,000
-------------- -------------- -------------- --------------
Gross profit 1,868,000 1,663,000 6,063,000 4,814,000
Selling, general and administrative expenses 2,214,000 1,808,000 6,134,000 5,605,000
-------------- -------------- -------------- --------------
Loss from operations (346,000) (145,000) (71,000) (791,000)
Interest expense and amortization of
subordinated debt issuance costs 87,000 205,000 564,000 364,000
Other (income) expense, net (2,000) 1,000 (5,000) 1,926,000
-------------- -------------- -------------- --------------
Loss from operations before
income taxes (431,000) (351,000) (630,000) (3,081,000)
Income tax benefit 176,000 64,000 202,000 386,000
-------------- -------------- -------------- --------------
Net loss $ (255,000) $ (287,000) $ (428,000) $ (2,695,000)
============== ============== ============== ==============
Basic and diluted loss per share $ (0.06) $ (0.08) $ (0.10) $ (0.81)
============== ============== ============== ==============
Weighted average number of shares
outstanding - basic and diluted 4,574,000 3,814,000 4,312,000 3,314,000
============== ============== ============== ==============
See accompanying notes.
4
ARGAN, INC.
Condensed Consolidated Statements of Cash Flows
(unaudited)
Nine Months Ended
October 31,
2006 2005
-------------- --------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss $ (428,000) $ (2,695,000)
Adjustments to reconcile net loss to net cash provided by
operating activities:
Depreciation 797,000 595,000
Amortization of debt issuance costs 257,000 126,000
Amortization of purchase intangibles 991,000 1,272,000
Deferred income taxes (491,000) (430,000)
Non-cash loss on liabililty for derivative financial instruments -- 1,930,000
Loss (gain) on sale of property and equipment 1,000 (33,000)
Non-cash stock option compensation expense 185,000 --
Changes in operating assets and liabilities:
Accounts receivable, net (1,375,000) (578,000)
Receivable from affiliated entity 18,000 (63,000)
Estimated earnings in excess of billings (30,000) (25,000)
Inventories, net 1,208,000 1,090,000
Prepaid expenses and other current assets (361,000) 110,000
Accounts payable and accrued expenses 687,000 298,000
Billings in excess of estimated earnings 3,000 --
Due to affiliates (110,000) 65,000
Other 2,000 9,000
-------------- --------------
Net cash provided by operating activities 1,354,000 1,671,000
-------------- --------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property and equipment (778,000) (955,000)
Purchase of Vitarich Laboratories, Inc -- (426,000)
Proceeds from sale of property and equipment 15,000 70,000
-------------- --------------
Net cash used in investing activities (763,000) (1,311,000)
-------------- --------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from escrow -- 304,000
Net proceeds from sale of stock 1,862,000 --
Proceeds from line of credit 4,575,000 2,500,000
Proceeds from long-term debt 1,500,000 8,000
Payments on line of credit (4,530,000) (2,781,000)
Principal payments on long-term debt (478,000) (531,000)
Principal payments on subordinated note due former
owner of Vitarich Laboratories, Inc. (3,292,000) --
-------------- --------------
Net cash used in financing activities (363,000) (500,000)
-------------- --------------
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 228,000 (140,000)
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD 5,000 167,000
-------------- --------------
CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 233,000 $ 27,000
============== ==============
NON-CASH FINANCING ACTIVITY:
Fair Market Value of shares issued by a Subscription Agreement $ -- $ 481,371
============== ==============
See accompanying notes.
5
ARGAN, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
NOTE 1 - ORGANIZATION
Nature of Operations
--------------------
Argan, Inc. ("AI" or the "Company") conducts its operations through its wholly
owned subsidiaries Vitarich Laboratories, Inc. ("VLI") which it acquired in
August 2004 and Southern Maryland Cable, Inc. ("SMC") which it acquired in July
2003. Through VLI, the Company develops, manufactures and distributes premium
nutritional supplements, whole-food dietary supplements and personal care
products. Through SMC, the Company provides telecommunications infrastructure
services including project management, construction and maintenance to the
Federal Government, telecommunications and broadband service providers, as well
as electric utilities primarily in the Mid-Atlantic region.
AI operates in two reportable segments. (See Note 9)
Management's Plans, Liquity and Business Risks
----------------------------------------------
As of October 31, 2006, the Company had an accumulated deficit of approximately
$16 million. At October 31, 2006, the Company had approximately $2.2 million
available under its revolving line of credit with the Bank of America, N.A. (the
Bank). The Company operates in two distinct and separate reportable segments.
The market for nutritional products is highly competitive and the telecom and
infrastructure services industry is fragmented, but also very competitive. The
successful execution of the Company's business plan is dependent upon the
Company's ability to integrate acquired businesses and their related assets into
its operations, its ability to increase and retain its customers, the ability to
maintain compliance with significant government regulation, the ability to
attract and retain key employees and the Company's ability to manage its growth
and expansion, among other factors.
On May 4, 2006, the Company completed a private offering of 760,000 shares of
common stock at a price of $2.50 per share for aggregate proceeds of $1.9
million. The Company used $1.8 million of the proceeds to pay down an equal
notional amount of the subordinated note due the former owner of VLI. The
remainder of the proceeds were used for general corporate purposes. One of the
investors, MSRI SBIC, L.P., which acquired 240,000 shares in the offering, is
controlled by Daniel Levinson, a director of the Company. In addition, James
Quinn, a director of the Company acquired 40,000 shares for his own account.
(See Notes 5 and 7)
On May 5, 2006, the Company renewed its line of credit with the Bank, extending
the maturity date to May 31, 2007. Concurrent with the renewal, the Bank has
agreed to provide a new $1.5 million term loan facility (New Term Loan). On
August 31, 2006, the Company borrowed $1.5 million under the New Term Loan and
paid the remaining principal and interest due on the subordinated note with the
former owner of VLI, Kevin Thomas ("Thomas"). (See Note 6)
Management believes that capital resources available under its renewed line of
credit combined with cash generated from the Company's operations is adequate to
meet the Company's future operating cash needs. Accordingly, the carrying value
of the assets and liabilities in the accompanying balance sheet do not reflect
any adjustments should the Company be unable to meet its future operating cash
needs in the ordinary course of business. The Company continues to take various
actions to align its cost structure to appropriately match its expected
revenues, including limiting its operating expenditures and controlling its
capital expenditures. Any future acquisitions, other significant unplanned costs
or cash requirements may require the Company to raise additional funds through
the issuance of debt and equity securities. There can be no assurance that such
financing will be available on terms acceptable to the Company, or at all. If
additional funds are raised by issuing equity securities, significant dilution
to the existing stockholders may result.
6
NOTE 2 - SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation - The condensed consolidated balance sheet as of October
31, 2006, the condensed consolidated statements of operations for the three and
nine months ended October 31, 2006 and 2005, and the statements of cash flows
for the nine month period ended October 31, 2006 and 2005, are unaudited. In the
opinion of management, the accompanying financial statements contain all
adjustments, which are of a normal and recurring nature, considered necessary to
present fairly the financial position of the Company as of October 31, 2006 and
the results of its operations and its cash flows for the interim periods
presented. The Company prepares its interim financial information using the same
accounting principles as it does for its annual financial statements.
These financial statements do not include all disclosures associated with annual
financial statements and, accordingly, should be read in conjunction with the
footnotes contained in the Company's consolidated financial statements for the
year ended January 31, 2006, together with the independent registered public
accounting firm's report, included in the Company's Annual Report on Form
10-KSB, as filed with the Securities and Exchange Commission (SEC). The results
of operations for any interim period are not necessarily indicative of the
results of operations for any other interim period or for a full fiscal year.
Reclassifications - Certain amounts in the prior year financial statements have
been reclassified to conform with the presentation in the current year financial
statements.
Accounts Receivable and Estimated Earnings in Excess of Billings - Accounts
receivable and estimated earnings in excess of billings represent amounts due
from customers for services rendered or products delivered. The timing of
billing to customers varies based on individual contracts and often differs from
the period of revenue recognition. The Company's unbilled receivables on time
and materials and unit contracts were $485,000 and $121,000 at October 31, 2006
and January 31, 2006, respectively, and are included as a component of accounts
receivable. Estimated earnings in excess of billings and billings in excess of
estimated earnings on fixed priced contracts totaled $705,000 and $3,000,
respectively, at October 31, 2006. Estimated earnings in excess of billings and
billings in excess of estimated earnings on fixed priced contracts totaled
$675,000 and none, respectively, at January 31, 2006.
Inventories - Inventories are stated at the lower of cost or market (net
realizable value). Cost is determined on the first-in, first-out (FIFO) method.
Appropriate consideration is given to obsolescence, excessive inventory levels,
product deterioration, and other factors in evaluating net realizable value.
Inventories consist of the following:
October 31, January 31,
2006 2006
------------- -------------
Raw materials $ 1,991,000 $ 3,190,000
Work-in process 77,000 70,000
Finished goods 197,000 245,000
Less: Reserves (63,000) (95,000)
------------- -------------
Inventories, net $ 2,202,000 $ 3,410,000
============= =============
The Company entered into an agreement with one of its major customers, whereby
the customer made advanced payments to the Company for a significant portion of
raw materials at cost. The raw materials are held at the Company's premises and
are used in the production of a product for the customer. The Company is
accounting for this as an inventory financing arrangement and recognizes revenue
from the sale of the raw materials when the finished product is shipped to the
customer. At October 31, 2006, the Company had customer deposits and inventories
related to this arrangement of $238,000.
7
Earnings Per Share - Income per share is computed by dividing net loss by the
weighted average number of common shares outstanding for the period. Dilutive
earnings per share represent net income divided by the weighted average number
of common shares outstanding inclusive of the effects of dilutive securities.
Outstanding stock options and warrants for the purchase of 228,000 shares of
common stock were not included in the weighted average shares outstanding during
the three and nine months ended October 31, 2006, because they are antidilutive.
Seasonality - The Company's telecom infrastructure services operations are
expected to have seasonally weaker results in the first and fourth quarters of
our year, and may produce stronger results in the second and third quarters.
Seasonality is primarily due to the effect of winter weather on outside plant
activities as well as reduced daylight hours and customer budgetary constraints.
Certain customers tend to complete budgeted capital expenditures before the end
of the year, and postpone additional expenditures until the subsequent fiscal
period.
Derivative Financial Instruments - The Company accounts for derivative financial
instruments in accordance with Statement of Financial Accounting Standards
("SFAS") No. 133 "Accounting for Derivative Instruments and Hedging Activities"
and Emerging Issues Task Force Issue No. 00-19, "Accounting for Derivative
Financial Instruments Indexed to, and Potentially Settled in a Company's Own
Stock." The derivative financial instruments are recognized on the consolidated
balance sheet as either assets or liabilities and are measured at fair value.
Changes in the fair value of derivatives are recorded each period in earnings or
accumulated other comprehensive income, depending on whether a derivative is
designated and effective as part of a hedge transaction, and if it is, the type
of hedge transaction. Gains and losses on derivative instruments reported in
accumulated other comprehensive income are subsequently included in earnings in
the periods in which earnings are affected by the hedged item. The determination
of fair value for some of the company's derivative financial instruments is
subject to the volatility of the company's stock price as well as certain
underlying assumptions which include the probability of raising additional
capital. In fiscal year 2006 the company began using an interest rate swap to
hedge the fluctuation in interest rates for long term debt.
Stock Option Plans - Prior to February 1, 2006, the Company measured
compensation costs for stock based compensation plans using the intrinsic value
method of accounting as prescribed in Accounting Principles Board Opinion No. 25
"Accounting for Stock Issued to Employees" ("APB No. 25") and related
interpretations. In electing to follow APB No. 25 for expense recognition
purposes for the three and nine months ended October 31, 2005, the Company has
provided below the expanded disclosures required under Statement of Financial
Accounting Standards No. 148 "Accounting for Stock Based Compensation" ("SFAS
No. 148") for stock-based compensation granted including, if materially
different from reported results, disclosure of pro forma net income and net
income per share had compensation expense relating to grants been measured under
the fair value recognition provisions of SFAS No. 123, "Accounting for
Stock-Based Compensation" ("SFAS No. 123"). All options issued and outstanding
at October 31, 2005 had an exercise price greater than the market price of the
Company's stock on the date of grant. The fair values of options granted have
been estimated at the date of grant using a Black-Scholes option-pricing model.
Option valuation models require the use of subjective assumptions and changes in
these assumptions can materially impact the fair value of the options.
The following table illustrates the effect on net loss and net loss per share if
the Company had applied the fair value recognition provisions of SFAS No. 123 to
options granted and unvested under the Plan for the three and nine months ended
October 31, 2005. For purposes of this pro forma disclosure, the value of
options is estimated using a Black-Scholes option-pricing formula and amortized
over the options' vesting periods.
8
Pro Forma Disclosures
Three months Nine months
ended ended
October 31, October 31,
2005 2005
------------- -------------
Net loss, as reported $ (287,000) $ (2,695,000)
Deduct: Total stock-based employee
compensation expense determined
under fair value based methods
12,000 38,000
------------- -------------
Pro forma net loss $ (299,000) $ (2,733,000)
============= =============
Basic and diluted per share:
Basic and diluted - as reported $ (0.08) $ (0.81)
============= =============
Basic and diluted - pro forma $ (0.08) $ (0.82)
============= =============
Impact of Changes in Accounting Standards
-----------------------------------------
In July 2006, the Financial Accounting Standards Board (FASB) issued FASB
Interpretation No. 48, Accounting for Uncertainty in Income Taxes - an
interpretation of FASB Statement No. 109 ("FIN 48"), which clarifies the
accounting for uncertainty in income tax positions. FIN 48 requires that the
Company recognize in the consolidated financial statements the impact of a tax
position that is more likely than not to be sustained upon examination based on
the technical merits of the position. The provisions of FIN 48 will be effective
for the Company, as of the beginning of the Company's fiscal year ending January
31, 2008, with the cumulative effect of the change in accounting principle
recorded as an adjustment to opening retained earnings. The Company is still
evaluating the impact of FIN 48 on its consolidated financial statements.
In September 2006, the SEC issued Staff Accounting Bulletin No. 108 ("SAB 108"),
Considering the Effects of Prior Year Misstatements When Quantifying
Misstatements in Current Year Financial Statements. SAB 108 provides guidance to
registrants for assessing materiality. SAB No. 108 states that registrants
should use both a balance sheet approach and income statement approach when
quantifying and evaluating the materiality of a misstatement. SAB 108 also
provides guidance on correcting errors under the dual approach as well as
transition guidance for correcting previously immaterial errors that are now
considered material. The provisions of SAB 108 is effective for the Company, as
of the fiscal year ending January 31, 2007. The Company does not expect SAB 108
to have a significant impact on the consolidated financial statements.
In September 2006, the FASB issued FAS No. 157, "Fair Value Measurements," which
provides guidance for using fair value to measure assets and liabilities. FAS
157 will apply whenever another standard requires or permits assets or
liabilities to be measured at fair value. The standard does not expand the use
of fair value to any new circumstances. The provisions of FAS 157 will be
effective for the Company, as of the beginning of the Company's fiscal year
ending January 31, 2009. The Company does not expect FAS 157 to have a
significant impact on the consolidated financial statements.
NOTE 3 - STOCK BASED COMPENSATION
At October 31, 2006, the Company has a stock option plan which was established
in August 2001 (Plan). Under the Plan, the Company's Board of Directors may
grant stock options to officers, directors and key employees. The Plan was
amended in April 2003 to authorize the grant of options for up to 250,000 shares
of common stock.
9
Prior to February 1, 2006, the Company accounted for the Plan under the
recognition and measurement provisions of Accounting Principles Board Opinion
No. 25 "Accounting for Stock Issued to Employees ("APB No. 25"), and related
interpretations, as permitted by Statements of Financial Accounting Standards
("SFAS") No. 123, "Accounting for Stock Based Compensation ("SFAS No. 123"). No
stock-based employee compensation cost was recognized in the Statement of
Operations for the three and nine months ended October 31, 2005, as all options
granted under the Plan had an exercise price equal to or greater than the market
value of the underlying common stock on the date of grant. Effective February 1,
2006, the Company adopted the fair value recognition provisions of SFAS No.
123(R), "Share-Based Payment" (SFAS No. 123(R)), using the modified-prospective
transition method. Under that transition method, compensation cost recognized in
the nine months ended October 31, 2006 includes: (a) compensation cost for all
share-based payments granted prior to, but not yet vested as of February 1,
2006, based on grant date fair value estimated in accordance with the original
provisions of SFAS No. 123 and (b) compensation cost for all share-based
payments granted on or subsequent to February 1, 2006, based on the grant-date
fair value estimated in accordance with the provisions of SFAS No. 123(R).
Results for prior periods have not been restated.
As a result of adopting SFAS No. 123(R) on February 1, 2006, the Company's loss
before income taxes for the three and nine months ended October 31, 2006, was
approximately $105,000 and $185,000, respectively, more than if it had continued
to account for share based compensation under APB No. 25. Basic and diluted loss
per share for the three and nine months ended October 31, 2006 would have been
$0.02 and $0.04, respectively, more than if it had continued to account for
share based compensation under APB No. 25.
Stock options granted may be "Incentive Stock Options" ("ISOs") or "Nonqualified
Stock Options" (NSOs"). ISOs have an exercise price at least equal to the
stock's fair market value at the date of grant, a ten year term and vest and
become fully exercisable one year from the date of grant. NSOs may be granted at
an exercise price other than the stock's fair market value at the date of grant
and have up to a ten year term, and vest and become fully exercisable as
determined by the Board.
The fair value of each option award is estimated on the date of grant using a
Black-Scholes option-pricing formula that uses the assumptions noted in the
table and discussion that follows:
Nine Months Ended
October 31,
2006 2005
========== ==========
Dividend yield -- --
Expected volatility 57% 53%
Risk-free interest rate 5.11% 4.28%
Expected life in years 5 5
A summary of option activity under the Plan as of October 31, 2006, and changes
in the nine months then ended is presented below:
Weighted-
Weighted- Average
Average Remaining Aggregate
Exercise Contract Intrinsic
Options Shares Price Term Value
------- ------------- ------------- ------------- -------------
Outstanding at beginning
of period 73,000 $ 7.84
Granted 160,000 $ 2.49
Exercised --
Forfeited or expired (5,000) $ 7.79
-------------
Outstanding at end of period 228,000 $ 4.09 8.4 $ 418,000
=============
Vested or expected to vest at
end of period 228,000 $ 4.09 8.4 $ 418,000
Exercisable at end of period 118,000 $ 5.43 7.2 $ 261,000
10
The weighted average grant date fair value of options granted during the nine
months ended October 31, 2006 and 2005 was $1.34 and $1.95, respectively.
No options were exercised during the nine months ended October 31, 2006 and
2005. At October 31, 2006, there was $44,000 of total unrecognized compensation
cost related to stock options granted under the Plan. That cost is expected to
be recognized over the remaining three months of the six month vesting period.
The total fair value of shares vested during the nine months ended October 31,
2006 and 2005, was $228,000 and $93,000, respectively.
A summary of the status of the Company's nonvested shares as of October 31,
2006, and changes during the nine months then ended, is present below:
Aggregate
Intrinsic
Shares Value
------------ ------------
Nonvested at beginning of period 16,000 $ 1.95
Granted 160,000 $ 1.34
Vested (66,000) $ 1.35
Forfeited -- --
------------
Nonvested at end of period 110,000 $ 1.42
============
The fair value of nonvested shares is determined based on the opening trading
price of the Company's shares on the grant date.
In connection with the Company's private placement in April 2003, the Company
issued warrants to purchase shares of the Company's common stock at a price of
$7.75 per share with a ten year term. 180,000 of the warrants were granted to
three individuals who became the executive officers of the Company upon
completion of the offering. In addition, MSR Advisors, Inc. (MSR) received
warrants to purchase 50,000 shares of the Company's stock. A director of the
Company is the Chief Executive Officer of MSR. The fair value of the warrants of
$849,000 was recognized as offering costs. All warrants are exercisable.
At October 31, 2006, there were 474,000 shares of the Company's common stock
reserved for issuance upon exercise of stock options and warrants.
NOTE 4 - SUMMARY OF INTANGIBLE ASSETS
The Company's intangible assets consist of the following at October 31, 2006:
Gross Net
Estimated Carrying Accumulated Carrying
Useful Life Amount Amortization Amount
----------- ----------- ----------- -----------
Goodwill Indefinite $ 7,505,000 $ -- $ 7,505,000
Contractual
Customer
Relationships 5-7 years 2,854,000 1,337,000 1,517,000
Proprietary
Formulas 3 years 1,813,000 1,431,000 382,000
Non-Compete
Agreement 5 years 1,800,000 780,000 1,020,000
Trade Name Indefinite 224,000 -- 224,000
----------- ----------- -----------
$14,196,000 $ 3,548,000 $10,648,000
=========== =========== ===========
11
During the twelve months ended January 31, 2006, the Company recorded an
impairment loss with respect to goodwill and proprietary formulas at VLI of
$5,810,000 and $687,000, respectively. Amortization expense for the nine months
ended October 31, 2006, aggregated $377,000, $344,000 and $270,000 for
Contractual Customer Relationships, Proprietary Formulas and Non-Compete
Agreement, respectively. Amortization expense for the nine months ended October
31, 2005, aggregated $377,000, $625,000 and $270,000 for Contractual Customer
Relationships, Proprietary Formulas and Non-Compete Agreement, respectively.
NOTE 5 - RELATED PARTY TRANSACTIONS
On May 4, 2006, the Company completed a private offering of 760,000 shares of
common stock at a price of $2.50 per share for aggregate proceeds of $1.9
million. These shares were registered with the SEC effective July 10, 2006. The
Company used $1.8 million of the proceeds to pay down an equal notional amount
of the subordinated note due Thomas. The remainder of the proceeds were used for
general corporate purposes.
One of the investors, MSRI SBIC, L.P., which acquired 240,000 shares in the
offering, is controlled by Daniel Levinson, a director of the Company. In
addition, James Quinn, a director of the Company acquired 40,000 shares for his
own account.
On January 28, 2005, the Company sold and issued to MSRI SBIC, L.P., a Delaware
limited partnership ("Investor"), 129,032 shares of common stock of the Company
pursuant to a Subscription Agreement between the Company and Investor
("Subscription Agreement"). These shares were issued at a purchase price of
$7.75 per share, yielding aggregate proceeds of $999,998. (See Note 7) These
shares were issued pursuant to the exemption provided by Section 4(2) of the
Securities Act of 1933, as amended. The Investor is an entity controlled by
Daniel Levinson, a director of the Company.
Pursuant to the Subscription Agreement, the Company agreed to issue additional
shares of the Company's common stock to Investor in accordance with the
Subscription Agreement under certain conditions upon the earlier of (i) the
Company's issuance of additional shares of common stock having an aggregate
purchase price of at least $2,500,000, at a price per share less than $7.75
subject to certain exclusions, or (ii) ninety percent of the average bid price
of the Company's common stock for the thirty days ended July 31, 2005 if the
price was less than $7.75, less the 129,032 shares previously issued. The
Company settled the liability for issuance of additional shares in a non-cash
transaction at July 31, 2005 with the issuance of 95,321 shares of the Company's
common stock.
The provision in the Subscription Agreement which allows the Investor to receive
additional shares under certain conditions represents a derivative under
Statement of Financial Accounting Standards No. 133 "Accounting for Derivative
Instruments and Hedging Activities." Accordingly, $139,000 of the proceeds
received at issuance was accounted for as a liability for a derivative financial
instrument. This liability relates to the obligation to issue Investor
additional shares under certain conditions. The derivative financial instrument
was subject to adjustment for changes in fair value subsequent to issuance.
During the nine months ended October 31, 2005, the Company recorded a fair value
loss adjustment of $343,000, which is recorded in other expense (income), net.
On January 31, 2005, the Company entered into a debt subordination agreement
with Thomas, the former owner of VLI, for the cash portion of the additional
consideration the Company owes Thomas. The subordinated debt had an original
maturity of August 1, 2006 and had an interest rate of 10%. On May 5, 2006, the
Company entered into an extension with Thomas of the maturity date of the
subordinated note to August 1, 2007. The remaining principal and interest due on
this note was paid on August 31, 2006.
12
At issuance, $501,000 of the charge related to the liability for derivative
financial instruments was recorded as deferred issuance cost for subordinated
debt which will be amortized over the life of the subordinated debt. The
amortization of the deferred loan issuance cost increased the Company's interest
expense and reduced net income. The derivative financial instrument was subject
to adjustment for changes in fair value subsequent to issuance. The fair value
loss adjustment of $1,587,000 during the nine months ended October 31, 2005, was
reflected as a change in liability for the derivative financial instruments and
as other expense (income), net. The liability for the derivative financial
instrument was settled as a non-cash transaction by the issuance of 535,052
shares of the Company's common stock on September 1, 2005.
The Company leases administrative, manufacturing and warehouse facilities for
various lengths of time from individuals who were or are officers of SMC and
VLI. The related party relationship for SMC ended in July 2006. The total
expense under these arrangements was $68,000 and $208,000 for the three and nine
months ended October 31, 2006, respectively, and $75,000 and $222,000 for the
three and nine months ended October 31, 2005, respectively.
The Company has also entered into a supply agreement with an entity owned by the
former shareholder of VLI whereby the supplier committed to sell to the Company
and the Company committed to purchase on an as-needed basis, certain organic
products. VLI made $23,000 and $77,000 in purchases under the supply agreement
during the three and nine months ended October 31, 2006, respectively, and
$68,000 and $146,000 for the three and nine months ended October 31, 2005,
respectively.
The Company also sells its products in the normal course of business to an
entity in which the former owner of VLI has an ownership interest. VLI had
approximately $118,000 and $405,000 in sales with this entity for three and nine
months ended October 31, 2006, respectively, and $129,000 and $430,000 for the
three and nine months ended October 31, 2005, respectively. At October 31, 2006
and January 31, 2006, the affiliated entity owed $139,000 and $157,000,
respectively, to VLI.
NOTE 6 - DEBT
In May 2006, the Company agreed to amend the existing financing arrangements
with the Bank of America (Bank). Under this arrangement, the Company had a
revolving line of credit of $4.25 million in maximum availability and a term
loan with an original balance of $1.2 million. The May 2006 amendment extended
the expiration of the revolving line of credit to May 31, 2007. Under the
amended financing arrangements, amounts outstanding under the revolving line of
credit and the three year term note bear interest at LIBOR plus 3.25% and 3.45%,
respectively. Availability on a monthly basis under the revolving line is
determined by reference to accounts receivable and inventory on hand which meet
certain Bank criteria (Borrowing Base). The aforementioned three year term note
was paid on July 31, 2006. At October 31, 2006 and January 31, 2006, the Company
had $1,288,000 and $1,243,000, respectively, outstanding under the revolving
line of credit and an effective interest rate of 9.12% and 7.74%, respectively,
with $2.2 million of additional availability under its Borrowing Base.
The amended financing arrangements provides for a new $1.5 million three year
term loan facility (New Term Loan). On August 31, 2006, the Company borrowed
$1.5 million under the New Term Loan and paid the remaining principal and
interest due on the subordinated note with Thomas. As a result of this draw, the
Company's Borrowing Base was reduced by $750,000 for maximum availability under
the revolving line of credit. The New Term Loan will be repaid in thirty-six
equal monthly principal payments and bears interest at LIBOR plus 3.25%.
In conjunction with the New Term Loan the Company entered into an interest rate
swap agreement with a notional debt amount of $1,125,000, which effectively
fixes the variable interest rate. The fair value of this interest rate swap as
of October 31, 2006, is a loss of approximately $7,000 and is recorded in equity
as accumulated other comprehensive loss and as other liabilities on the balance
sheet.
13
The financing arrangements provide for the measurement at the Company's fiscal
year end and at each of the Company's fiscal quarter ends of certain financial
covenants including requiring that the ratio of debt to pro forma earnings
before interest, taxes, depreciation and amortization (EBITDA) not exceed 2.5 to
1 and requiring a pro forma fixed charge coverage ratio of not less than 1.25 to
1. The amended financings also require that the Company meet minimum EBITDA
covenants equal to or exceeding (on a trailing twelve months) $1.3 million for
October 31, 2006 and $1.8 million for January 31, 2007 and for each successive
quarter end thereafter. The Bank's consent continues to be required for
acquisitions and divestitures. The Company continues to pledge the majority of
the Company's assets to secure the financing arrangements.
The amended financing arrangement contains a subjective acceleration clause
which allows the Bank to declare amounts outstanding under the financing
arrangements due and payable if certain material adverse changes occur. The
Company believes that it will continue to comply with its financial covenants
under the financing arrangement. If the Company's performance does not result in
compliance with any of its financial covenants, or if the Bank seeks to exercise
its rights under the subjective acceleration clause referred to above, the
Company would seek to modify its financing arrangement, but there can be no
assurance that the Bank would not exercise their rights and remedies under the
financing arrangement including accelerating payment of all outstanding senior
and subordinated debt due and payable.
At October 31, 2006, the Company was in compliance with the covenants of its
amended financing arrangements.
NOTE 7 - PRIVATE OFFERINGS OF COMMON STOCK
On December 8, 2006, the Company completed a private offering of approximately
2,853,000 shares of common stock at a price of $3.75 per share. The proceeds of
approximately $10,699,000 were used in the acquisition of Gemma Power Systems,
LLC.
On May 4, 2006, the Company completed a private offering of 760,000 shares of
common stock at a price of $2.50 per share for aggregate proceeds of $1.9
million. These shares were registered with the SEC effective July 10, 2006. The
Company used $1.8 million of the proceeds to pay down an equal notional amount
of the subordinated note due Kevin Thomas. The remainder of the proceeds were
used for general corporate purposes.
One of the investors, MSRI SBIC, L.P., which acquired 240,000 shares in the
offering, is controlled by Daniel Levinson, a director of the Company. In
addition, James Quinn, a director of the Company acquired 40,000 shares for his
own account.
On January 28, 2005, the Company sold and issued to MSR I SBIC, L.P., a Delaware
limited partnership ("Investor"), 129,032 shares of the Company's common stock,
pursuant to a Subscription Agreement between the Company and Investor
("Subscription Agreement"). These shares were issued at a purchase price of
$7.75 per share, yielding aggregate proceeds of $999,998. These shares were
issued pursuant to the exemption provided by Section 4(2) of the Securities Act
of 1933, as amended. The Investor is an entity controlled by Daniel Levinson, a
director of the Company. (See Note 5) Pursuant to the Subscription Agreement,
the Company has agreed to issue additional shares of the Company's common stock
to Investor in accordance with the Subscription Agreement based upon the earlier
of (i) the Company's issuance of additional shares of common stock having an
aggregate purchase price of at least $2,500,000 at a price per share less than
$7.75, or (ii) July 31, 2005. The additional shares of common stock to be issued
would equal the price paid by Investor divided by the lower of (i) the weighted
average of all stock sold by the Company prior to July 31, 2005 or; (ii) ninety
percent of the average bid price of the Company's common stock for the thirty
days ended July 31, 2005 if the price was less than $7.75, less the 129,032
shares previously issued. The Company settled the liability for issuance of
additional shares in a non-cash transaction at July 31, 2005 with the issuance
of 95,321 shares of the Company's common stock.
14
The provision in the Subscription Agreement which allows the Investor to receive
additional shares under certain conditions represents a derivative under
Statement of Financial Accounting Standards No. 133 "Accounting for Derivative
Instruments and Hedging Activities." Accordingly, at January 31, 2005, $139,000
of the proceeds was accounted for as a liability for a derivative financial
instrument. This liability related to the obligation to issue Investor
additional shares under certain conditions. The derivative financial instrument
was subject to adjustment for changes in fair value subsequent to issuance.
During the nine months ended October 31, 2005, the Company recorded a fair loss
value loss adjustment of $343,000, which is recorded in other expense (income),
net.
NOTE 8 - INCOME TAXES
The Company had an effective income tax benefit rate of 32% and 26% for the
three and nine months ended October 31, 2006 and an effective income tax benefit
rate of 18% and 13% for the three and nine months ended October 31, 2005. During
the nine months ended October 31, 2006, the Company's effective income tax
benefit rate decreased, from the standard rate of 38%, by the impact of the
amortization of issuance cost for subordinated debt which is treated as a
permanent difference for income tax reporting purposes. During the three and
nine months ended October 31, 2005, the Company recorded the change in fair
value of the liability for derivative financial instruments as other expense
which is treated as a permanent difference for income tax reporting purposes.
This permanent difference reduced the income tax benefit rate from 38%.
NOTE 9 - SEGMENT REPORTING
The Company has two reportable operating segments. Operating segments are
defined as components of an enterprise about which separate financial
information is available that is evaluated regularly by the chief operating
decision maker, or decision making group, in deciding how to allocate resources
and assessing performance.
The Company's two operating segments are nutraceutical products and telecom
infrastructure services. The Company conducts its operations through its wholly
owned subsidiaries - VLI and SMC. The "Other" column includes the Company's
corporate and unallocated expenses.
The Company's operating segments are organized in separate business units with
different management, customers, technology and services. The respective
segments account for the respective businesses using the accounting policies in
Note 2 to the Company's Form 10-KSB and Note 2 in this filing. Summarized
financial information concerning the Company's operating segments is shown in
the following tables:
15
For the Nine Months
Ended October 31, 2006
Telecom
Nutraceutical Infrastructure
Products Services Other Consolidated
-------------- -------------- -------------- --------------
Net sales $ 16,288,000 $ 10,843,000 $ -- $ 27,131,000
Cost of sales 12,561,000 8,507,000 -- 21,068,000
-------------- -------------- -------------- --------------
Gross profit 3,727,000 2,336,000 -- 6,063,000
Selling, general and administrative
expenses 3,335,000 1,249,000 1,550,000 6,134,000
-------------- -------------- -------------- --------------
Income (loss) from operations 392,000 1,087,000 (1,550,000) (71,000)
Interest expense and amortization of
subordinated debt issuance costs 287,000 41,000 236,000 564,000
Other income, net -- (5,000) -- (5,000)
-------------- -------------- -------------- --------------
Income (loss) before income taxes $ 105,000 $ 1,051,000 $ (1,786,000) (630,000)
============== ============== ============== --------------
Income tax benefit 202,000
--------------
Net loss $ (428,000)
==============
Depreciation and amortization $ 419,000 $ 351,000 $ 284,000 $ 1,054,000
============== ============== ============== ==============
Amortization of intangibles $ 914,000 $ 77,000 $ -- $ 991,000
============== ============== ============== ==============
Goodwill $ 6,565,000 $ 940,000 $ -- $ 7,505,000
============== ============== ============== ==============
Total assets $ 16,200,000 $ 6,439,000 $ 468,000 $ 23,107,000
============== ============== ============== ==============
Fixed asset additions $ 281,000 $ 489,000 $ 8,000 $ 778,000
============== ============== ============== ==============
For the Three Months
Ended October 31, 2006
Telecom
Nutraceutical Infrastructure
Products Services Other Consolidated
-------------- -------------- -------------- --------------
Net sales $ 5,248,000 $ 4,361,000 $ -- $ 9,609,000
Cost of sales 4,235,000 3,506,000 -- 7,741,000
-------------- -------------- -------------- --------------
Gross profit 1,013,000 855,000 -- 1,868,000
Selling, general and administrative
expenses 1,178,000 411,000 625,000 2,214,000
-------------- -------------- -------------- --------------
Income (loss) from operations (165,000) 444,000 (625,000) (346,000)
Interest expense and amortization of
subordinated debt issuance costs 79,000 12,000 (4,000) 87,000
Other income, net -- (2,000) -- (2,000)
-------------- -------------- -------------- --------------
Income (loss) before income taxes $ (244,000) $ 434,000 $ (621,000) (431,000)
============== ============== ============== --------------
Income tax benefit 176,000
--------------
Net loss $ (255,000)
==============
Depreciation and amortization $ 146,000 $ 121,000 $ 12,000 $ 279,000
============== ============== ============== ==============
Amortization of intangibles $ 305,000 $ 26,000 $ -- $ 331,000
============== ============== ============== ==============
Goodwill $ 6,565,000 $ 940,000 $ -- $ 7,505,000
============== ============== ============== ==============
Total assets $ 16,200,000 $ 6,439,000 $ 468,000 $ 23,107,000
============== ============== ============== ==============
Fixed asset additions $ 92,000 $ 74,000 $ -- $ 166,000
============== ============== ============== ==============
16
For the Nine Months
Ended October 31, 2005
Telecom
Nutraceutical Infrastructure
Products Services Other Consolidated
-------------- -------------- -------------- --------------
Net sales $ 13,337,000 $ 7,804,000 $ -- $ 21,141,000
Cost of sales 10,227,000 6,100,000 -- 16,327,000
-------------- -------------- -------------- --------------
Gross profit 3,110,000 1,704,000 -- 4,814,000
Selling, general and administrative
expenses 3,225,000 1,128,000 1,252,000 5,605,000
-------------- -------------- -------------- --------------
(Loss) income from operations (115,000) 576,000 (1,252,000) (791,000)
Interest expense and amortization of
subordinated debt issuance costs 238,000 43,000 83,000 364,000
Other expense, net -- (2,000) 1,928,000 1,926,000
-------------- -------------- -------------- --------------
(Loss) income before income taxes $ (353,000) $ 535,000 $ (3,263,000) (3,081,000)
============== ============== ============== --------------
Income tax benefit 386,000
--------------
Net loss $ (2,695,000)
==============
Depreciation and amortization $ 267,000 $ 300,000 $ 154,000 $ 721,000
============== ============== ============== ==============
Amortization of intangibles $ 1,194,000 $ 78,000 $ -- $ 1,272,000
============== ============== ============== ==============
Goodwill $ 12,375,000 $ 940,000 $ -- $ 13,315,000
============== ============== ============== ==============
Total Assets $ 21,314,000 $ 5,281,000 $ 3,127,000 $ 29,722,000
============== ============== ============== ==============
Fixed asset additions $ 749,000 $ 206,000 $ -- $ 955,000
============== ============== ============== ==============
For the Three Months
Ended October 31, 2005
Telecom
Nutraceutical Infrastructure
Products Services Other Consolidated
-------------- -------------- -------------- --------------
Net sales $ 4,085,000 $ 3,048,000 $ -- $ 7,133,000
Cost of sales 3,185,000 2,285,000 -- 5,470,000
-------------- -------------- -------------- --------------
Gross profit 900,000 763,000 -- 1,663,000
Selling, general and administrative
expenses 1,023,000 382,000 403,000 1,808,000
-------------- -------------- -------------- --------------
(Loss) income from operations (123,000) 381,000 (403,000) (145,000)
Interest expense and amortization of
subordinated debt issuance costs 106,000 19,000 80,000 205,000
Other expense, net 1,000 -- -- 1,000
-------------- -------------- -------------- --------------
(Loss) income before income taxes $ (230,000) $ 362,000 $ (483,000) (351,000)
============== ============== ============== --------------
Income tax benefit 64,000
--------------
Net loss $ (287,000)
==============
Depreciation and amortization $ 101,000 $ 102,000 $ 96,000 $ 299,000
============== ============== ============== ==============
Amortization of intangibles $ 398,000 $ 26,000 $ -- $ 424,000
============== ============== ============== ==============
Goodwill $ 12,375,000 $ 940,000 $ -- $ 13,315,000
============== ============== ============== ==============
Total Assets $ 21,314,000 $ 5,281,000 $ 3,127,000 $ 29,722,000
============== ============== ============== ==============
Fixed asset additions $ 121,000 $ 41,000 $ -- $ 162,000
============== ============== ============== ==============
17
NOTE 10 - CONTINGENCIES
On September 17, 2004, Western Filter Corporation (WFC) notified the Company
that WFC believes that the Company breached certain representations and
warranties under the stock purchase agreement dated October 31, 2003 by and
between AI and WFC ("Stock Purchase Agreement"). WFC asserts damages in excess
of the $300,000 escrow which is being held by a third party in connection with
the Stock Purchase Agreement.
On March 22, 2005, WFC filed a complaint in Los Angeles Superior Court alleging
the Company and its executive officers, individually, committed breach of
contract, intentional misrepresentation, concealment and non-disclosure,
negligent misrepresentation and false promise. WFC seeks declaratory relief and
compensatory and punitive damages in an amount to be proven at trial as well as
the recovery of attorney's fees.
Although the Company has reviewed WFC's claim and believes that substantially
all of the claims are without merit, at October 31, 2006, the Company has
recorded an accrual related to this matter of $360,000 for estimated payments
and legal fees related to the claims of WFC that it considers to be probable and
that can be reasonably estimated. It is possible however, that the ultimate
resolution of WFC's claim could result in a material adverse effect on the
Company's results of operations for a particular reporting period. The Company
will vigorously contest WFC's claim.
In the normal course of business, the Company has pending claims and legal
proceedings. It is the opinion of the Company's management, based on information
available at this time, that none of the other current claims and proceedings
will have a material effect on the Company's consolidated financial statements.
NOTE 11 - ACQUISITION
On December 8, 2006, the Company announced the acquisition of Gemma Power
Systems, LLC and affiliates (Gemma), a leading powerplant builder with expertise
in the rapidly growing alternative fuel industry including biodiesel, ethanol
and other power energy systems.
The purchase price of the acquisition was approximately $25,000,000, with 55% of
the transaction being paid in stock and 45% in cash. In conjunction with the
merger, the Company completed a private offering of 2,853,335 shares of common
stock at a price of $3.75 per share for aggregate proceeds of approximately
$10,700,000. The Company also agreed to amend its existing financing
arrangements with the Bank whereby the Bank is providing a new $8 million, four
year term loan (New Term Loan). The proceeds of the private offering and the New
Term Loan were used to acquire Gemma and to provide the Company with working
capital.
Two of the investors, MSRI SBIC, L.P. and MSR Fund II Series A, which in the
aggregate acquired 533,333 shares in the offering, are controlled by Daniel
Levinson, a director of the Company. In addition, James Quinn, a director of the
Company, acquired 26,667 shares for his own account.
NOTE 12 - LETTER OF INTENT
During July 2006, the Company entered into a letter of intent detailing its
proposed merger with Supplement and Nutrition Technologies, Inc. (SNT). The
consummation of this proposed acquisition is contingent upon the completion of
the Company's due diligence, the signing of a definitive purchase and sale
agreement, approval of both companies' board of directors and other conditions.
18
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION
This Form 10-QSB contains certain forward-looking statements within the meaning
of Section 21E of the Securities Exchange Act of 1934, as amended, which are
intended to be covered by the safe harbor created thereby. These statements
relate to future events or our future financial performance, including
statements relating to our products, customers, suppliers, business prospects,
financings, investments and effects of acquisitions. In some cases, forward
looking statements can be identified by terminology such as "may," "will,"
"should," "expect," "anticipate," "intend," "plan," "believe," "estimate,"
"potential," or "continue," the negative of these terms or other comparable
terminology. These statements involve a number of risks and uncertainties,
including preliminary information; the effects of future acquisitions and/or
investments; competitive factors; business and economic conditions generally;
changes in government regulations and policies, our dependence upon third-party
suppliers; continued acceptance of our products in the marketplace;
technological changes; and other risks and uncertainties that could cause actual
events or results to differ materially from any forward-looking statement.
GENERAL
Argan, Inc. (the "Company," "we," "us," or "our") conduct our operations through
our wholly owned subsidiaries, Vitarich Laboratories, Inc. ("VLI") that we
acquired in August 2004 and Southern Maryland Cable, Inc. ("SMC") that we
acquired in July 2003. Through VLI, we develop, manufacture and distribute
premium nutritional products. Through SMC, we provide telecommunications
infrastructure services including project management, construction and
maintenance to the Federal Government, telecommunications and broadband service
providers as well as electric utilities.
On December 8, 2006, the Company announced the acquisition of Gemma Power
Systems, LLC and affiliates (Gemma), a leading powerplant builder with expertise
in the rapidly growing alternative fuel industry including biodiesel, ethanol
and other power energy systems.
The purchase price of the acquisition was approximately $25,000,000, with 55% of
the transaction being paid in stock and 45% in cash. In conjunction with the
merger, the Company completed a private offering of 2,853,335 shares of common
stock at a price of $3.75 per share for aggregate proceeds of approximately
$10,700,000. The Company also agreed to amend its existing financing
arrangements with the Bank whereby the Bank is providing a new $8 million, four
year term loan (New Term Loan). The proceeds of the private offering and the New
Term Loan were used to acquire Gemma and to provide the Company with working
capital.
Two of the investors, MSRI SBIC, L.P. and MSR Fund II Series A, which in the
aggregate acquired 533,333 shares in the offering, are controlled by Daniel
Levinson, a director of the Company. In addition, James Quinn, a director of the
Company, acquired 26,667 shares for his own account.
Private Offering of Common Stock
--------------------------------
On December 8, 2006, the Company completed a private offering of approximately
2,853,335 shares of common stock at a price of $3.75 per share. The proceeds of
approximately $10,700,000 were used in the acquisition of Gemma (see details
above)
On May 4, 2006, the Company completed a private offering of 760,000 shares of
common stock at a price of $2.50 per share for aggregate proceeds of $1.9
million. These shares were registered with the SEC effective July 10, 2006. The
Company used $1.8 million of the proceeds to pay down an equal notional amount
of the subordinated note due Kevin Thomas. The remainder of the proceeds were
used for general corporate purposes.
One of the investors, MSRI SBIC, L.P., which acquired 240,000 shares in the
offering, is controlled by Daniel Levinson, a director of the Company. In
addition, James Quinn, a director of the Company acquired 40,000 shares for his
own account.
Amendment of Financing Arrangements
-----------------------------------
In May 2006, the Company agreed to amend the existing financing arrangements
with the Bank of America, N.A. (Bank). Under this arrangement, the Company had a
revolving line of credit of $4.25 million in maximum availability and a three
year term loan with an original balance of $1.2 million. The May 2006 amendment
extended the expiration of the revolving line of credit to May 31, 2007. Under
the amended financing arrangements, amounts outstanding under the revolving line
of credit and the three year note bear interest at LIBOR plus 3.25% and 3.45%
respectively. Availability on a monthly basis under the revolving line is
determined by reference to accounts receivable and inventory on hand which meet
certain Bank criteria (Borrowing Base). The aforementioned three year note was
paid in full on July 31, 2006. At October 31, 2006 and January 31, 2006, the
Company also had $1,288,000 and $1,243,000, respectively, outstanding under the
revolving line of credit and an effective interest rate of 9.12% and 7.74%,
respectively, with $2.2 million of additional availability under its Borrowing
Base.
19
The amended financing arrangements provides for a new $1.5 million term loan
facility (New Term Loan). On August 31, 2006, the proceeds of the New Term Loan
were used to pay the remaining principal and interest due on the subordinated
note with Kevin Thomas. The New Term Loan will be repaid in thirty six equal
monthly principal payments and bears interest at LIBOR plus 3.25%. As a result
of this draw, the Company's Borrowing Base was reduced by $750,000 for maximum
availability under the revolving line of credit.
In conjunction with the New Term Loan the Company entered into an interest rate
swap agreement with a notional debt amount of $1,125,000, which effectively
fixes the variable interest rate. The fair value of this interest rate swap as
of October 31, 2006, is a loss of approximately $7,000 and is recorded in equity
as accumulated other comprehensive income and as other liabilities on the
balance sheet.
The amended financing arrangements provides for the measurement of certain
financial covenants including requiring the ratio of debt to pro forma earnings
before interest, taxes, depreciation and amortization (EBITDA) not to exceed 2.5
to 1 and requiring pro forma fixed charge coverage ratio not less than 1.25 to
1. The amended financings also require that the Company meet minimum EBITDA
covenants equal to or exceeding (on a trailing twelve months) $1.3 million for
October 31, 2006 and $1.8 million for January 31, 2007 and for each successive
quarter end thereafter. The Bank's consent continues to be required for
acquisitions and divestitures. The Company continues to pledge the majority of
the Company's assets to secure the financing arrangements.
The amended financing arrangement contains a subjective acceleration clause
which allows the Bank to declare amounts outstanding under the financing
arrangement due and payable if certain material adverse changes occur. We
believe that we will continue to comply with our financial covenants under our
financing arrangement. If our performance does not result in compliance with any
of our financial covenants, or if the Bank seeks to exercise its rights under
the subjective acceleration clause referred to above, we would seek to modify
our financing arrangement, but there can be no assurance that the Bank would not
exercise their rights and remedies under our financing arrangement including
accelerating payment of all outstanding senior and subordinated debt due and
payable.
Holding Company Structure
-------------------------
We intend to make additional acquisitions and/or investments. We intend to have
more than one industrial focus and to identify those companies that are in
industries with significant potential to grow profitably both internally and
through acquisitions. We expect that companies acquired in each of these
industrial groups will be held in separate subsidiaries that will be operated in
a manner that best provides cashflow and value for the Company.
We are a holding company with no operations other than our investments in VLI
and SMC. At October 31, 2006, there were no restrictions with respect to
payments from VLI and SMC to the Company.
Nutritional Products
--------------------
We are dedicated to the research, development, manufacture and distribution of
premium nutritional supplements, whole-food dietary supplements and personal
care products. Several of these products have garnered honors including the
National Nutritional Foods Association's prestigious Peoples Choice Awards for
best products of the year in its respective category.
We provide nutrient-dense, super-food concentrates, vitamins and supplements.
Our customers include health food store chains, mass merchandisers, network
marketing companies, pharmacies and major retailers.
20
We intend to enhance our position in the fast growing global nutrition industry
through our innovative product development and research. We believe that we will
be able to expand our distribution channels by providing continuous quality
assurance and by focusing on timely delivery of superior nutraceutical products.
We are focused on efficiently utilizing the strong cash flow potential from
manufacturing nutritional products. To ensure that working capital is
effectively allocated, we closely monitor our inventory turns as well as the
number of days sales that we have in our accounts receivable.
Telecom Infrastructure Services
-------------------------------
We currently provide inside plant, premise wiring services to the Federal
Government and have plans to expand that work to commercial customers who
regularly need upgrades in their premise wiring systems to accommodate
improvements in security, telecommunications and network capabilities.
We continue to participate in the expansion of the telecommunications industry
by working with various telecommunications providers. We are actively pursuing
contracts with a wide variety of telecommunications providers. We provide
maintenance and upgrade services for their outside plant systems that increase
the capacity of existing infrastructure. We also provide outside plant services
to the power industry by providing maintenance and upgrade services to
utilities.
We intend to emphasize our high quality reputation, outstanding customer base
and highly motivated work force in competing for larger and more diverse
contracts. We believe that our high quality and well maintained fleet of
vehicles and construction machinery and equipment is essential to meet
customers' needs for high quality and on-time service. We are committed to
invest in our repair and maintenance capabilities to maintain the quality and
life of our equipment. Additionally, we invest annually in new vehicles and
equipment.
Letters of Intent
-----------------
During July 2006, the Company entered into a letter of intent detailing its
proposed merger with Supplement and Nutrition Technologies, Inc. (SNT). The
consummation of this proposed acquisition is contingent upon the completion of
the Company's due diligence, the signing of a definitive purchase and sale
agreement, approval of both companies' board of directors and other conditions.
CRITICAL ACCOUNTING POLICIES
Management is required to make judgments, assumptions and estimates that affect
the amounts reported when we prepare financial statements and related
disclosures in conformity with generally accepted accounting principles. Note 2
contained in the Company's consolidated financial statements for the year ended
January 31, 2006 included in the Company's Annual Report contained in Form
10-KSB, as filed with the Securities and Exchange Commission describes the
significant accounting policies and methods used in the preparation of our
consolidated financial statements. Estimates are used for, but not limited to
our accounting for revenue recognition, allowance for doubtful accounts,
inventory valuation, long-lived assets and deferred income taxes. Actual results
could differ from these estimates. The following critical accounting policies
are impacted significantly by judgments, assumptions and estimates used in the
preparation of our consolidated financial statements. If future conditions and
results are different than our assumptions and estimates, materially different
amounts could be reported.
Revenue Recognition
-------------------
Vitarich Laboratories, Inc.
We manufacture products for our customers based on their orders. We typically
ship the orders immediately after production keeping relatively little on-hand
as finished goods inventory. We recognize customer sales at the time title and
the risks and rewards of ownership passes to our customer which is generally
when orders are shipped. Sales are recognized on a net basis which reflect
reductions for certain product returns and discounts. Cost of goods sold and
finished goods inventory sold include materials and direct labor as well as
other direct costs combine with allocations of indirect operational costs.
21
Southern Maryland Cable, Inc.
We generate revenue under various arrangements, including contracts under which
revenue is based on a fixed price basis and on a time and materials basis.
Revenues from time and materials contracts are recognized when the related
service is provided to the customer. Revenues from fixed price contracts,
including a portion of estimated profit, are recognized as services are
provided, based on costs incurred and estimated total contract costs using the
percentage of completion method.
The timing of billing to customers varies based on individual contracts and
often differs from the period of revenue recognition. The Company's unbilled
receivables on time and materials and unit contracts were $485,000 and $121,000
at October 31, 2006 and January 31, 2006, respectively, and are included as a
component of accounts receivable. Estimated earnings in excess of billings and
billings in excess of estimated earnings on fixed priced contracts totaled
$705,000 and $3,000, respectively, at October 31, 2006. Estimated earnings in
excess of billings and billings in excess of estimated earnings on fixed priced
contracts totaled $675,000 and none, respectively, at January 31, 2006.
Contract costs are recorded when incurred and include direct labor and other
direct costs combined with allocations of operational indirect costs. Management
periodically reviews the costs incurred and revenue recognized from contracts
and adjusts recognized revenue to reflect current expectations. Provisions for
estimated losses on incomplete contracts are provided in full in the period in
which such losses become known.
Inventories
-----------
Inventories are stated at the lower of cost or market (net realizable value).
Cost is determined on the first-in first-out (FIFO) method. Appropriate
consideration is given to obsolescence, excessive inventory levels, product
deterioration and other factors in evaluating net realizable value.
Impairment of Long-Lived Assets, Including Definite Lived Intangible Assets
---------------------------------------------------------------------------
Long-lived assets, consisting primarily of property and equipment, are reviewed
for impairment whenever events or changes in circumstances indicate that the
carrying amount should be assessed pursuant to SFAS No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets." We determine whether any
impairment exists by comparing the carrying value of these long-lived assets to
the undiscounted future cash flows expected to result from the use of these
assets. In the event we determine that an impairment exists, a loss would be
recognized based on the amount by which the carrying value exceeds the fair
value of the assets, which is generally determined by using quoted market prices
or valuation techniques such as the discounted present value of expected future
cash flows, appraisals, or other pricing models as appropriate.
Goodwill and Other Indefinite Lived Intangible Assets
-----------------------------------------------------
In connection with the acquisitions of VLI and SMC, the Company has substantial
goodwill and intangible assets including contractual customer relationships,
proprietary formulas, non-compete agreements and trade names. In accordance with
SFAS 142 "Goodwill and Other Intangible Assets," the Company reviews for
impairment, at least annually, goodwill and intangible assets deemed to have an
indefinite life.
22
Goodwill impairment is determined using a two-step process. The first step of
the goodwill impairment test is to identify a potential impairment by comparing
the fair value of a reporting unit with its carrying amount, including goodwill.
The estimates of fair value of a reporting unit, generally a Company's operating
segment, is determined using various valuation techniques, with the principal
techniques being a discounted cash flow analysis and market multiple valuation.
A discounted cash flow analysis requires making various judgmental assumptions,
including assumptions about future cash flows, growth rates and discount rates.
Developing assumptions for the Company's entrepreneurial business requires
significant judgment and to a great extent relies on the Company's ability to
successfully determine trends with respect to customers, industry and regulatory
environment. The assumptions, including assumptions about future flows and
growth rates, are based on the Company's budget and business plans as well as
industry trends with respect to customers and other manufacturers' and
distributors' sales and margins. The Company reviews trends for publicly traded
companies which either compete with the Company to provide services or the types
of products the Company produces or are users of the types of services and
products provided by the Company. Changes in economic and operating conditions
impacting these assumptions could result in goodwill impairment in future
periods. Discount rate assumptions are based on the Company's subjective
assessment of the risk inherent in the respective reporting units. Risks which
the Company faces in its business include the public's perception of our
integrity and the safety and quality of our products and services. In addition,
in the industries that we operate we are subject to rapidly changing consumer
demands and preferences. The Company also operates in competitive industries. We
are not assured that customers or potential customers will regard our products
and services as sufficiently distinguishable from our competitors' product and
service offerings. If after taking into consideration industry and Company
trends, the fair value of a reporting unit exceeds its carrying amount, goodwill
of the reporting unit is not deemed impaired and the second step of the
impairment test is not performed. If the carrying amount of a reporting unit
exceeds its fair value, the second step of the goodwill impairment test compares
the implied fair value of the reporting unit's goodwill with the carrying amount
of that goodwill. If the carrying amount of the reporting unit's goodwill
exceeds the implied fair value of that goodwill, an impairment loss is
recognized in an amount equal to that excess. The implied fair value of goodwill
is determined in the same manner as the amount of goodwill recognized in a
business combination. Accordingly, the fair value of the reporting unit is
allocated to all of the assets and liabilities of that unit (including any
unrecognized intangible assets) as if the reporting unit had been acquired in a
business combination and the fair value of the reporting unit was the purchase
price paid to acquire the reporting unit.
The Company will test for impairment of Goodwill and other intangible assets
more frequently if events or changes in circumstances indicate that the asset
might be impaired.
Contractual Customer Relationships
----------------------------------
Southern Maryland Cable, Inc. - The fair value of the Contractual Customer
Relationships (CCR's) was determined at the time of the acquisition of SMC by
discounting the cash flows expected from SMC's continued relationships with
three customers - General Dynamics Corp. (GD), Verizon Communications (VZ) and
Southern Maryland Electric Cooperative (SMECO). Expected cash flows were based
on historical levels, current and anticipated projects and general economic
conditions. In some cases, the estimates of future cash flows reflect periods
beyond those of the current contracts in place. While SMC's relationship with GD
is relatively recent, SMC has performed work for VZ and SMECO for approximately
twenty years and ten years, respectively. The long-term relationship with VZ and
SMECO affected the discount rate used to discount cost of capital and SMC's
asset mix. We are amortizing the CCR's over a seven year weighted average life
given the long standing relationships SMC has with Verizon and SMECO.
23
Vitarich Laboratories, Inc. - The fair value of the Contractual Customer
Relationships at VLI (VCCR's) was determined at the time of the acquisition of
VLI by identifying long established customer relationships in which VLI has a
pattern of recurring purchase and sales orders. The Company estimated expected
cash flows attributable to these existing customer relationships factoring in
market place assumptions regarding future contract renewals, customer attrition
rates and forecasted expenses to maintain the installed customer base. These
cash flows were then discounted based on a rate that reflects the perceived risk
of the VCCR's, the Company's estimated weighted average cost of capital and
VLI's asset mix. VLI has had a relationship of five years or more with most if
its currently significant customers. We are amortizing VCCR's over a five year
life based on our expectations of continued cash flows from these relationships
and our history of maintaining relationships.
Trade Name
----------
The fair value of the SMC trade name was estimated using a relief-from-royalty
methodology. We determined that the useful life of the trade name was indefinite
since it is expected to contribute directly to future cash flows in perpetuity.
The Company has also considered the effects of demand and competition including
its customer base. While SMC is not a nationally recognized trade name, it is a
regionally recognized name in the Mid-Atlantic region, SMC's primary region of
operations.
We are using the relief-from-royalty method described above to test the trade
name for impairment annually on November 1 and on an interim basis if events or
changes in circumstances between annual tests indicate the trade name might be
impaired.
Proprietary Formulas
--------------------
The Fair Value of the Proprietary Formulas (PFs) was determined at the time of
the acquisition of VLI by discounting the cash flows expected from developed
formulations based on relative technology contribution and estimates regarding
product lifecycle and development costs and time. The expected cash flows were
discounted based on a rate that reflects the perceived risk of the PFs, the
estimated weighted average cost of capital and VLI's asset mix. We are
amortizing the PFs over a three year life based on the estimated contributory
life of the proprietary formulations utilizing estimated historical product
lifecycles and changes in technology.
Non-Compete Agreement
---------------------
The fair value of the Non-Compete Agreement (NCA) was determined at the time of
acquisition of VLI by discounting the estimated reduction in the cash flows
expected if one key employee, the former sole shareholder of VLI, were to leave.
The key employee signed a non-compete clause prohibiting the employee from
competing directly or indirectly for five years. The estimated reduced cash
flows were discounted based on a rate that reflects the perceived risk of the
NCA, the estimated weighted average cost of capital and VLI's asset mix. We are
amortizing the NCA over five years, the length of the non-compete agreement.
Derivative Financial Instruments
--------------------------------
The Company accounts for derivative financial instruments in accordance with
Statement of Financial Accounting Standards ("SFAS") No. 133 "Accounting for
Derivative Instruments and Hedging Activities" and Emerging Issues Task Force
Issue No. 00-19, "Accounting for Derivative Financial Instruments Indexed to,
and Potentially Settled in a Company's Own Stock." The derivative financial
instruments are recognized on the consolidated balance sheet as either assets or
liabilities and are measured at fair value. Changes in the fair value of
derivatives are recorded each period in earnings or accumulated other
comprehensive income, depending on whether a derivative is designated and
effective as part of a hedge transaction, and if it is, the type of hedge
transaction. Gains and losses on derivative instruments reported in accumulated
other comprehensive income are subsequently included in earnings in the periods
in which earnings are affected by the hedged item. The determination of fair
value for some of the company's derivative financial instruments is subject to
the volatility of the company's stock price as well as certain underlying
assumptions which include the probability of raising additional capital. In
fiscal year 2006 the company began using an interest rate swap to hedge the
fluctuation in interest rates for long term debt.
24
Deferred Tax Assets and Liabilities
-----------------------------------
We account for income taxes under the asset and liability method. The approach
requires the recognition of deferred tax assets and liabilities for the expected
future tax consequences of temporary differences between the carrying amounts
and the tax basis of assets and liabilities. Developing our provision for income
taxes requires significant judgment and expertise in Federal and state income
tax laws, regulations and strategies, including the determination of deferred
tax assets and liabilities and, if necessary, any valuation allowances that may
be required for deferred tax assets.
WESTERN FILTER CORPORATION LITIGATION
On September 17, 2004, Western Filter Corporation ("WFC") notified the Company
that WFC believes that the Company breached certain representations and
warranties under the stock purchase agreement dated October 31, 2003 by and
between Argan, Inc. and WFC ("Stock Purchase Agreement"). WFC asserts damages in
excess of the $300,000 escrow which is being held by a third party in connection
with the Stock Purchase Agreement.
On March 22, 2005, WFC filed a complaint in Los Angeles Superior Court alleging
the Company and its executive officers, individually, committed breach of
contract, intentional misrepresentation, concealment and non-disclosure,
negligent misrepresentation and false promise. WFC seeks declaratory relief and
compensatory and punitive damages in an amount to be proven at trial as well as
the recovery of attorneys' fees.
Although the Company has reviewed WFC's claim and believes that substantially
all of the claims are without merit, at October 31, 2006, the Company had an
accrual related to this matter of $360,000 for estimated payments and legal fees
related to the claims of WFC that it considers to be probable and that can be
reasonably estimated. It is possible, however, that the ultimate resolution of
WFC's claim could result in a material adverse effect on the Company's results
of operations for a particular reporting period. The Company will vigorously
contest WFC's claim.
CONSOLIDATED RESULTS OF OPERATIONS
For the three months ended October 31:
--------------------------------------
Increase Percent
2006 2005 (Decrease) Change
=========== =========== =========== ===========
Net sales
Nutraceutical products $ 5,248,000 $ 4,085,000 $ 1,163,000 28.5%
Telecom infrastructure services 4,361,000 3,048,000 1,313,000 43.0
----------- ----------- ----------- -----------
Net Sales 9,609,000 7,133,000 2,476,000 34.7
Cost of sales
Nutraceutical products 4,235,000 3,185,000 1,050,000 33.0
Telecom infrastructure services 3,506,000 2,285,000 1,221,000 53.4
----------- ----------- ----------- -----------
Gross profit 1,868,000 1,663,000 205,000 12.3
Selling, general and administrative
expenses 2,214,000 1,808,000 406,000 22.5
----------- ----------- ----------- -----------
Income (loss) from operations (346,000) (145,000) (201,000) 138.6
Interest expense and amortization of
subordinated debt issuance costs 87,000 205,000 (118,000) (57.6)
Other (income) expense, net (2,000) 1,000 (3,000) (300.0)
----------- ----------- ----------- -----------
Loss from operations before
income taxes (431,000) (351,000) (80,000) 22.8
Income tax benefit 176,000 64,000 112,000 175.0
----------- ----------- ----------- -----------
Net loss $ (255,000) $ (287,000) $ 32,000 (11.1)
=========== =========== =========== ===========
25
Net sales
---------
Net sales of nutraceutical products increased by $1,163,000 or 29% for the three
months ended October 31, 2006 compared to the three months ended October 31,
2005, primarily due to increased sales to three of our largest customers,
Trivita Way International, Cyberwize.com and Rob Reiss Companies (RRC) as well
as to seven new customers.
Net sales of telecommunications infrastructure services increased by $1,313,000
or 43% for the three months ended October 31, 2006 compared to the three months
ended October 31, 2005, primarily due to increased sales to VZ and Electronic
Data Systems Corp. (EDS) which offset the decline in business with GD whose
contract with SMC was completed last year.
Cost of sales
-------------
For the three months ended October 31, 2006, cost of sales for nutraceutical
products was 81% of net sales for nutraceutical products. For the three months
ended October 31, 2005, cost of sales was 78% of net sales for nutraceutical
products. The decrease in margin is primarily the result of an increase in
depreciation expense related to leasehold improvements for additional
manufacturing space that became operational in November 2005.
For the three months ended October 31, 2006, cost of sales for
telecommunications infrastructure services was 80% of net sales of
telecommunications infrastructure services. For the three months ended October
31, 2005, cost of sales was 75% of net sales of telecommunications
infrastructure services. The decrease in margin is primarily the result of the
change in contracts since September 2005. The contract with GD ended in
September 2005 and the contract with EDS began in late October 2005. Even though
the sales volume with EDS is much larger the profit margin is approximately 2%
lower than the GD profit margin. In August 2006 the contract with VZ was
renegotiated to more competitive rates which resulted in an approximate 3%
decrease in profit margin.
Selling, general and administrative expenses
--------------------------------------------
Consolidated selling, general and administrative expenses were $2,214,000 or 23%
of consolidated net sales for the three months ended October 31, 2006 compared
to $1,808,000 or 25% of consolidated net sales for the three months ended
October 31, 2005. SMC increased its selling, general and administrative expenses
due to the hiring of additional sales and support personnel. Corporate expenses
increased due to higher professional service fees. VLI increased its selling,
general and administrative expenses due to an increase in bad debt expense.
Interest expense and amortization of subordinated debt issuance costs
---------------------------------------------------------------------
Consolidated interest expense and amortization of subordinated debt issuance
costs decreased by $118,000 or 58% for the three months ended October 31, 2006
compared to the three months ended October 31, 2005, due to the full
amortization of issuance costs at July 31, 2006.
Income tax benefit
------------------
The Company's consolidated effective income tax benefit rate was 32% for the
three months ended October 31, 2006 compared to an 18% effective income tax
benefit rate for the three months ended October 31, 2005.
26
During the three months ended October 31, 2006, the Company's effective income
tax benefit rate was decreased, from the standard rate of 38%, by the impact of
its adjusted forecast of annual pretax income and the impact of the amortization
of issuance cost for subordinated debt which is treated as a permanent
difference for income tax reporting purposes.
For the three months ended October 31, 2005, the Company's effective income tax
benefit rate was decreased by the impact of the fair value adjustment for
liability for derivative financial instrument which is a permanent difference
for income tax reporting purposes. This permanent difference reduced the
effective income tax benefit rate from 38%.
For the nine months ended October 31:
-------------------------------------
Increase Percent
2006 2005 (Decrease) Change
============ ============ ============ ============
Net sales
Nutraceutical products $ 16,288,000 $ 13,337,000 $ 2,951,000 22.1%
Telecom infrastructure services 10,843,000 7,804,000 3,039,000 38.9
------------ ------------ ------------ ------------
Net Sales 27,131,000 21,141,000 5,990,000 28.3
Cost of sales
Nutraceutical products 12,561,000 10,227,000 2,334,000 22.8
Telecom infrastructure services 8,507,000 6,100,000 2,407,000 39.5
------------ ------------ ------------ ------------
Gross profit 6,063,000 4,814,000 1,249,000 25.6
Selling, general and administrative
expenses 6,134,000 5,605,000 529,000 9.4
------------ ------------ ------------ ------------
Loss from operations (71,000) (791,000) 720,000 (91.0)
Interest expense and amortization of
subordinated debt issuance costs 564,000 364,000 200,000 55.0
Other (income) expense, net (5,000) 1,926,000 (1,931,000) (100.3)
------------ ------------ ------------ ------------
Loss from operations before
income taxes (630,000) (3,081,000) 2,451,000 (79.6)
Income tax benefit 202,000 386,000 (184,000) (47.7)
------------ ------------ ------------ ------------
Net loss $ (428,000) $ (2,695,000) $ 2,267,000 (84.1)
============ ============ ============ ============
Net sales
---------
Net sales of nutraceutical products increased by $2,951,000 or 22% for the nine
months ended October 31, 2006 compared to the nine months ended October 31,
2005, primarily due to increased sales to two of our largest customers Rob Reiss
Companies (RRC) and Cyberwise.com, as well as to nine new customers.
Net sales of telecommunications infrastructure services increased by $3,039,000
or 39% for the nine months ended October 31, 2006 compared to the nine months
ended October 31, 2005, primarily due to increased sales to VZ and Electronic
Data Systems Corp. (EDS) which offset the decline in business with GD whose
contract with SMC was completed last year.
Cost of sales
-------------
For the nine months ended October 31, 2006, cost of sales for nutraceutical
products was 77% of net sales for nutraceutical products. For the nine months
ended October 31, 2005, cost of sales was 77% net sales for nutraceutical
products. Cost of sales increased due to the increase in net sales.
For the nine months ended October 31, 2006, cost of sales for telecommunications
infrastructure services were 78% of net sales of telecommunications
infrastructure services. For the nine months ended October 31, 2005, cost of
sales was 78% of net sales of telecommunications infrastructure services. The
profit margin for the nine months ended October 31, 2006 has leveled out to the
same profit margin for the same period as 2005 after the renegotiation of the VZ
contract twice during 2006.
27
Selling, general and administrative expenses
--------------------------------------------
Consolidated selling, general and administrative expenses were $6,134,000 or 23%
of consolidated net sales for the nine months ended October 31, 2006 compared to
$5,605,000 or 27% of consolidated net sales for the nine months ended October
31, 2005. SMC increased its selling, general and administrative expenses due to
the hiring of additional sales support personnel. In addition, SMC has incurred
expense increased bonuses as a result of improved financial performance for the
nine months ended October 31, 2006 compared to the same period in 2005.
Corporate expenses increased due to higher professional service fees. VLI
increased its selling, general and administrative expenses due to an increase in
bad debt expense.
Interest expense and amortization of subordinated debt issuance costs
---------------------------------------------------------------------
Consolidated interest expense and amortization of subordinated debt issuance
costs increased by $200,000 or 55% for the nine months ended October 31, 2006
compared to the nine months ended October 31, 2005, due primarily to increased
interest expense for subordinated debt of $137,000 and amortization of issuance
cost for the subordinated debt of $257,000 for the nine months ended October 31,
2006. The subordinated note was issued on June 30, 2005 and repaid in May 2006,
resulting in four months of amortization for the nine months ended October 31,
2005 and the remaining balance of the issuance costs were expensed as of July
31, 2006.
Other (income) expense, net
---------------------------
Other (income) expense, net changed from $1,926,000 in expense for the nine
months ended October 31, 2005 to income of $5,000 for the nine months ended
October 31, 2006, primarily due to the fair value loss of the liability for
derivative financial instrument of $1,930,000 realized during the nine months
ended October 31, 2005.
Income tax benefit
------------------
The Company's consolidated effective income tax benefit rate was 26% for the
nine months ended October 31, 2006 compared to a 13% effective income tax
benefit rate for the nine months ended October 31, 2005.
During the nine months ended October 31, 2006, the Company's effective income
tax benefit rate was decreased by the impact of the amortization of issuance
cost for subordinated debt which is treated as a permanent difference for income
tax reporting purposes. This permanent difference reduced the effective income
tax benefit rate from 38%.
For the nine months ended October 31, 2005, the Company's effective income tax
benefit rate was decreased by the impact of the fair value adjustment for
liability for derivative financial instruments which is a permanent difference
for income tax reporting purposes. This permanent difference reduced the
effective income tax benefit rate from 38%.
LIQUIDITY AND CAPITAL RESOURCES
Net cash flows from operating activities and selected borrowings have
represented our primary sources of funds for growth of the business, including
capital expenditures and acquisitions. We had $1.4 million in working capital at
October 31, 2006, including $233,000 of cash and cash equivalents. In addition
we had $2.2 million available under credit facilities.
Cash Flows
----------
Net cash provided by operations for the nine months ended October 31, 2006 was
$1,354,000 compared with $1,671,000 million of cash provided by operations for
the nine months ended October 31, 2005. Net cash flows from operating activities
decreased primarily as a result of an increase in accounts receivable and
prepaid expenses and other assets, partially offset by an increase in accounts
payable and accrued expenses and improved operating performance by both VLI and
SMC.
28
For the nine months ended October 31, 2006, SMC had income from operations of
$1,087,000 compared to income from operations of $576,000 for the nine months
ended October 31, 2005. Net sales from VZ increased by $1.9 million due to SMC
reestablishing a contractual relationship with VZ which had previously been
discontinued. In July 2004, SMC lost a significantly profitable contract with
VZ. In September 2005, SMC commenced work on an underground telecommunications
infrastructure services contract with VZ. In addition, SMC has experienced
strong revenue growth from EDS, since November 2005. During the nine months
ended October 31, 2006, VLI had income from operations of $392,000 compared to
income from operations of $115,000 for the nine months ended October 31, 2005.
VLI experienced revenue growth from two of its most significant customers, RRC
and Cyberwize, as well as from nine new customers.
During the nine months ended October 31, 2006, accounts receivable used cash of
$1,375,000. Increases in revenue at both SMC and VLI resulted in the substantial
increase in accounts receivable which was offset, in part, by inventories, net
which provided cash flows of $1,208,000. VLI carefully monitored inventory
levels as it experienced strong revenue growth.
During the nine months ended October 31, 2006, net cash used for investing
activities was $763,000 compared to net cash used for investing activities of
$1,311,000 for the nine months ended October 31, 2005. The decrease was due
primarily to the purchase consideration for VLI in the nine months ended October
31, 2005.
For the nine months ended October 31, 2006, net cash used by financing
activities was $363,000 compared to cash provided by financing activities of
$500,000 for the nine months ended October 31, 2005. The change from net cash
provided by financing activities during the nine months ended October 31, 2005
to net cash used during the nine months ended October 31, 2006 is due to
payments made on the three year term loan and the New Term Loan described below.
As well as the subordinated note with Kevin Thomas, offset by net proceeds from
the sale of stock and a new term loan. During the nine months ended October 31,
2005, the Bank of America, N.A. released $304,000 in previously escrowed funds
in accordance with the amended financing arrangements of April 2005 which offset
the net pay down of the Company's line of credit and long term debt.
In May 2006, the Company agreed to amend the existing financing arrangements
with the Bank of America, N.A. (Bank). Under this arrangement, the Company had a
revolving line of credit of $4.25 million in maximum availability and a term
loan with an original balance of $1.2 million. The May 2006 amendment extended
the expiration of the revolving line of debt to May 31, 2007. Under the amended
financing arrangements, amounts outstanding under the revolving line of credit
and the three year note bear interest at LIBOR plus 3.25% and 3.45%,
respectively. Availability on a monthly basis under the revolving line is
determined by reference to accounts receivable and inventory on hand which meet
certain Bank criteria (Borrowing Base). The aforementioned three year note was
paid in full on July 31, 2006. At October 31, 2006 and January 31, 2006, the
Company had $1,288,000 and $1,243,000, respectively, outstanding under the
revolving line of credit and an effective interest rate of 9.12% and 7.74%,
respectively, with $2.2 million of additional availability under its Borrowing
Base.
The amended financing arrangement provides for a new $1.5 million term loan
facility (New Term Loan). On August 31, 2006, the Company borrowed $1.5 million
under the New Term Loan and paid the remaining principal and interest due on the
subordinated note with Thomas. As a result of this draw, the Company's Borrowing
Base will be reduced by $750,000 for maximum availability under the revolving
line of credit. The New Term Loan will be repaid in thirty six equal monthly
principal payments and bear interest at LIBOR plus 3.25%.
29
In conjunction with the New Term Loan the Company entered into an interest rate
swap agreement with a notional debt amount of $1,125,000, which effectively
fixes the variable interest rate. The fair value of this interest rate swap as
of October 31, 2006, is a loss of approximately $7,000 and is recorded in equity
as accumulated other comprehensive loss and as other liabilities on the balance
sheet.
The amended financing arrangements provides for the measurement of certain
financial covenants including requiring the ratio of debt to pro forma earnings
before interest, taxes, depreciation and amortization (EBITDA) not to exceed 2.5
to 1 and requiring pro forma fixed charge coverage ratio not less than 1.25 to
1. The amended financing arrangements also provide a requirement that the
Company meet minimum EBITDA covenants equal to or exceeding (on a trailing
twelve months) $1.3 million for October 31, 2006 and $1.8 million for January
31, 2007 and for each successive quarter end thereafter. Bank consent continues
to be required for acquisitions and divestitures. The Company continues to
pledge the majority of the Company's assets to secure the financing
arrangements.
The amended financing arrangement contains a subjective acceleration clause
which allows the Bank to declare amounts outstanding under the financing
arrangement due and payable if certain material adverse changes occur. We
believe that we will continue to comply with our financial covenants under our
financing arrangement. If our performance does not result in compliance with any
of our financial covenants, or if the Bank seeks to exercise its rights under
the subjective acceleration clause referred to above, we would seek to modify
our financing arrangement, but there can be no assurance that the Bank would not
exercise their rights and remedies under our financing arrangement including
accelerating payment of all outstanding senior and subordinated debt due and
payable.
At October 31, 2006, the Company was in compliance with the covenants of its
amended financing arrangements.
Management believes that cash generated from the Company's operations combined
with capital resources available under its renewed line of credit is adequate to
meet the Company's future operating cash needs. Any future acquisitions, other
significant unplanned costs or cash requirements may require the Company to
raise additional funds through the issuance of debt and equity securities. There
can be no assurance that such financing will be available on terms acceptable to
the Company, or at all. If additional funds are raised by issuing equity
securities, significant dilution to the existing stockholders may result.
Customers
---------
During the nine months ended October 31, 2006, we provided nutritional and
whole-food supplements as well as personal care products to customers in the
global nutrition industry and services to telecommunications and utilities
customers as well as to the Federal Government, through a contract with
Electronic Data Systems Corp. (EDS). Certain of our more significant customer
relationships are with TriVita, Inc. (TVC), Rob Reiss Companies (RRC), Verizon
Communications, Inc. (VZ), Southern Maryland Electrical Cooperative (SMECO),
EDS, CyberWize.com, Inc. (C), and Orange Peel Enterprises, Inc. (OPE). TVC, RRC,
C and OPE are VLI customers. SMC's significant customers are VZ, SMECO and EDS.
TVC, RRC, C and OPE accounted for approximately 17%, 13%, 7% and 4% of
consolidated net sales during the nine months ended October 31, 2006. VZ, SMECO
and EDS accounted for approximately 11%, 10% and 13% of consolidated net sales
during the nine months ended October 31, 2006. Combined TVC, RRC, VZ, SMECO,
EDS, C and OPE accounted for approximately 80% of consolidated net sales during
the nine months ended October 31, 2006.
30
Seasonality
-----------
The Company's telecom infrastructure services operations are expected to have
seasonally weaker results in the first and fourth quarters of the year, and may
produce stronger results in the second and third quarters. This seasonality is
primarily due to the effect of winter weather on outside plant activities as
well as reduced daylight hours and customer budgetary constraints. Certain
customers tend to complete budgeted capital expenditures before the end of the
year, and postpone additional expenditures until the subsequent fiscal period.
IMPACT OF CHANGES IN ACCOUNTING STANDARDS
In July 2006, the Financial Accounting Standards Board (FASB) issued FASB
Interpretation No. 48, Accounting for Uncertainty in Income Taxes - an
interpretation of FASB Statement No. 109 ("FIN 48"), which clarifies the
accounting for uncertainty in income tax positions. FIN 48 requires that the
Company recognize in the consolidated financial statements the impact of a tax
position that is more likely than not to be sustained upon examination based on
the technical merits of the position. The provisions of FIN 48 will be effective
for the Company, as of the beginning of the Company's fiscal year ending January
31, 2008, with the cumulative effect of the change in accounting principle
recorded as an adjustment to opening retained earnings. The Company is still
evaluating the impact of FIN 48 on its consolidated financial statements.
In September 2006, the SEC issued Staff Accounting Bulletin No. 108 ("SAB 108"),
Considering the Effects of Prior Year Misstatements When Quantifying
Misstatements in Current Year Financial Statements. SAB 108 provides guidance to
registrants for assessing materiality. SAB 108 states that registrants should
use both a balance sheet approach and income statement approach when quantifying
and evaluating the materiality of a misstatement. SAB 108 also provides guidance
on correcting errors under the dual approach as well as transition guidance for
correcting previously immaterial errors that are now considered material. The
provisions of SAB 108 will be effective for the Company, as of the beginning of
the Company's fiscal year ending January 31, 2008. The Company does not expect
SAB 108 to have a significant impact on the consolidated financial statements.
In September 2006, the FASB issued FAS No. 157, "Fair Value Measurements," which
provides guidance for using fair value to measure assets and liabilities. FAS
157 will apply whenever another standard requires or permits assets or
liabilities to be measured at fair value. The standard does not expand the use
of fair value to any new circumstances. The provisions of FAS 157 will be
effective for the Company, as of the beginning of the Company's fiscal year
ending January 31, 2009. The Company does not expect FAS 157 to have a
significant impact on the consolidated financial statements.
ITEM 3. CONTROLS AND PROCEDURES
Disclosure Controls and Procedures
----------------------------------
As of the end of the period covered by this report, the Company carried out an
evaluation, under the supervision and with the participation of the Company's
management, including its Chief Executive Officer and its Chief Financial
Officer, of the effectiveness of the design and operation of the Company's
disclosure controls and procedures (as defined in Rule 13a-15 of the Securities
Exchange Act of 1934). Based on that evaluation, our Chief Executive Officer and
our Chief Financial Officer have concluded that the Company's current disclosure
controls and procedures are effective in timely alerting them of material
information relating to the Company that is required to be disclosed by the
Company in the reports it files or submits under the Securities Exchange Act of
1934.
Changes in Internal Control Over Financial Reporting
----------------------------------------------------
Our management is responsible for establishing and maintaining adequate internal
control over financial reporting, as such term is defined in Rules 13a-15(f)
under the Securities Exchange Act of 1934 and for of the effectiveness of
internal control over financial reporting.
31
There have been no changes in the Company's internal control over financial
reporting that occurred during the quarter ended October 31, 2006 that have
materially affected, or are reasonably likely to materially affect the Company's
internal control over financial reporting.
PART II
OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
(See Note 10 of the financial statements)
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
None.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 5. OTHER INFORMATION
None.
ITEM 6. EXHIBITS
Exhibit No. Title
----------- -----
Exhibit:31.1 Certification of Chief Executive Officer, pursuant
to Rule 13a-14(c) under the Securities Exchange Act
of 1934
Exhibit:31.2 Certification of Chief Financial Officer, pursuant
to Rule 13a-14(c) under the Securities Exchange Act
of 1934
Exhibit:32.1 Certification of Chief Executive Officer, pursuant
to 18 U.S.C. Section 1350
Exhibit:32.2 Certification of Chief Financial Officer, pursuant
to 18 U.S.C. Section 1350
32
SIGNATURES
In accordance with the requirements of the Exchange Act, the registrant caused
this report to be signed on its behalf by the undersigned, thereunto, duly
authorized.
ARGAN, INC.
December 13, 2006 By: /s/ Rainer Bosselmann
-------------------------------------
Rainer Bosselmann
Chairman of the Board and
Chief Executive Officer
December 13, 2006 By: /s/ Arthur F. Trudel
-------------------------------------
Arthur F. Trudel
Senior Vice President,
Chief Financial Officer and Secretary
33