ITEM 1B.
UNRESOLVED STAFF COMMENTS
Not applicable.
Our international corporate headquarters is located in Deerfield, Illinois in a leased facility. We position our manufacturing locations and warehouses in order to optimize access to our customers and distributors. Our Protective Packaging segment operates 22 manufacturing facilities in North America (United States, Canada and Mexico) and 16 in Europe. We have broad reach within Europe, through key facilities located in Belgium, Germany, the Netherlands, Italy, England, Poland and the Czech Republic. We own approximately half of our Protective Packaging facilities, while the rest are leased. Our Flexible Packaging segment operates from two manufacturing facilities in Germany and one in Egypt, all of which are owned. The Hospital Supplies segment also maintains two manufacturing facilities in Germany and one in Bulgaria, all of which are owned. The Rigid Packaging segment operates three facilities in the United Kingdom (one each in England, Scotland and Wales), all of which are leased. We also lease other warehouse and administrative space at other locations. We believe the plants, warehouses, and other properties owned or leased by us are well maintained and in good operating condition.
On July 13, 2007, July 24, 2007 and August 28, 2007, the Kentucky Department for Environmental Protection (DEP) issued notices of violation against our Wurtland, Kentucky manufacturing facility. The DEP alleged that we discharged excessive levels of chemical emissions into public waters without valid permits. The Company filed timely responses to the notifications substantially denying the allegations. Following an administrative hearing with the DEP in December 2007, the Company settled the matter by agreeing to pay a civil penalty of $0.1 million and to undertake certain remedial measures to prevent any improper releases into the environment.
In addition to the matter noted above, we are party to various lawsuits, legal proceedings and administrative actions arising out of the normal course of our business. While it is not possible to predict the outcome of any of these lawsuits, proceedings and actions, management, based on its assessment of the facts and circumstances now known, does not believe that any of these lawsuits, proceedings and actions, individually or in the aggregate, will have a material adverse effect on our financial position. However, actual outcomes may be different than expected and could have a material effect on our results of operations or cash flows in a particular period.
ITEM 4.
ITEM 4.
SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of security holders during the year ended December 31, 2007.
PART II
ITEM 5.
ITEM 5.
MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
There is no established public trading market for the registrant’s common stock. All of the registrant’s issued and outstanding common stock is held by Pregis Holding I.
The registrant has not paid any cash dividends in the past. We anticipate that any earnings will be retained for development of our business and we do not anticipate paying any cash dividends in the foreseeable future. Pregis’s senior secured credit facilities, senior subordinated notes and senior secured notes all restrict our ability to issue cash dividends. Any future dividends declared would be at the discretion of our board of directors and would depend on our financial condition, results of operations, contractual obligations, the terms of our financing agreements at the time a dividend is considered, and other relevant factors.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The historical financial information as of December 31, 2007, 2006 and 2005, and for the years ended December 31, 2007 and 2006 and the period from October 13, 2005 to December 31, 2005 has been derived from the audited consolidated financial statements of Pregis Holding II following the Acquisition (the “Successor”). The historical financial data set forth below for the period from January 1, 2005 to October 12, 2005 and as of and for the years ended December 31, 2004 and 2003 has been derived from the audited combined financial statements of the business comprising Pregis prior to the Acquisition (the “Predecessor”). You should read this data in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated and combined financial statements and the related notes included elsewhere in this report.
(1)
Working capital in the Successor period is defined as current assets, excluding cash, less current liabilities. Working capital in the Predecessor period is defined as trade receivables, plus inventory, less trade payables.
(2)
Total debt includes short-term and long-term debt, including affiliated debt in the predecessor periods.
ITEM 7.
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion and analysis should be read in conjunction with the consolidated and combined financial statements and accompanying notes included elsewhere in this report. In addition to historical information, this discussion may contain forward-looking statements that involve risks and uncertainties, including, but not limited to, those described in this report under Item 1A, “Risk Factors.” Future results could differ materially from those discussed below. See “Cautionary Note Regarding Forward-Looking Statements” in Item 1A above.
BASIS OF PRESENTATION
We commenced operations as Pregis Corporation on October 13, 2005, at which time Pregis acquired all of the outstanding shares of capital stock of Pactiv Corporation’s subsidiaries operating its global protective packaging and European specialty packaging businesses.
Successor - The historical consolidated financial statements for 2007, 2006 and the period from October 13, 2005 through December 31, 2005 include the accounts of Pregis Holding II and its subsidiaries subsequent to the Acquisition. The consolidated financial statements of the Successor reflect the Acquisition under the purchase method of accounting, in accordance with the Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting Standards (“SFAS”) No. 141, Business Combinations.
Predecessor - Prior to October 13, 2005, we were wholly-owned subsidiaries of Pactiv Corporation. The historical financial information for the period from January 1, 2005 through October 12, 2005 represents the combined financial statements of the businesses comprising the Global Protective Packaging, Flexible Packaging, Hospital Supplies and Rigid Packaging segments, all of which were under the common ownership of Pactiv and under common management during the periods presented.
The combined financial statements for the period January 1, 2005 through October 12, 2005 included elsewhere in this report include allocations of certain Pactiv corporate expenses. The expenses and cost allocations have been determined on bases that Pactiv and we considered to be a reasonable reflection of the utilization of services provided or the benefit received by us during the periods presented. The combined financial information included in this report for periods prior to October 13, 2005 may not reflect the combined financial position, operating results and change in owner’s equity and cash flows of our company in the future or what they would have been had we operated as a stand-alone entity during the periods presented. See Note 13 to our audited consolidated and combined financial statements.
All significant intercompany transactions have been eliminated in the consolidated and combined financial statements.
EXECUTIVE OVERVIEW
We are an international manufacturer, marketer and supplier of protective packaging products and specialty packaging solutions. We currently operate 47 facilities in 18 countries, with approximately 4,500 employees world-wide. The majority of the products we sell are plastic-resin based, and therefore, our operations are highly sensitive to fluctuations in the costs of plastic resins. We sell our products to a wide array of customers, including retailers, distributors, packer processors, hospitals, fabricators and directly to the end-users. Approximately 65% of our 2007 net sales were generated outside of the U.S., so we are sensitive to fluctuations in foreign currency exchange rates, primarily between the euro and pound sterling with the U.S. dollar.
Demand for protective packaging products has historically grown at a higher rate than the broader economy. Although the North American economy weakened somewhat in 2007, we expect this underlying global trend to
continue, prompted by further expansion of Internet commerce and mail order catalog sales as well as the increased customization of protective packaging applications in the general industrial, electronics, medical and other industries. Demand for our flexible and rigid packaging products is influenced by increases in consumer demand for convenience products and disposable packaging. Similarly, we expect to see continued growth in the demand for pre-packaged procedure packs and disposable hospital supplies products, such as drapes and gowns.
2007 represented another solid year of performance for Pregis. We generated net sales totaling $979.4 million, representing an increase of $53.9 million or 5.8%, over our 2006 net sales of $925.5 million. Excluding the impact of favorable foreign currency translation, resulting from continued strengthening of the euro and pound sterling to the U.S. dollar, our 2007 net sales were relatively flat compared to 2006. While we grew volumes in our European businesses, and through new product introductions and both internal and acquisitive geographic expansion, this growth was substantially offset by volume declines in our North American protective packaging businesses, due to the weakened North American economic environment as well as the impact of our product mix and customer rationalization efforts carrying over from the prior year.
More than 75% of our annual sales come from products made from various types of plastic resins, principally polyethylene and polypropylene. While the costs of our key resin and plastic-based raw materials declined towards the end of 2006, they increased throughout 2007 to near-historical highs by the end of the year. Therefore, while we benefited during the first half of the year from selling price increases implemented towards the end of 2006, this benefit eroded as the year progressed and the underlying raw material costs continued to escalate. In order to mitigate the continued rising costs of raw materials, energy and freight, we implemented a number of additional price increases in the latter half of 2007.
We generated significant improvements in profitability during 2007 driven in part by productivity and efficiency initiatives implemented throughout our businesses. Our gross margin (defined as net sales less cost of sales) as a percentage of net sales increased by 150 basis points to 24.4% in 2007, compared to 22.9% in 2006. Our operating income increased by 41.1%, to $46.0 million in 2007 from $32.6 million in 2006. We continue to focus on productivity improvements and launched initiatives towards the end of 2007 to derive sustainable cost efficiencies within our general and administrative structure. We expect to begin achieving the benefits from these efforts in 2008.
We expect many of the challenges faced in 2007 to carry into 2008, with continued volatility in resin and other raw material costs, as well as the potential for further economic weakening, both in the U.S. and Europe. Despite these challenges, we believe we are well positioned to achieve further growth in 2008 by executing upon our additional opportunities for productivity improvement and by generating growth through new products and global expansion.
RESULTS OF OPERATIONS
Net Sales - 2007 vs. 2006
For the year ended December 31, 2007, our net sales increased by $53.9 million to $979.4 million, from $925.5 million for the year ended December 31, 2006. The key factors that contributed to the increase in 2007 net sales were as follows:
On a consolidated basis, favorable foreign currency accounted for the majority of the increase in net sales, due to the strengthening of the euro and British pound sterling in relation to the U.S. dollar.
Segment Net Sales - 2007 vs. 2006
For the year ended December 31, 2007, net sales of our Protective Packaging segment totaled $637.1 million, representing an increase of $19.6 million, or 3.2%, compared to net sales of $617.5 million for the year ended December 31, 2006. The improvement in 2007 was driven by the favorable impact of price increases implemented in 2006 in the North American businesses, increased European product volumes, and favorable foreign currency translation, partially offset by reduced North American product volumes. As the year progressed, the benefit from increased selling prices, primarily in the North American businesses, lessened as our raw material costs continued to escalate. The segment experienced volume declines in its U.S. businesses due to the impact of the rationalization of product and customer mix carrying over from 2006, as well as weakened demand in the U.S. for the segment’s furniture, building and automotive products. The domestic volume declines were partially mitigated by volume growth in the European protective packaging businesses. Excluding the impact of favorable foreign currency effects, 2007 net sales for the segment would have decreased 0.4% compared to the prior year.
For the year ended December 31, 2007, net sales of our Flexible Packaging segment were $175.4 million, representing an increase of $20.8 million, or 13.4%, compared to net sales of $154.6 million for the year ended December 31, 2006. The increase was driven by higher product sales volume and favorable foreign currency translation, offset in part by unfavorable customer mix. The sales volume growth was primarily driven by demand in the fresh foods sector. Excluding the impact of favorable foreign currency effects, 2007 net sales for the segment would have increased 4.4% compared to the prior year.
For the year ended December 31, 2007, net sales of our Hospital Supplies segment were $74.2 million, representing an increase of $9.5 million, or 14.7%, compared to net sales of $64.7 million for the year ended December 31, 2006. The net sales improvement was driven by increased volume in disposable medical products and surgical procedure packs. Excluding the impact of favorable foreign currency translation, net sales for the segment would have increased 5.5%.
For the year ended December 31, 2007, net sales of our Rigid Packaging segment were $98.2 million, representing an increase of $4.3 million, or 4.6%, compared to net sales of $93.9 million for the year ended December 31, 2006. The increase in net sales was due to favorable foreign currency translation, which more than offset reduced product volumes. The volume declines were attributed in large part to unfavorable weather conditions in certain of our key markets, which weakened demand for our containers for salads and other convenience foods. Excluding the favorable foreign currency impact, 2007 net sales would have decreased 3.4%.
Net Sales - 2006 vs. 2005
Net sales for the year ended December 31, 2006 were $925.5 million compared to $191.6 million for the Successor period of 2005 and $678.0 million for the Predecessor period of 2005. Therefore, our 2006 net sales increased $55.9 million, or 6.4%, as compared to the combined results of the Successor and Predecessor periods of 2005. The key factors that contributed to the increase in 2006 net sales were as follows:
On a consolidated basis, our sales growth was driven by increased pricing implemented in response to higher raw material costs, along with a modest increase in product volume. Foreign currency exchange rates had a favorable impact on our 2006 sales compared to the prior year, due primarily to strengthening of the euro and the British pound sterling in relation to the U.S. dollar. Excluding the impacts of foreign currency translation, our net sales would have increased by 5.5% in 2006.
Segment Net Sales - 2006 vs. 2005
For the year ended December 31, 2006, net sales of our Protective Packaging segment were $617.5 million, representing an increase of $43.8 million, or 7.6%, compared to net sales in the 2005 Successor and Predecessor periods of $129.7 million and $444.0 million, respectively. The improvement was driven by increased pricing implemented in response to higher raw material costs. Additionally, the segment benefited from moderate increases in product sales volume and favorable currency impacts. Product volume growth was generated primarily by the European-based protective packaging businesses due to the strong economic environment, particularly in certain of the developing Eastern European countries, offset in part by reduced volumes in a portion of the U.S. business, as a result of the higher pricing in certain cases and reduced demand from certain customer sectors, such as automotive and housing.
For the year ended December 31, 2006, net sales of our Flexible Packaging segment were $154.6 million, representing an increase of $8.6 million, or 5.9%, compared to net sales in the 2005 Successor and Predecessor periods of $30.3 million and $115.7 million, respectively. The growth was due to product sales price improvement, offset in part by a slight decrease in product sales volume, which was attributed to management’s efforts to improve product mix. Foreign currency fluctuation favorably impacted net sales in 2006. Excluding the foreign currency impact, 2006 net sales for the segment would have increased 4.0%.
For the year ended December 31, 2006, net sales of our Hospital Supplies segment were $64.7 million, representing an increase of $3.2 million, or 5.2%, compared to net sales in the 2005 Successor and Predecessor periods of $12.8 million and $48.7 million, respectively. The growth was due to higher volumes of fast growth, disposable medical products, offset in part by unfavorable pricing due to product mix and competitive pricing reductions. Foreign currency fluctuation favorably impacted net sales in 2006. Excluding the foreign currency impact, 2006 net sales for the segment would have increased 4.1%.
For the year ended December 31, 2006, net sales of our Rigid Packaging segment were $93.9 million, which was comparable to the combination of our net sales in the 2005 Successor and Predecessor periods of $19.6 million and $75.0 million, respectively. The segment realized lower pricing in its efforts to change its product mix to more profitable products. However, this was substantially offset by favorable foreign currency impacts and a slight improvement in product volume. Excluding the foreign currency impact, 2006 net sales for the segment would have decreased 2.4%.
Gross Margin
Our gross margin (defined as net sales less cost of sales, excluding depreciation and amortization) as a percentage of net sales increased to 24.4% for the year ended December 31, 2007, compared to 22.9% for the year ended December 31, 2006, 18.7% for the Successor period of 2005, and 21.0% for the Predecessor period of 2005. The improvement in our 2007 gross margin percentage reflects significant net cost savings generated by our lean manufacturing and other productivity initiatives, as well as higher profitability resulting from our efforts to rationalize product mix and customer base, primarily in our U.S. businesses. Our 2006 gross margin improved relative to the 2005 periods since our price increases and product mix improvement in 2006 more than offset the increase in raw material costs. Our 2006 gross margin also reflects costs savings generated by productivity, as compared to the 2005 periods. The 2005 Successor period gross margin also includes the impact of approximately $4.0 million of additional cost of sales resulting from the sale of inventory that was revalued in connection with the Acquisition.
Selling, General and Administrative Expenses
For the year ended December 31, 2007, selling, general and administrative expenses totaled $137.2 million, representing an increase of $11.3 million, or 8.9%, compared to selling, general and administrative expenses of $125.9 million for the year ended December 31, 2006. Approximately $6.0 million of the increase relates to the impact of foreign currency translation. The 2007 expenses also include the write-off of approximately $3.1 million of third party due diligence and legal costs related to a potential acquisition that was ultimately not consummated, as well as approximately $0.7 million of incremental expense attributed to entities that were acquired during 2007. For the year ended December 31, 2006, selling, general and administrative expenses of $125.9 million, represented an increase of $13.8 million, or 12.3%, compared to selling, general and administrative expenses in the 2005 Successor and Predecessor periods of $112.1 million on a combined basis. The 2006 increase was primarily a result of costs incurred to establish our stand-alone IT and corporate infrastructure, including management change costs and other third party costs necessary to transition from Pactiv’s systems and infrastructure. As a percent of net sales, our selling, general and administrative costs were 14.0%, 13.6%, 12.6%, and 13.0% for the years ended December 31, 2007 and 2006, and the Successor and Predecessor periods of 2005, respectively.
Depreciation and Amortization
For the year ended December 31, 2007, depreciation and amortization totaled $55.8 million, representing an increase of $2.6 million, or 4.9%, compared to depreciation of $53.2 million in 2006. The increase was primarily due to foreign currency translation. For the year ended December 31, 2006, depreciation and amortization of $53.2 million represented an increase of $17.1 million, or 47.1%, compared to depreciation and amortization in the 2005 Successor and Predecessor periods of $10.9 million and $25.2 million, respectively. Both the year ended December 31, 2006 and Successor period of included higher levels of depreciation and amortization expense resulting from the establishment of new fair values and useful lives of our tangible and intangible assets as a result of the Acquisition.
Goodwill Impairment
In the Predecessor period of 2005, we recorded a pre-tax charge of $35.6 million for goodwill impairment, primarily in the Protective Packaging segment, as a result of using the preliminary purchase price as an indication of fair market value. In 2007 and 2006 we performed our annual test for impairment of goodwill and determined that no impairment to goodwill exists.
Other Operating Expense (Income), Net
Other operating expense (income), net includes other minor activity incidental to our operations, such as gain or losses on sale of operating fixed assets, and royalty expense. Detail of this activity is provided in Note 15 to the financial statements. Included in the year ended December 31, 2007 was a reserve of $2.9 million established primarily by the Flexible Packaging segment for severance and related costs arising from a plan to restructure its workforce which will be implemented in 2008. This expense was offset by a gain of $2.9 million on the insurance settlement for a printer operated by the Flexible Packaging segment, which was destroyed by fire in the first quarter of 2007. The replacement printer is expected to be commissioned by mid-2008.
There was no formal restructuring program in 2006 or 2005; however, in the Predecessor period of 2005 we recorded restructuring income of $0.4 million, due primarily to the reversal of remaining accruals that had been estimated for a restructuring program implemented in 2004.
Segment Income
We measure our segment’s operating performance on the basis of segment EBITDA, defined as net sales, less cost of sales, less selling, general and administrative expenses. See Note 18 to the consolidated financial statements for a reconciliation of total segment EBITDA to consolidated income (loss) before income taxes. Segment EBITDA for the relevant periods is as follows:
On a consolidated basis, approximately $6.0 million of the segment EBITDA growth in 2007 compared to 2006 was due to the favorable foreign currency impact from translating our foreign operations.
For the year ended December 31, 2007, the Protective Packaging segment’s EBITDA totaled $80.4 million, representing an increase of $8.9 million, or 12.5%, compared to EBITDA of $71.5 million for the year ended December 31, 2006. The improvement was due to favorable pricing and significant productivity savings, offset in part by volume declines in the U.S. businesses and higher selling, general and administrative expenses. Compared to the 2005 periods, the segment’s EBITDA in 2006 reflected positive cost recovery and productivity improvements.
For the year ended December 31, 2007, the Flexible Packaging segment’s EBITDA totaled $27.0 million, representing an increase of $7.0 million, or 13.0%, compared to EBITDA of $20.0 million for the year ended December 31, 2006. The segment’s earnings improved due to increased volumes, productivity savings and favorable foreign currency impact. Compared to the 2005 periods, the segment’s EBITDA in 2006 reflected positive cost recovery, increased volumes and savings in selling, general and administrative expenses.
For the year ended December 31, 2007, EBITDA of the Hospital Supplies segment totaled $10.8 million, representing an increase of $0.4 million, or 3.5%, compared to EBITDA of $10.4 million for the year ended December 31, 2006. The segment benefited from higher sales volumes and favorable foreign currency impact; however, this was offset by unfavorable pricing, due to the segment’s current competitive pricing environment. Compared to the 2005 periods, the segment’s EBITDA in 2006 benefited from higher sales volumes, costs savings
generated by productivity improvements, and reduced selling, general and administrative expenses, offset by unfavorable price.
For the year ended December 31, 2007, the Rigid Packaging segment’s EBITDA totaled $7.7 million, representing an increase of $1.7 million, or 29.5%, compared to EBITDA of $6.0 million for the year ended December 31, 2006. The improvement was driven primarily by productivity savings, offset in part by unfavorable price/mix and higher raw material costs. Compared to the 2005 periods, the segment’s EBITDA in 2006 also reflected significant productivity improvements offset by unfavorable price.
Operating Income (Loss)
Operating income for the year ended December 31, 2007 was $46.0 million, compared to $32.6 million for the year ended December 31, 2006, $0.9 million for the Successor period of 2005, and an operating loss of $6.7 million for the Predecessor period of 2005. Our 2007 operating income reflects the benefits of the productivity savings discussed previously, partially offset by increased selling, general and administrative expenses and depreciation and amortization. Our 2006 operating income, compared to the 2005 periods, reflects the impact of increased net sales and productivity improvements, also offset in part by higher selling, general and administrative expenses. The 2005 Predecessor period operating loss includes the impact of the $35.6 million non-cash goodwill impairment charge discussed previously. The Successor period results also reflect the impact of higher depreciation and amortization expense attributable to the fair value accounting resulting from the Acquisition.
Interest Expense
Interest expense for the year ended December 31, 2007 was $46.7 million, compared to $42.5 million for the year ended December 31, 2006, $10.5 million for the Successor period of 2005, and $2.2 million for the Predecessor period of 2005. Interest expense in 2007 increased relative to 2006 due in part to the strengthening of the euro relative to the U.S. dollar, which increased the U.S. dollar equivalent interest on our euro-denominated debt. In addition, the market rates underlying most of our variable rate debt increased in 2007, and, in the first half of 2007, we incurred approximately $1.0 million of penalty interest on our senior secured and senior subordinated notes, since we did not complete the exchange offer within the time frame specified by the registration rights agreement. Interest expense for 2006 reflects the impact of the new debt structure put in place to fund the Acquisition. The 2005 Successor period interest expense includes the impact of the new debt structure as well as the immediate write-off of $1.8 million for bridge financing commitment fees incurred in connection with the Acquisition. Our interest expense for the Predecessor period of 2005 is significantly lower than the successive periods since it did not yet reflect the debt structure put in place in connection with the Acquisition. A description of our outstanding indebtedness follows in the “Liquidity and Capital Resources” section.
Foreign Exchange Gain, Net
For the years ended December 31, 2007 and 2006, we generated net foreign exchange gains of $2.3 million and $6.1 million, respectively, most of which related to net unrealized foreign exchange gains resulting from the revaluation of our euro-denominated third-party debt and intercompany loans based on the exchange rates in effect at the respective year-ends. In the 2005 Successor period, we realized net foreign exchange gains of $4.8 million. This related primarily to a pre-tax gain of $5.4 million realized on a foreign-exchange forward contract that was put in place in advance of the Acquisition to fix the dollar-equivalent cost of the euro denominated debt issued to fund the Acquisition, partially offset by a net unrealized foreign exchange loss of $0.7 million resulting from the revaluation of our euro-denominated third-party debt and intercompany loans at December 31, 2005.
Gain on Sale of Securities
In connection with the Acquisition, in the 2005 Predecessor period, our Flexible Packaging segment sold its shares in a German recycling business and realized a $1.2 million gain.
Income Tax Expense (Benefit)
Our effective tax rate for the year ended December 31, 2007 was 263.2%, which compares to an effective tax rate of 136.1% for the year ended December 31, 2006, an effective rate benefit of 27.4% for the Successor period of 2005, and an effective tax rate of 19.5% for the Predecessor period of 2005.
The key factors driving up our effective tax rate in 2007 were interest expense incurred in certain foreign businesses that is not deductible for statutory tax purposes (resulting in a 44-percentage point increase) and the establishment of additional valuation allowances taken against losses in certain countries that are not certain to result in future tax benefits (which increased the effective rate by 161-percentage points).
In 2006, we generated a net loss for book purposes, primarily due to interest expense. Therefore, our 2006 effective rate was also higher than the statutory rate due to significant non-deductible interest expense, establishment of additional valuation allowances, and foreign tax rate differentials, including local taxes assessed on foreign income adjusted for items disallowed for tax purposes. The effective tax rate for the 2005 Successor period reflects the tax benefit resulting principally from the additional depreciation, amortization and interest expense generated by the Acquisition. Operations in Predecessor period of 2005 also resulted in an operating loss due primarily to the write off of goodwill in the U.S. operations, a significant portion of which was not deductible for tax purposes, which resulted in a 45-percentage point increase in the period’s effective rate. Additionally, we incurred tax expense of $1.3 million on distributions made by our Belgian company, which also increased our 2005 Predecessor rate by approximately 19-percentage points. See Note 14 to our consolidated financial statements for the detailed reconciliation of the U.S. federal statutory rate to our effective tax rate.
Net Income (Loss)
As a result of the factors discussed previously, we generated a net loss of $4.8 million for the year ended December 31, 2007, compared to a net loss of $8.4 million for the year ended December 31, 2006, a net loss of $3.4 million in the Successor period of 2005, and a net loss of $8.3 million in the Predecessor period of 2005.
LIQUIDITY AND CAPITAL RESOURCES
Historical Cash Flows
The following table shows our historical sources and uses of funds for the periods presented:
Significant items affecting our cash flows for the periods presented are not comparable, given the impact of the Acquisition, which took place at inception of the Successor period, on October 13, 2005. Therefore, for the Successor period of 2005, our sources and uses of cash were predominantly driven by the requirements of the Acquisition. The Acquisition was financed by equity investments from AEA Investors totaling $149.0 million, along with proceeds from the issuance of senior secured notes and senior subordinated notes in a private offering, and borrowings under new term loan facilities. The new indebtedness issued in connection with the Acquisition totaled $437.2 million. The proceeds from the new equity and debt issuances were used to acquire the Pregis
businesses at a final purchase price of $559.7 million, which included direct costs of the acquisition of $15.7 million and pension plan funding of $20.1 million. In addition, the proceeds were used to fund $17.7 million of other costs incurred in connection with the debt financing, which are being amortized over the terms of the financings. During the Successor period of 2005, we generated cash from operations of $39.1 million, which is more than we have historically generated in typical quarterly periods. However, we experienced a reduction in working capital during this period, due in part to an increase in payables to Pactiv due to timing of reimbursement for certain expenses, such as payroll, that Pactiv funded on our behalf for the transition period following the Acquisition.
Certain variances in our cash flows for the years ended December 31, 2007 and 2006 compared to the Predecessor period of 2005 are explained as follows:
Operating Activities
Cash generated by operating activities in 2007 totaled $51.2 million, which represents a significant increase over cash generated in 2006 of $22.6 million. The improvement is due primarily to higher earnings generated in 2007. Additionally, cash generated by operating activities in 2006 was reduced by approximately $9.0 million, which we paid to Pactiv and other vendors to settle amounts which had accumulated at 2005 year-end for payroll administered by Pactiv and other services related to the Acquisition.
Cash generated by operating activities in 2006 totaled $22.6 million, compared to cash generated in the Predecessor period of 2005 of $88.0 million. In advance of the Acquisition, Pactiv settled the majority of intercompany receivables and payables between the Pregis businesses and other Pactiv affiliates, which generated cash of $46.3 million due to the reduction in net affiliate receivables. The cash generated by operations during this period was offset by a $12.8 million reduction in pension liabilities, due primarily to Pactiv’s contribution to two under-funded defined benefit pension plans sponsored by our U.K. businesses. After giving consideration to this activity, cash provided by typical operating activities in the Predecessor period of 2005 was $54.5 million. While we had a higher revenue level and better gross margins in the 2006 annual period, our 2006 cash flows are reduced from the 2005 Predecessor period level because we made interest payments of approximately $42.0 million and settled amounts due to Pactiv and other vendors of approximately $9.0 million, which had accumulated at 2005 year-end for payroll administered by Pactiv and other services related to the Acquisition. Additionally, we had higher working capital investment at the end of 2006, due in part to a particularly strong fourth quarter.
Investing Activities
Cash used in investing activities totaled $62.0 million, $33.0 million and $21.3 million for the years ended December 31, 2007 and 2006, and the Predecessor period of 2005. In each of these periods, cash was used primarily to fund capital expenditures, which totaled $34.6 million, $28.1 million, and $21.9 million for each of the same respective periods. In 2007, we made significant investments in inflatable machines within our protective packaging businesses. Additionally, we converted a portion of our rigid packaging extrusion capacity to APET from PVC, and expanded of our flexible packaging capacity with new printing and laminating equipment. In 2007, we also used cash on hand of $28.8 million to fund the acquisitions of a protective packaging business based in Romania and a honeycomb manufacturer based in the Netherlands. In 2006, in addition to our investment in machinery and equipment, we used $4.9 million to acquire a business in the hospital supplies segment.
Financing Activities
Cash used in financing activities totaled $2.8 million, $1.7 million and $77.9 million for the years ended December 31, 2007 and 2006, and the Predecessor period of 2005. In 2007 and 2006, we funded the scheduled principal payments under our senior secured credit facilities. In 2007, we also funded financing costs related to the registration of our senior secured floating rate notes and subordinated notes and a technical amendment to our debt agreements. In the Predecessor period of 2005, we used cash to settle affiliate activity with Pactiv prior to the Acquisition, including the pay-down of $98.0 million of loans from other Pactiv affiliates. The cash used to settle these loans was generated by the collection of intercompany receivables, as well as cash capital contributions totaling $20.5 million made by Pactiv to certain subsidiaries to enable them to settle the affiliate debt.
Contractual Obligations
Our primary contractual cash obligations as of December 31, 2007 are summarized in the table below.
(1)
Represents scheduled annual repayments on the term B-1 and term B-2 loans under our credit facility. The senior secured floating rate notes and senior subordinated notes mature in their entirety on April 15, 2013 and October 15, 2013, respectively.
(2)
Represents estimated cash interest expense on borrowings outstanding as of December 31, 2007, assuming principal payments are made as scheduled, without giving effect to any interest rate hedge arrangements. Interest on floating rate debt was estimated using the index rates in effect as of December 31, 2007.
(3)
Represents the amounts outstanding as of December 31, 2007 under contractual agreements for the acquisition of certain machinery and equipment by the flexible packaging segment.
(4)
This table does not include information on our recurring purchases of materials for use in production, as our raw material purchase contracts typically do not require fixed or minimum quantities.
Due to the uncertainty of the timing of settlement with taxing authorities, we are unable to make reasonably reliable estimates of the period of cash settlement of unrecognized tax benefits. Therefore, $9.6 million of unrecognized tax benefits as of December 31, 2007 have been excluded from the table above. Of this amount, $7.1 million is subject to indemnification under the Stock Purchase Agreement with Pactiv and would therefore be reimbursed if the Company is required to settle these amounts in cash. See Note 14 to the consolidated financial statements included elsewhere within this report.
Our contractual obligations and commitments over the next several years are significant. In addition to our contractual obligations noted above, we will also require cash to make capital expenditures, pay taxes, and make contributions under the defined benefit pension plans covering certain of our European employees. We incur capital expenditures for the purpose of maintaining and replacing existing equipment and facilities, and from time to time, for facility expansion. Our capital expenditures totaled $34.6 million, $28.1 million, and $25.8 million for the years ended December 31, 2007, 2006 and 2005, respectively, and we expect our 2008 capital expenditures to total approximately $28 to $32 million, including the amounts committed to at December 31, 2007. We paid taxes of $3.8 million, $5.2 million, and $5.2 million during 2007, 2006 and 2005, respectively. In connection with the Acquisition, in 2005 Pregis and Pactiv contributed a total of $34.3 million to Pregis’s underfunded U.K. defined benefit plans to fully fund those plans. We contributed approximately $3.0 million annually to our defined benefit plans in 2007 and 2006 and anticipate contributing a similar amount during 2008. We are also paying an annual management fee of $1.5 million, plus reasonable out-of-pocket expenses, to AEA Investors LLC for advisory and consulting services provided to us under the terms of a management agreement.
Our principal source of liquidity will continue to be cash flow generated from operations, as well as borrowings available to us under a $50 million revolving credit facility. To the extent that we generate cash in
excess of that needed to fund our requirements as discussed above, we presently expect that such excess cash would be used to invest in the business, with any additional excess used to pay down principal on our term loan facilities. At December 31, 2007, we had cash and cash equivalents of $35.0 million. Additionally, we had availability of $43.9 million under our revolving credit facility, after taking into account $6.1 million in outstanding letters of credit issued under this facility.
Long-term Liquidity. We believe that cash flow generated from operations and our borrowing capacity will be adequate to meet our obligations and business requirements for the next twelve months. There can be no assurance, however, that our business will generate sufficient cash flow from operations, that anticipated net sales growth and operating improvements will be realized or that future borrowings will be available under Pregis’s senior secured credit facilities in an amount sufficient to enable us to service our indebtedness or to fund our other liquidity needs. Our ability to meet our debt service obligations and other capital requirements, including capital expenditures, will depend upon our future performance which, in turn, will be subject to general economic, financial, business, competitive, legislative, regulatory and other conditions, many of which are beyond our control. Some other risks that could materially adversely affect our ability to meet our debt service obligations include, but are not limited to, risks related to increases in the cost of resin, our ability to protect our intellectual property, rising interest rates, a decline in the overall U.S. and European economies, weakening in our end markets, the loss of key personnel, our ability to continue to invest in equipment, and a decline in relations with our key distributors and dealers. In addition, any of the other items discussed in detail under Item 1A, “Risk Factors,” may also significantly impact our liquidity.
The following discussion provides a description of our outstanding indebtedness at December 31, 2007:
Senior Secured Credit Facilities. In connection with the Acquisition on October 13, 2005, Pregis entered into senior secured credit facilities which provided for a revolving credit facility and two term loans: an $88.0 million term B-1 facility and a 68.0 million term loan B-2 facility, both of which mature in October 2012. The revolving credit facility matures in October 2011 and provides for borrowings of up to $50.0 million, a portion of which may be made available to the Company’s non-U.S. subsidiary borrowers in euros and/or pounds sterling. The revolving credit facility also includes a swing-line loan sub-facility and a letter of credit sub-facility. The revolving credit facility bears interest at a rate equal to, at the Company’s option, (1) an alternate base rate or (2) LIBOR or EURIBOR, plus an applicable margin of 0.375% to 1.00% for base rate advances and 1.375% to 2.00% for LIBOR or EURIBOR advances, depending on the leverage ratio of the Company, as defined in the credit agreement. In addition, the Company is required to pay an annual commitment fee of 0.375% to 0.50% on the revolving credit facility depending on the leverage ratio of the Company, as well as customary letter of credit fees.
The term loan B-1 facility amortizes at a rate of 1% per annum in equal quarterly installments during the first six years thereof, with the balance payable in equal quarterly installments during the seventh year thereof. The term loan B-2 facility amortizes at a rate of 1% per annum in equal quarterly installments during the first six years thereof, with the balance payable in equal quarterly installments during the seventh year thereof.
Subject to exceptions and, in the case of asset sale proceeds, reinvestment options, Pregis’s senior secured credit facilities require mandatory prepayments of the loans from excess cash flows, asset sales and dispositions (including insurance and condemnation proceeds), issuances of debt and issuances of equity.
Pregis’s senior secured credit facilities and related hedging arrangements are guaranteed by Pregis Holding II, the direct holding parent company of Pregis, all of Pregis’s current and future domestic subsidiaries and, if no material tax consequences would result, Pregis’s future foreign subsidiaries and, subject to certain exceptions, are secured by a first priority security interest in substantially all of Pregis’s and its current and future domestic subsidiaries’ existing and future assets (subject to certain exceptions), and a first priority pledge of the capital stock of Pregis and the guarantor subsidiaries and an aggregate of 66% of the capital stock of Pregis’s first-tier foreign subsidiary.
Pregis’s senior secured credit facilities require that it comply on a quarterly basis with certain financial covenants, including a maximum leverage ratio test and a minimum cash interest coverage ratio test. In addition,
Pregis’s senior secured credit facilities include negative covenants, subject to certain exceptions, that restrict or limit Pregis’s ability and the ability of its subsidiaries to, among other things:
•
incur, assume or permit to exist additional indebtedness, guaranty obligations or hedging arrangements,
•
incur liens or agree to negative pledges in other agreements,
•
engage in sale and leaseback transactions,
•
make capital expenditures,
•
make loans and investments,
•
declare dividends, make payments or redeem or repurchase capital stock,
•
in the case of subsidiaries, enter into agreements restricting dividends and distributions,
•
engage in mergers, acquisitions and other business combinations,
•
prepay, redeem or purchase certain indebtedness,
•
amend or otherwise alter the terms of Pregis’s organizational documents, Pregis’s indebtedness and other material agreements,
•
sell assets or engage in receivables securitization,
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transact with affiliates, and
•
alter the business that Pregis conducts.
As of December 31, 2007, Pregis was in compliance with all covenants contained in its senior secured credit facilities.
Senior Secured Floating Rate Notes and Senior Subordinated Notes. In connection with the Acquisition on October 13, 2005, Pregis issued 100.0 million aggregate principal amount of second priority senior secured floating rate notes due 2013 (the “senior secured notes”) and $150.0 million aggregate principal amount of 123/8% senior subordinate notes due 2013 (the “senior subordinated notes”).
The senior secured notes mature on April 15, 2013. Interest accrues at a floating rate equal to EURIBOR plus 5.00% per year and is payable quarterly on January 15, April 15, July 15 and October 15 of each year. The senior secured notes are guaranteed on a senior secured basis by Pregis Holding II, Pregis’s immediate parent, and each of Pregis’s current and future domestic subsidiaries. Pregis may redeem some or all of the senior secured notes at redemption prices equal 101% of their principal amount (in the 12 months beginning October 15, 2007) and 100% of their principal amount (beginning October 15, 2008). Upon the occurrence of a change of control, Pregis will be required to make an offer to repurchase each holder’s notes at a repurchase price equal to 101% of their principal amount, plus accrued and unpaid interest to the date of repurchase.
The senior subordinated notes mature on October 15, 2013. Interest accrues at a rate of 12.375% and is payable semi-annually on April 15 and October 15 of each year. The notes are senior subordinated obligations and rank junior in right of payment to all of Pregis’s senior indebtedness. The senior subordinated notes are guaranteed on a senior subordinated basis by Pregis Holding II and each of Pregis’s current and future domestic subsidiaries. Pregis may redeem up to 35% of the senior subordinated notes at any time prior to October 15, 2008 with the net proceeds of certain equity offerings at a redemption price equal to 112.375% of their principal amount plus accrued interest. Pregis may redeem some or all of the senior subordinated notes at any time prior to October 15, 2009 at a redemption price equal to par plus a make-whole premium. Pregis may redeem some or all of the notes on or after October 15, 2009 at redemption prices equal to 106.188% of their principal amount (in the 12 months beginning October 15, 2009), 103.094% of their principal amount (in the 12 months beginning October 15, 2010) and 100% of their principal amount (beginning October 15, 2011).
The indentures governing the senior secured notes and the senior subordinated notes contain covenants that limit or prohibit Pregis’s ability and the ability of its restricted subsidiaries, subject to certain exceptions, to incur additional indebtedness, pay dividends or make other equity distributions, make investments, create liens, incur obligations that restrict the ability of Pregis’s restricted subsidiaries to make dividends or other payments to Pregis, sell assets, engage in transactions with affiliates, create unrestricted subsidiaries, and merge or consolidate with other companies or sell substantially all of Pregis’s assets. The indentures also contain reporting covenants regarding delivery of annual and quarterly financial information. The indenture governing the senior secured notes limits Pregis’s ability to incur first priority secured debt to an amount which results in its secured debt leverage ratio being equal to 3:1, plus $50 million, and prohibits it from incurring additional second priority secured debt other than by issuing additional senior secured notes. The indenture governing the senior secured notes also limits Pregis’s ability to enter into sale and leaseback transactions. The indenture governing the senior subordinated notes prohibits Pregis from incurring debt that is senior to such notes and subordinate to any other debt.
In connection with issuing the notes, Pregis entered into a registration rights agreement in which Pregis agreed to file a registration statement which will permit it to offer to exchange the senior secured notes and the senior subordinated notes for new issues of identical debt securities registered under the Securities Act of 1933. Pregis agreed to complete the exchange offer for the notes by July 9, 2006. Pregis also agreed to provide a shelf registration statement to cover resales of the notes under certain circumstances. Given the delay in the completion of the audit of Pregis’s 2005 financial statements, Pregis was unable to consummate the exchange offer by July 9, 2006. Therefore, beginning July 9, 2006, Pregis was required to pay penalty interest on the notes. Under the registration rights agreement, Pregis was required to pay additional interest on the notes equal to 0.25% per year on the principal amount of notes for the first 90 days following any default, increasing by an additional 0.25% for each subsequent 90-day period, up to a maximum additional interest of 1.0% per year. Following the cure of all registration defaults, the accrual of additional interest ceased. On May 11, 2007, the SEC declared Pregis’s exchange offer effective, and Pregis completed the exchange offer with respect to the notes on June 15, 2007, at which time the accrual of penalty interest ceased.
The senior secured notes and senior subordinated notes are not listed on any national securities exchange in the United States. The senior secured notes were listed on the Irish Stock Exchange in June 2007. However, there can be no assurance that the senior secured notes will remain listed.
Collateral for the Senior Secured Floating Rate Notes. The senior secured floating rate notes are secured by a second priority lien, subject to permitted liens, on all of the following assets owned by Pregis or the guarantors, to the extent such assets secure Pregis’s senior secured credit facilities on a first priority basis (subject to exceptions):
(1)
substantially all of Pregis’s and each guarantor’s existing and future property and assets, including, without limitation, real estate, receivables, contracts, inventory, cash and cash accounts, equipment, documents, instruments, intellectual property, chattel paper, investment property, supporting obligations and general intangibles, with minor exceptions; and
(2)
all of the capital stock or other securities of Pregis’s and each guarantor’s existing or future direct or indirect domestic subsidiaries and 66% of the capital stock or other securities of Pregis’s and each guarantor’s existing or future direct foreign subsidiaries, but only to the extent that the inclusion of such capital stock or other securities will mean that the par value, book value as carried by us, or market value (whichever is greatest) of such capital stock or other securities of any subsidiary is not equal to or greater than 20% of the aggregate principal amount of the senior secured floating rate notes outstanding.
As of December 31, 2007, the capital stock of the following subsidiaries of Pregis constitutes collateral for the senior secured floating rate notes:
As described above, under the collateral agreement, the capital stock pledged to the senior secured floating rate noteholders constitutes collateral only to the extent that the par value or market value or book value (whichever is greatest) of the capital stock does not exceed 20% of the aggregate principal amount of the senior secured floating rate notes. This threshold is 20,000,000, or, at the December 31, 2007 exchange rate of U.S. dollars to euros of 1.4598:1.00, approximately $29.2 million. As of December 31, 2007, the book value and the market value of the shares of capital stock of Pregis Innovative Packaging Inc. were approximately $30.2 million and $75.0 million, respectively; the book value and the market value of the shares of capital stock of Hexacomb Corporation were approximately $23.1 million and $74.6 million, respectively; and the book value and the market value of 66% of the shares of capital stock of Pregis (Luxembourg) Holding S.àr.l. were approximately $23.0 million and $84.9 million, respectively. Therefore, in accordance with the collateral agreement, the collateral pool for the senior secured floating rate notes includes approximately $29.2 million with respect to the shares of capital stock of each of Pregis Innovative Packaging Inc., Hexacomb Corporation, and Pregis (Luxembourg) Holding S.àr.l. Since the book value and market value of the shares of capital stock of our other domestic subsidiary are each less than the $29.2 million threshold, it is not effected by the 20% clause of the collateral agreement.
For the year ended December 31, 2007, certain historical corporate expenses incurred by Pregis Management Corporation were allocated to each of the three entities, Pregis Innovative Packaging Inc., Hexacomb Corporation, and Pregis (Luxembourg) Holding S.àr.l, in order to better reflect their current book values for presentation herein on a fully-allocated basis.
The market value of the capital stock of the guarantors and subsidiaries constituting collateral for the senior secured floating rate notes has been estimated by us on an annual basis, using a market approach. At the time of the Acquisition, the purchase price paid for these entities was determined based on a multiple of EBITDA, as was contractually agreed in the stock purchase agreement. Since that time, we have followed a similar methodology, using a multiple of EBITDA, based on that of recent transactions of comparable companies, to determine the enterprise value of these entities. To arrive at an estimate of the market value of the entities’ capital stock, we have subtracted from the enterprise value the existing debt, net of cash on hand, and have also made adjustments for the businesses’ relative portion of corporate expenses. We have determined that this methodology is a reasonable and appropriate means for determining the market value of the capital stock pledged as collateral. We intend to complete these estimates of value of the capital stock of these subsidiaries for so long necessary to determine our compliance with the collateral arrangement governing the notes.
The value of the collateral for the senior secured floating rate notes at any time will depend on market and other economic conditions, including the availability of suitable buyers for the collateral. As of December 31, 2007, the value of the collateral for the senior secured floating rate notes totaled approximately $456.1 million, estimated as the sum of (1) the book value of the total assets of Pregis and each guarantor, excluding intercompany activity (which amount totaled $368.5 million), and (2) the collateral value of the capital stock, as outlined above (which amount totaled $87.6 million). Any proceeds received upon the sale of collateral would be paid first to the lenders under our senior secured credit facilities, who have a first lien security interest in the collateral, before any payment could be made to holders of the senior secured floating rate notes. There is no assurance that any collateral value
would remain for the holders of the senior secured floating rate notes after payment in full to the lenders under our senior secured credit facilities.
Covenant Ratios Contained in the Senior Secured Floating Rate Notes and Senior Subordinated Notes. The indentures governing the senior secured floating rate notes and senior subordinated notes contain two material covenants which utilize financial ratios. Non-compliance with these covenants could result in an event of default under the indentures and, under certain circumstances, a requirement to immediately repay all amounts outstanding under the notes and could trigger a cross-default under Pregis’s senior secured credit facilities or other indebtedness we may incur in the future. First, Pregis is permitted to incur indebtedness under the indentures if the ratio of Consolidated Cash Flow to Fixed Charges on a pro forma basis (referred to in the indentures as the “Fixed Charge Coverage Ratio”) is greater than 2:1 or, if the ratio is less, only if the indebtedness falls into specified debt baskets, including, for example, a credit agreement debt basket, an existing debt basket, a capital lease and purchase money debt basket, an intercompany debt basket, a permitted guarantee debt basket, a hedging debt basket, a receivables transaction debt basket and a general debt basket. In addition, under the senior secured floating rate notes indenture, Pregis is permitted to incur first priority secured debt only if the ratio of Secured Indebtedness to Consolidated Cash Flow on a pro forma basis (referred to in the senior secured floating rate notes indenture as the “Secured Indebtedness Leverage Ratio”) is equal to or less than 3:1, plus $50 million. Second, the restricted payment covenant provides that Pregis may declare certain dividends, or repurchase equity securities, in certain circumstances only if Pregis’s Fixed Charge Coverage Ratio is greater than 2:1.
As used in the calculation of the Fixed Charge Coverage Ratio and the Secured Indebtedness Leverage Ratio, Consolidated Cash Flow, commonly referred to as Adjusted EBITDA, is calculated by adding Consolidated Net Income, income taxes, interest expense, depreciation and amortization and other non-cash expenses, amounts paid pursuant to the management agreement with AEA Investors LLC, and the amount of any restructuring charge or reserve (including, without limitation, retention, severance, excess pension costs, contract termination costs and cost to consolidate facilities and relocate employees). In calculating the ratios, Consolidated Cash Flow is further adjusted by giving pro forma effect to acquisitions and dispositions that occurred in the prior four quarters, including certain cost savings and synergies expected to be obtained in the succeeding twelve months. In addition, the term Net Income is adjusted to exclude any gain or loss from the disposition of securities, and the term Consolidated Net Income is adjusted to exclude, among other things, the non-cash impact attributable to the application of the purchase method of accounting in accordance with GAAP, the cumulative effect of a change in accounting principles, and other extraordinary, unusual or nonrecurring gains or losses. While the determination of appropriate adjustments is subject to interpretation and requires judgment, we believe the adjustments listed below are in accordance with the covenants discussed above. The credit agreement governing our senior secured credit facilities calculates Adjusted EBITDA (referred to therein as “Consolidated EBITDA”) in a similar manner.
The following table sets forth the Fixed Charge Coverage Ratio, Consolidated Cash Flow (“Adjusted EBITDA”), Secured Indebtedness Leverage Ratio, Fixed Charges and Secured Indebtedness as of and for the years ended December 31, 2007 and 2006:
Adjusted EBITDA is calculated under the indentures governing our senior secured floating rate notes and senior subordinated notes for the years ended December 31, 2007 and 2006 as follows:
(1)
Other non-cash charges (income) include (a) net unrealized foreign currency transaction gains, (b) non-cash compensation expense resulting from the grant of Pregis Holding I options, (c) a non-cash trademark impairment charge of $403, determined pursuant to the Company’s 2007 annual impairment test, and (d) purchase accounting adjustments for the write-up of inventory to fair value, which was subsequently charged to cost of sales in 2006 ($1.0 million) as the inventory was sold.
(2)
As provided by our indentures, we adjusted for gains or losses deemed to be unusual or nonrecurring, including (a) adjustments for costs and expenses related to acquisition, disposition or equity offering activities, including a $3.1 million adjustment in 2007 for third party due diligence and legal costs related to a potential acquisition that was ultimately not consummated, (b) severance and related expenses due to the separation of certain former executive management, and (c) in 2007, restructuring costs incurred principally by the flexible packaging segment, net of the nonrecurring gain on insurance settlement.
(3)
Our indentures also require us to make adjustments for fees, and reasonable out-of-pocket expenses, paid under the management agreement with AEA Investors LLC.
(4)
Our indentures also permit adjustments to net income on a pro forma basis for certain costs savings that we expect to achieve with respect to acquisitions or dispositions. Therefore, in 2007, we have adjusted for (a) approximately $1.1 million relating to pre-acquisition earnings and pro forma cost savings for anticipated synergies relating to the June 2007 acquisition of a Romanian protective packaging provider, and (b) approximately $2.4 million for pre-acquisition earnings and pro forma cost savings for anticipated synergies relating to the December 2007 acquisition of a European honeycomb manufacturer. There can be no assurance that we will be able to achieve these comparable earnings or estimated savings in the future.
Local lines of credit. From time to time, certain of the foreign businesses utilize various lines of credit in their operations. These lines of credit are generally used as overdraft facilities or for issuance of trade letters of credit and are in effect until cancelled by one or both parties. Amounts available under these lines of credit were $12.8 million and $12.0 million at December 31, 2007 and 2006, respectively. At December 31, 2007, no borrowings were drawn under these lines, but trade letters of credit totaling $3.6 million were issued and outstanding.
OFF BALANCE SHEET ARRANGEMENTS
We have no special purpose entities or off balance sheet arrangements, other than operating leases in the ordinary course of business, which are disclosed in Note 12 to the consolidated financial statements.
SUMMARY OF CRITICAL ACCOUNTING POLICIES
Our consolidated and combined financial statements are prepared in accordance with generally accepted accounting principles in the United States, which require management to make estimates, judgments and assumptions that affect the amounts reported in the consolidated and combined financial statements and accompanying notes. While our estimates and assumptions are based on our knowledge of current events and actions we may undertake in the future, actual results may ultimately differ from these estimates and assumptions. The Notes to our annual audited consolidated and combined financial statements contain a summary of our significant accounting policies. We believe the following discussion addresses our most critical accounting policies, which are those that require our most subjective or complex judgments that could materially impact our reported results if actual outcomes differed significantly from estimates.
Revenue Recognition. Our principal business is the manufacture and supply of protective and specialty packaging products. We recognize net sales of our products when the risks and rewards of ownership have transferred to the customer, which is generally upon shipment (but in some cases may be upon delivery), based on specific terms of sale. In arriving at net sales, we estimate the amount of deductions from sales that are likely to be earned or taken by customers in conjunction with incentive programs, such as volume rebates and early payment discounts, and record such estimates as sales are recorded. Our deduction estimates are based on historical experience.
In recent years, we began participating in programs in certain of our European protective packaging and flexible packaging businesses whereby the businesses purchase resin quantities in excess of their internal requirements and resell the surplus to other customers at a nominal profit. These “resin resale programs” enable the businesses to benefit from improved quantity discounts and volume rebates, as well as increased flexibility in their resin purchasing. This activity is presented on a net basis within net sales, in accordance with EITF No. 99-19, Reporting Revenue Gross as a Principal versus Net as an Agent, on the basis that the third-party resin supplier is responsible for fulfillment of the order to the customer’s specifications, ships the resin directly to the customer, and maintains general inventory risk and risk of physical loss during shipment. We recognize revenue related to resin resale activity upon delivery to the customer.
Pension. Predominantly in our U.K. and Netherlands based businesses, we provide defined benefit pension plan coverage for salaried and hourly employees. We use several statistical and other models which attempt to anticipate future events in calculating the expenses and liabilities related to the plans. These factors include actuarial
assumptions about discount rates, long-term return on assets, salary increases, mortality rates, and other factors. The actuarial assumptions used may differ materially from actual results due to changing market and economic conditions, or longer or shorter life spans of participants. Such differences may result in a significant impact on the recognized pension expense and recorded liability.
Goodwill and Other Indefinite Lived Intangible Assets. Carrying values of goodwill and other intangible assets not subject to amortization are reviewed at least annually for possible impairment using discounted cash flow and market multiple approaches. The estimates and assumptions we use are consistent with the business plans and estimates we use to manage operations and to make acquisition and divestiture decisions. The use of different assumptions may increase or decrease the estimated value of future cash flows and may increase or decrease the calculated impairment charge. Future outcomes may also differ. If we fail to achieve estimated volume and pricing targets, experience unfavorable market conditions or achieve results that differ from our estimates, then revenue and cost forecasts may not be achieved, and we may be required to recognize additional impairment charges. Our annual impairment test, performed as of October 1, 2007, did not result in any impairment of goodwill. However, our 2007 annual test for impairment of trade names, our only other intangible assets not subject to amortization, did result in an impairment write-down of approximately $0.4 million, due primarily to reduced near-term net sales projections for the respective product.
Impairment of Long-Lived Assets. We periodically re-evaluate carrying values and estimated useful lives of long-lived assets whenever events or changes in circumstances indicate that the carrying amount of the related asset may not be recoverable. We use estimates of undiscounted cash flows from long-lived assets to determine whether the book value of such assets is recoverable over the assets’ remaining useful lives. If an asset is determined to be impaired, the impairment is measured by the amount by which the carrying value of the asset exceeds its fair value. An impairment charge would have a negative impact on net income.
Income Taxes. Our overall tax position is complex and requires careful analysis by management to estimate the expected realization of income tax assets and liabilities. We recognize deferred tax assets and liabilities based on the differences between the financial statement carrying amounts and the tax bases of assets and liabilities. Deferred tax assets generally represent items that can be used as a tax deduction or credit in the tax return in future years for which we have already recorded the tax benefit in the financial statements. We regularly review our deferred tax assets for recoverability and establish a valuation allowance to reduce such assets to amounts expected to be realized. In determining the required level of valuation allowance, we consider whether it is more likely than not that all or some portion of deferred tax assets will not be realized. This assessment is based on management’s expectations as to whether sufficient taxable income of an appropriate character will be realized within the tax carryback and carryforward periods. Our assessment involves estimates and assumptions about matters that are inherently uncertain, and unanticipated events or circumstances could cause actual results to differ from these estimates. Should we change our estimate of the amount of deferred tax assets that we would be able realize, an adjustment to the valuation allowance would result in an increase or decrease to the provision for income taxes in the period such a change in estimate was made.
We record liabilities for uncertain tax positions in accordance with FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes (FIN 48). The tax positions we take are based on our interpretations of tax laws and regulations in the applicable federal, state and international jurisdictions. We believe that our tax returns properly reflect the tax consequences of our operations, and that our reserves for tax contingencies are appropriate and sufficient for the positions taken. However, these positions are subject to audit and review by the tax authorities, which may result in future taxes, interest and penalties. Because of the uncertainty of the final outcome of these examinations, we have reserved for potential reductions of tax benefits (including related interest) for amounts that do not meet the more-likely-than-not thresholds for recognition and measurement as required by FIN 48. The tax reserves are reevaluated throughout the year, taking into account new legislation, regulations, case law and audit results.
RECENT ACCOUNTING PRONOUNCEMENTS
In December 2007, the FASB issued SFAS No. 141(R), Business Combinations, which revised SFAS No. 141, Business Combinations. which requires an acquiror to measure the identifiable assets acquired, liabilities assumed and any noncontrolling interest in the acquiree at their fair values on the acquisition date, with goodwill being the excess value over the net identifiable assets acquired. SFAS No. 141(R) will also impact the accounting for transaction costs, restructuring costs as well as the initial recognition on contingent assets and liabilities assumed during a business combination. In addition, under SFAS No. 141(R), adjustments to the acquired entity’s deferred tax assets and uncertain tax position balances occuring outside the measurement period are recorded as a component of the income tax expense, rather than goodwill. SFAS No. 141(R) is effective for financial statements issued for fiscal years beginning after December 15, 2008. The provisions of SFAS No. 141(R) are applied prospectively, so the Company has not yet determined the effect on its financial statements, if any, upon adoption of SFAS No. 141(R).
In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities-including an amendment to FASB Statement No. 115, which permits entities to choose to measure many financial instruments and certain other items at fair value that are not currently required to be measured at fair value. SFAS No. 159 is effective as of January 1, 2008. The adoption of SFAS No. 159 is not expected to have a material effect on the Company’s consolidated financial statements.
In September 2006, the FASB issued SFAS No. 158, Employer’s Accounting for Defined Benefit Pension and Other Postretirement Plans (an amendment of FASB Statements No. 87, 88, 106, and 132R) (SFAS 158). SFAS 158 requires an employer to recognize a plan’s funded status in its balance sheet, measure a plan’s assets and obligations as of the end of the employer’s fiscal year (with limited exceptions), and recognize the changes in a defined benefit postretirement plan’s funded status in comprehensive income in the year in which the changes occur. The Company adopted SFAS No. 158 on December 31, 2007 on a prospective basis, in accordance with the statement’s transition rules. The adoption of SFAS No. 158 resulted in an adjustment to the Company’s balance sheet, but had no impact on net earnings or cash flow. See Note 16 to the financial statements for additional information regarding the Company’s pension plans.
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurement. SFAS No. 157 defines fair value, establishes a framework for measuring fair value, and expands disclosure about fair value measurements. The statement is effective for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The adoption of SFAS No. 157 is not expected to have a material effect on the Company’s consolidated financial statements.
In June 2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes (FIN 48). FIN 48 prescribes a more likely than not threshold for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This Interpretation also provides guidance on derecognition of income tax assets and liabilities, classification of current and deferred income tax assets and liabilities, accounting for interest and penalties associated with tax positions, accounting for income taxes in interim periods, and income tax disclosures. The Company adopted the provisions of FIN 48 effective January 1, 2007, and the impact of adoption was not material. See Note 14 for additional information.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We are exposed to market risks related to changes in interest rates, foreign currency exchange rates and commodity prices. To manage these risks, we may enter into various hedging contracts in accordance with established policies and procedures. We do not use hedging instruments for trading purposes.
Interest Rate Risk. We are subject to interest rate market risk in connection with our long-term debt. Our principal interest rate exposure relates to outstanding amounts under our senior secured credit facilities and senior secured floating rate notes. At December 31, 2007, we had $330.0 million of variable rate debt. A one percentage point increase or decrease in the average interest rates would correspondingly change our interest expense by approximately $3.3 million per year. This excludes the impact of the interest rate swap arrangement that was put in place in November 2005 to balance the fixed and variable rate debt components of our capital structure. The carrying value of our senior secured credit facilities at December 31, 2007 approximates fair value, since the interest rates vary with market conditions. At December 31, 2007 and 2006, the carrying value of our senior secured floating rate notes was $146.0 million and $132.0 million, respectively, which compares to fair value, based upon quoted market prices, of $140.0 million and $135.8 million for the respective periods.
The fair value of our fixed rate senior subordinated notes is exposed to market risk of interest rate changes. The carrying value of the senior subordinated notes was $147.8 million and $147.5 million at December 31, 2007 and 2006, respectively. The estimated fair value of such notes was $158.4 million and $161.8 million at December 31, 2007 and 2006, based upon quoted market prices.
Raw Material; Commodity Price Risk. We rely upon the supply of certain raw materials and commodities in our production processes. The primary raw materials we use in the manufacture of our products are various plastic resins, primarily polyethylene and polypropylene. Approximately 75% of our 2007 net sales were from products made with plastic resins. We manage the exposures associated with these costs primarily through terms of the sales and by maintaining relationships with multiple vendors. We acquire these materials at market prices, which are negotiated on a continuous basis, and we do not typically buy forward beyond two or three months or enter into guaranteed supply or fixed price contracts with our suppliers. Additionally, we have not entered into hedges with respect to our raw material costs. We seek to mitigate the market risk related to commodity pricing by passing the increases in raw material costs through to our customers in the form of price increases.
Foreign Currency Exchange Rate Risk. Our results of operations are affected by changes in foreign currency exchange rates. Approximately 65% of our 2007 net sales were made in currencies other than the U.S. dollar, principally the euro and the pound sterling. We have a natural hedge in our operations, as we typically produce, buy raw materials, and sell our products in the same currency. We are exposed to translational currency risk, however, in converting our operating results in Europe, the United Kingdom and to a lesser extent Egypt, Poland, the Czech Republic, Hungary, Bulgaria, Romania, Canada, and Mexico at the end of each reporting period. The weakening of the U.S. dollar relative to the euro and the pound sterling in 2007 and 2006 had a favorable impact on our financial results in U.S. dollars, as compared to fiscal 2005 results. The translational currency impact of a plus/minus swing of 10% in the U.S. dollar exchange rate on our 2007 operating income would have been approximately $2.6 million.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Report of Independent Registered Public Accounting Firm
The Board of Directors and Shareholder of Pregis Holding II Corporation
We have audited the accompanying consolidated balance sheets as of December 31, 2007 and 2006 of Pregis Holding II Corporation and the related consolidated statements of operations, stockholder’s equity and comprehensive income (loss), and cash flows for the years ended December 31, 2007 and 2006 and the period from October 13, 2005 to December 31, 2005 (Successor), and the combined statements of operations, owner’s equity and comprehensive income (loss), and cash flows for the period from January 1, 2005 to October 12, 2005 (Predecessor) consisting of the companies listed in Note 1. Our audits also included the financial statement schedule listed in the index to the financial statements as “Schedule II - Valuation and Qualifying Accounts”. These financial statements and schedule are the responsibility of Pregis Holding II Corporation’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.
We conducted our audits in accordance with auditing standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Company’s internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Pregis Holding II Corporation at December 31, 2007 and 2006 and the consolidated results of its operations and its cash flows for the years ended December 31, 2007 and 2006 and the period from October 13, 2005 to December 31, 2005 (Successor), and the combined results of its operations and its cash flows for the period from January 1, 2005 to October 12, 2005 (Predecessor), in conformity with accounting principles generally accepted in the United States. Also in our opinion, the financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
During 2006, as discussed in Notes 3 and 17 to the financial statements, the Company adopted FASB Statement No. 123R, “Share-Based Payment”. During 2007, as discussed in Notes 3, 14 and 16 to the financial statements, the Company adopted FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” and FASB Statement No. 158, “Employer’s Accounting for Defined Benefit Pension and Other Postretirement Plans”.
Chicago, Illinois
March 17, 2008
Pregis Holding II Corporation
Consolidated Balance Sheets
(dollars in thousands)
The accompanying notes are an integral part of these financial statements.
Pregis Holding II Corporation
Consolidated and Combined Statements of Operations
(dollars in thousands)
The accompanying notes are an integral part of these financial statements.
Pregis Holding II Corporation
Consolidated and Combined Statements of Equity
and Comprehensive Income (Loss)
(dollars in thousands)
The accompanying notes are an integral part of these financial statements.
Pregis Holding II Corporation
Consolidated and Combined Statements of Cash Flows
(dollars in thousands)
The accompanying notes are an integral part of these financial statements.
Pregis Holding II Corporation
Notes to Consolidated and Combined Financial Statements
(Amounts in thousands of U.S. dollars, unless otherwise noted)
1. DESCRIPTION OF THE BUSINESS AND CHANGE IN OWNERSHIP
Description of the Business
Pregis Corporation (“Pregis”) is an international manufacturer, marketer and supplier of protective packaging products and specialty packaging solutions. Pregis operates through four reportable segments: Protective Packaging, Flexible Packaging, Hospital Supplies, and Rigid Packaging.
Change in Ownership
On October 13, 2005, Pregis, pursuant to a Stock Purchase Agreement (as amended, the “Stock Purchase Agreement”) with Pactiv Corporation (“Pactiv”) and certain of its affiliates, acquired the outstanding shares of capital stock of Pactiv’s subsidiaries comprising its global protective packaging and European specialty packaging businesses (the “Acquisition”). Pregis, along with Pregis Holding II Corporation (“Pregis Holding II” or the “Company”) and Pregis Holding I Corporation (“Pregis Holding I”), were formed by AEA Investors LLP and its affiliates (the “Sponsors”) for the purpose of consummating the Acquisition. The adjusted purchase price for the Acquisition was $559.7 million, which included direct costs of the acquisition of $15.7 million, pension plan funding of $20.1 million, and certain post-closing adjustments.
Funding for the Acquisition included equity investments from the Sponsors totaling $149.0 million, along with proceeds from the issuance of senior secured notes and senior subordinated notes in a private offering, and borrowings under new term loan facilities. The equity investments were made to Pregis Holding I, which is the direct parent company of Pregis Holding II, which in turn is the direct parent company of Pregis. Therefore, immediately following the Acquisition, AEA Investors LLP, through its indirect ownership, owned 100% of the outstanding common stock of the Company.
The Stock Purchase Agreement provided for certain adjustments of the purchase price, including adjustments based on the closing working capital and indebtedness and cash levels (as defined in the Stock Purchase Agreement) of the Company at the date of the Acquisition. On February 13, 2006, the Company and Pactiv agreed to a $1.8 million adjustment for excess cash held in the businesses at the closing date, net of a shortfall in capital spending by the businesses in comparison to their annual budgets. Such amount was paid to Pactiv and reflected as an increase to goodwill in the first quarter of 2006. On September 29, 2006, Pactiv paid $1.3 million to Pregis, reflecting an adjustment to the purchase price based on the level of closing working capital. Such amount was recorded as an adjustment to goodwill in the third quarter of 2006.
The Stock Purchase Agreement also indemnified the Company for payment of certain liabilities relating to the pre-acquisition period. Indemnification amounts for recorded liabilities, which primarily relate to pre-acquisition income tax liabilities, are reflected in the balance sheet as amounts due from Pactiv.
2. BASIS OF PRESENTATION
All significant intercompany balances and transactions have been eliminated in the consolidated and combined financial statements.
Predecessor - The accompanying combined financial statements of the Company for the period from January 1, 2005 to October 12, 2005, prior to the Acquisition, are a combination of the financial statements of Pregis Innovative Packaging, Inc. (U.S.), Hexacomb Corporation (U.S.), Pregis Canada Corp. (Canada), Pregis Mexico, S. de R.L. de
C.V. (Mexico), Wellenfoam NV (Belgium), Pregis NV (Belgium), Hexacomb S.A. (Spain), Pregis S.A.S. (France), Pregis BV (Netherlands), Pregis SpA. (Italy), Pregis Kft. (Hungary), Prvni Obalova Spol. S.R.O. (Czech Republic), Pregis GmbH (Germany), Pregis Sp. Z.o.o. (Poland), Jiffy Packaging Company Ltd. (U.K.), Ambassador Packaging Ltd. (U.K.), Pregis Rigid Packaging Ltd. (U.K.), Kobusch Packaging Egypt (Egypt), MSP Schmeisser GmbH (Germany), Sengewald Klinikprodukte GmbH (Germany), and Kobusch-Sengewald GmbH (Germany).
The combined financial statements of the Predecessor included allocations of certain Pactiv corporate expenses, including legal, human resources, payroll, accounting, employee benefits, real estate, insurance, information technology, telecommunications, treasury and other Pactiv corporate and infrastructure costs. The expense and cost allocations were determined on bases that were deemed reasonable by management in order to reflect the utilization of services provided or the benefit received by the Company during the periods presented. The combined financial information included herein does not necessarily reflect the results of operations, financial position, changes in owner’s equity and cash flows of the Company in the future or what would have been reflected had the Company operated as a separate, stand-alone entity during the predecessor period. The income tax provision and related tax payments were prepared as if the Company had operated as a stand-alone taxpayer during the predecessor period.
Successor - The accompanying consolidated financial statements include the accounts of Pregis Holding II and subsidiaries subsequent to the Acquisition. The consolidated financial statements of the Successor as of and for the years ended December 31, 2007 and 2006 and for the period from October 13, 2005 to December 31, 2005 reflect the Acquisition under the purchase method of accounting, in accordance with the Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting Standards (“SFAS”) No. 141, Business Combinations.
The following unaudited pro forma financial data summarizes the Company’s results of operations for the year ended December 31, 2005 as if the Acquisition had occurred as of the beginning of the year:
The pro forma results of operations include the full year effects of purchase accounting adjustments, principally:
(1)
increase in depreciation and amortization of $14.4 million, resulting from the new fair values of property, plant and equipment and identified intangible assets (with finite lives),
(2)
adjustment to cost of goods sold related to the sale of inventory that had been revalued in purchase accounting, resulting in an increased value by approximately $5.0 million. Of this amount, $4.0 million is reflected in the Successor’s results for the period from October 13, 2005 to December 31, 2005. The pro forma adjustment herein reflects the full-year impact of the $5.0 million adjustment, since the inventory to which this revaluation relates will be sold within a six-month time frame, and
(3)
corresponding adjustments to tax expense.
The pro forma results of operations also include adjustments for items directly related to the Acquisition and financing thereof, including:
(1)
elimination of excess pension cost of $1.5 million, since certain under-funded U.K. pensions were fully funded in connection with the Acquisition,
(2)
addition of a management fee of $1.2 million, that will be paid to the Sponsors, pursuant to a management agreement,
(3)
increase in interest expense of $29.8 million, to reflect the Company’s new capital structure, and
(4)
corresponding adjustments to income tax expense.
In connection with obtaining financing for the Acquisition, the Company committed to the use of a bridge loan facility that was not drawn upon. Therefore, the commitment fee of $1.8 million directly related to this facility was expensed in the period from October 13, 2005 to December 31, 2005. Additionally, in advance of the Acquisition, the
Company entered into a foreign-exchange forward contract to fix the dollar-equivalent cost of the euro denominated debt. The contract settled concurrent with the Acquisition, at which time the Company realized a pre-tax gain of $5.4 million. Pro forma adjustments were not made to exclude these nonrecurring items. Furthermore, no pro forma adjustment was made for the goodwill impairment reflected in the Predecessor statements of operations.
The pro forma information is not necessarily indicative of the results that actually would have been attained if the Acquisition had occurred as of the beginning of the period presented or that may be attained in the future.
The Company allocated the purchase price on the basis of the fair values, as finalized in 2006, of the underlying assets acquired and liabilities assumed as of October 13, 2005, as follows (see Note 7):
Cash, accounts receivable, accounts payable, and other current assets and liabilities were stated at historical carrying values, given their short-term nature. Other noncurrent assets and liabilities outstanding as of the effective date of the Acquisition were allocated based on management’s judgments and estimates.
The Company’s projected pension obligations and assets were reflected in the allocation of purchase price at the projected benefit obligation less plan assets at fair market value, based on management’s computations which included valuations performed by actuaries engaged by the Company. The fair value reflected the additional $20.1 million funding made by the Company immediately following close of the Acquisition, in accordance with the terms of the Stock Purchase Agreement.
The Company obtained valuations to support the fair values of property, plant and equipment, inventories, and intangible assets acquired, including tradenames and trademarks, patents and customer relationships.
Trademarks and tradenames were valued using a royalty savings method, whereby the value of the trademark or tradename was estimated based on benefit received by the Company for owning the trademarks or tradenames rather than paying a rent or royalty for their use. Using this approach, trademarks and tradenames were initially valued at $6.2 million with an estimated indefinite life. Patents were valued at $0.5 million using a similar methodology and were assigned a weighted average useful life of 10 years.
Customer relationships were valued in groupings, given the unique attributes of certain customers and customer segments. The value was determined using an income approach, which took into account the expected revenue growth and attrition rates of the customers and the estimated capital charges for the use of other net tangible and identifiable net intangible assets. Using this approach, customer relationships were assigned a value of $39.2 million with an estimated weighted average useful life of 12 years.
Land use rights in Germany held by the Hospital Supplies segment were valued by local appraisers, based on local market rates, resulting in a value of $0.6 million, with an estimated remaining useful life of 32 years.
The value of certain non-compete agreements held prior to the Acquisition was reassessed by management to be $2.4 million, based on the results of third-party appraisals prepared at inception of the agreements. The non-competes had an estimated remaining useful life of 2 years, corresponding to the remaining period of the agreements.
Deferred income tax assets and liabilities as of the acquisition date represent the expected future tax consequences of temporary differences between the fair values of the assets acquired and liabilities assumed and their tax bases. Valuation allowances were established for certain deferred tax assets, including those relating to all acquired net operating loss carryforwards, for which utilization is uncertain.
Based on the final valuations, approximately $58.4 million of the Company’s goodwill was determined to be deductible for income tax purposes. The primary reasons for the Acquisition and the primary factors that contributed to a purchase price that resulted in the recognition of goodwill include:
•
The Company’s position as one of the leading providers of protective packaging products, as well as a leading competitor in the European specialty packaging market, which enables the Company to benefit from its broad product offering, scale, expertise in innovation, long-standing customer relationships and diverse end-markets;
•
The Company’s ability to offer one of the broadest product lines in the packaging industry, including a variety of highly customized and tailored packaging solutions, offered to diversified geographical markets, end-markets and customers;
•
The Company’s advanced, low-cost manufacturing capabilities and expansive manufacturing and distribution network, which offers a competitive advantage that helps drive revenue growth and profitability.
Separate Financial Statements
Separate financial statements of Pregis are not presented since the floating rate senior secured notes due April 2013 and the 12.375% senior subordinated notes due October 2013 issued by Pregis are fully and unconditionally guaranteed on a senior secured and senior subordinated basis, respectively, by Pregis Holding II and all existing domestic subsidiaries of Pregis and since Pregis Holding II has no operations or assets separate from its investment in Pregis (see Note 22).
3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Use of Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates.
Revenue Recognition
The Company’s principal business is the manufacture and supply of protective and specialty packaging products. Pregis recognizes net sales of these products when the risks and rewards of ownership have transferred to the customer, which is generally upon shipment (but in some cases may be upon delivery), based on specific terms of sale. In arriving at net sales, Pregis estimates the amount of deductions from sales that are likely to be earned or taken by customers in conjunction with incentive programs, such as volume rebates and early payment discounts and records such estimates as sales are recorded. The Company bases its deduction estimates on historical experience.
In recent years, the Company began participating in programs in certain of its European protective packaging and flexible packaging businesses whereby the businesses purchase resin quantities in excess of their internal requirements and resell the surplus to other customers at a nominal profit. These “resin resale programs” enable the businesses to benefit from improved quantity discounts and volume rebates, as well as increased flexibility in their resin purchasing. The Company presents this activity on a net basis within net sales, in accordance with EITF No. 99-19, Reporting Revenue Gross as a Principal versus Net as an Agent, on the basis that the third-party resin supplier is responsible for fulfillment of the order to the customer’s specifications, ships the resin directly to the customer, and maintains general inventory risk and risk of physical loss during shipment. The Company recognizes revenue related to resin resale activity upon delivery to the customer. Net resin resale revenue totaled $5,004, $2,673, $191 and $676 for the years ended December 31, 2007 and 2006, the period from October 13, 2005 to December 31, 2005, and the period from January 1, 2005 to October 12, 2005, respectively.
Foreign Currency Translation
Local currencies are the functional currencies for all foreign operations. Financial statements of foreign subsidiaries are translated into U.S. dollars using end-of-period exchange rates for assets and liabilities and the periods’ weighted average exchange rates for revenue and expense components, with any resulting translation adjustments included as a component of stockholder’s equity. Foreign currency transaction gains and losses resulting from transactions executed in different currencies are included in results of operations.
Cash and Cash Equivalents
The Company defines cash and cash equivalents as checking accounts, money-market accounts, certificates of deposit, and U.S. Treasury notes having an original maturity of 90 days or less when purchased.
Accounts Receivable
Trade accounts receivable are classified as current assets and are reported net of allowances for doubtful accounts. Pregis reserves for amounts determined to be uncollectible based on a number of factors, including historical trends and specific customer liquidity. The determination of the amount of the allowance for doubtful accounts is subject to significant levels of judgment and estimation by management. If circumstances change or economic conditions deteriorate or improve, the allowance for doubtful accounts could increase or decrease.
Management believes that the allowances at December 31, 2007 are adequate to cover potential credit risk loss and that the likelihood of incurring a material loss due to concentration of credit risk is remote. Pregis has a large number of customers in diverse industries and geographies, as well as a practice of establishing reasonable credit limits, which limits credit risk.
Inventories
Inventories include costs of material, direct labor and related manufacturing overheads. Inventories are stated at the lower of cost or market. Cost is determined for substantially all inventories using the first-in, first-out (FIFO) or average-cost methods.
Property, Plant, and Equipment
Property, plant and equipment are stated at cost. Maintenance and repairs that do not improve efficiency or extend economic life are expensed as incurred. Depreciation is computed using the straight-line method over the remaining estimated useful lives of assets. Remaining useful lives range from 15 to 40 years for buildings and improvements and from 5 to 20 years for machinery and equipment. Depreciation expense totaled $50,374, $47,977, $9,767 and $23,593 for the years ended December 31, 2007 and 2006, the period from October 13, 2005 to December 31, 2005, and the period from January 1, 2005 to October 12, 2005, respectively.
Goodwill and Other Intangible Assets
In accordance with SFAS No. 142, Goodwill and Other Intangible Assets, goodwill and intangible assets with indefinite-lives, consisting of trademarks and tradenames, are not amortized but are instead reviewed for impairment on a reporting unit basis, at least annually, or more frequently if indicators arise. The Company defines its reporting units on an operating segment basis and conducts its annual review for impairment as of October 1 of each year. The Company’s annual review in 2007 and 2006 indicated no impairment of goodwill. However, in 2007, the Company did determine that a trade name intangible asset associated with its protective packaging business was impaired, due to near-term reduced sales levels. Using a discounted cash flow methodology, the Company calculated impairment of $403, which is reflected in other operating expense within the Company’s statement of operations for the year ended December 31, 2007.
The Company also has other intangible assets, consisting primarily of customer relationships, patents, licenses, and non-compete agreements, which are being amortized over their respective estimated useful lives.
Impairment of Other Long-Lived Assets
The Company periodically re-evaluates carrying values and estimated useful lives of other long-lived assets whenever events or changes in circumstances indicate that the carrying amount of the related asset may not be recoverable. Pregis uses estimates of undiscounted cash flows from long-lived assets to determine whether the book value of such assets is recoverable over the assets’ remaining useful lives. If the asset is determined to be impaired, the impairment is measured by the amount by which the carrying value of the asset exceeds its fair value.
Deferred Financing Costs
The Company incurred financing costs to put in place the long-term debt used to finance the Acquisition and to subsequently amend portions of such debt agreements. These costs have been deferred and are being amortized over the terms of the related debt. The amortization of deferred financing costs is classified as interest expense in the statement of operations and totaled $2,194 and $2,144 for the years ended December 31, 2007 and 2006. For the period from October 13, 2005 to December 31, 2005, amortization totaled $2,241, which included the immediate write-off of $1,800 for bridge financing commitment fees incurred in connection with the Acquisition.
Income Taxes
For the Predecessor period, the Company’s business income or loss was included in Pactiv’s consolidated federal income tax return for U.S. income tax purposes. The provision for income taxes in the Predecessor period combined financial statements reflects income taxes as if the entities that comprised Pregis were stand-alone entities and filed separate income tax returns.
In accordance with the provisions of SFAS No. 109, Accounting for Income Taxes, the Company utilizes the asset and liability method of accounting for income taxes, which requires that deferred tax assets and liabilities be recorded to reflect the future tax consequences of temporary differences between the book and tax basis of various assets and liabilities. A valuation allowance is established to offset any deferred tax assets if, based upon the available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized.
Effective January 1, 2007, the Company adopted the provisions of FIN 48, Accounting for Uncertainty in Income Taxes (FIN 48). FIN 48 provides guidance on de-recognition, classification, interest and penalties, and accounting in interim periods and requires expanded disclosure with respect to uncertainty in income taxes. The Company’s adoption of FIN 48 resulted in reclassification of certain tax liabilities from current to non-current and no impact to retained earnings. The Company also reclassified certain tax liability amounts in the December 31, 2006 balance sheet from current to non-current to be consistent with the 2007 presentation.
The Company does not provide for U.S. federal income taxes on unremitted earnings of foreign subsidiaries since it is management’s present intention to reinvest those earnings in foreign operations. Positive unremitted earnings of foreign subsidiaries totaled $32,057 at December 31, 2007. If such amounts were repatriated, determination of the amount of U.S. income taxes that would be incurred is not practicable due to the complexities associated with this calculation.
Financial Instruments
The Company may use derivative financial instruments primarily for purposes of hedging exposures to fluctuations in interest rates and foreign currency exchange rates. The Company does not use derivative instruments for trading or speculative purposes. The Company recognizes derivative instruments as either assets or liabilities in the balance sheet, at fair value. Changes in the fair value of derivatives are recorded in earnings or other comprehensive income, based on whether the instrument is designated as part of a hedge transaction, and, if so, the type of hedge transaction. Gains or losses on derivative instruments reported in other comprehensive income are reclassified to earnings in the period in which earnings are affected by the underlying hedged item. The ineffective portion of all hedges is recognized in earnings in the current period. See Note 10 for additional information.
Freight
Pregis records amounts billed to customers for shipping and handling as sales, and records shipping and handling expense as cost of sales.
Research and Development
Research and development costs, which are expensed as incurred, were $5,869, $6,976, $1,302 and $4,806 for the years ended December 31, 2007 and 2006, the period from October 13, 2005 to December 31, 2005, and the period from January 1, 2005 to October 12, 2005, respectively.
Stock-Based Compensation
Effective January 1, 2006, the Company adopted SFAS No. 123R, Share-Based Payment, which was issued in December 2004 and amended SFAS No. 123, Accounting for Stock Based Compensation. The Company used the prospective transition method upon adoption, which requires that nonpublic companies that had previously measured compensation cost under SFAS No. 123 using the minimum value method continue to account for non-vested equity awards outstanding at the date of adoption in the same manner as they had been accounted for prior to adoption. For all awards granted, modified or settled after the date of adoption, the Company recognizes compensation cost based on the grant-date fair value estimated in accordance with the provisions of SFAS No. 123R.
Prior to January 1, 2006, the Company followed the provisions of SFAS No. 123, which allowed entities to continue to apply the provisions of Accounting Principles Board (APB) No. 25, Accounting for Stock Issued to Employees, and related interpretations, and provide pro forma net income disclosures for employee stock-based compensation arrangements as if the minimum value method defined in SFAS No. 123 had been applied.
Recent Accounting Pronouncements
In December 2007, the FASB issued SFAS No. 141(R), Business Combinations, which revised SFAS No. 141, Business Combinations. SFAS No. 141(R) requires an acquiror to measure the identifiable assets acquired, liabilities
assumed and any noncontrolling interest in the acquiree at their fair values on the acquisition date, with goodwill being the excess value over the net identifiable assets acquired. SFAS No. 141(R) will also impact the accounting for transaction costs, restructuring costs as well as the initial recognition on contingent assets and liabilities assumed during a business combination. In addition, under SFAS No. 141(R), adjustments to the acquired entity’s deferred tax assets and uncertain tax position balances occurring outside the measurement period are recorded as a component of the income tax expense, rather than goodwill. SFAS No. 141(R) is effective for financial statements issued for fiscal years beginning after December 15, 2008. The provisions of SFAS No. 141(R) are applied prospectively, so the Company has not yet determined the effect on its financial statements, if any, upon adoption of SFAS No. 141(R).
In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities-including an amendment to FASB Statement No. 115, which permits entities to choose to measure many financial instruments and certain other items at fair value that are not currently required to be measured at fair value. SFAS No. 159 is effective as of January 1, 2008. The adoption of SFAS No. 159 is not expected to have a material effect on the Company’s consolidated financial statements.
In September 2006, the FASB issued SFAS No. 158, Employer’s Accounting for Defined Benefit Pension and Other Postretirement Plans (an amendment of FASB Statements No. 87, 88, 106, and 132R) (SFAS 158). SFAS No. 158 requires an employer to recognize a plan’s funded status in its balance sheet, measure a plan’s assets and obligations as of the end of the employer’s fiscal year (with limited exceptions), and recognize the changes in a defined benefit postretirement plan’s funded status in comprehensive income in the year in which the changes occur. The Company adopted SFAS No. 158 on December 31, 2007 on a prospective basis, in accordance with the statement’s transition rules. The adoption of SFAS No. 158 resulted in an adjustment to the Company’s balance sheet, but had no impact on net earnings or cash flow. See Note 16 for additional information regarding the Company’s pension plans.
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurement. SFAS No. 157 defines fair value, establishes a framework for measuring fair value, and expands disclosure about fair value measurements. The statement is effective for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The adoption of SFAS No. 157 is not expected to have a material effect on the Company’s consolidated financial statements.
In June 2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes (FIN 48). FIN 48 prescribes a more likely than not threshold for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This Interpretation also provides guidance on derecognition of income tax assets and liabilities, classification of current and deferred income tax assets and liabilities, accounting for interest and penalties associated with tax positions, accounting for income taxes in interim periods, and income tax disclosures. The Company adopted the provisions of FIN 48 effective January 1, 2007, and the impact of adoption was not material. See Note 14 for additional information.
4. ACQUISITIONS
Each of the transactions discussed below was accounted for using the purchase method of accounting, in accordance with SFAS No. 141, Business Combinations. Accordingly, in each instance, the purchase price was allocated to the assets acquired, liabilities assumed, and identifiable intangible assets as applicable based on their fair market values at the date of acquisition. Any excess of purchase price over the fair value of net assets acquired was recorded as goodwill. The results of operations of each business combination is included in the Company’s consolidated financial statements since the date of acquisition None of the goodwill related to these acquisitions is tax-deductible.
On July 4, 2007, the Company acquired all of the outstanding share capital of Petroflax S.A., a leading producer and distributor of foam-based products, located in Romania. The purchase price totaled $11,976, including direct costs of the acquisition, and was financed with cash-on-hand. The purchase price was allocated as follows: $4,195 million to net tangible assets, $4,434 to customer relationship-related intangibles, and $3,347 to goodwill.
On December 3, 2007, the Company acquired all of the outstanding share capital of Besin International B.V., a European honeycomb manufacturer. The purchase price, which remains subject to certain post-closing adjustments, totaled $17,356, including direct costs of the acquisition. The purchase price was also financed with cash-on-hand, and has been allocated on a preliminary basis as follows: $7,128 to net tangible assets and $10,228 to goodwill. The Company is in the process of finalizing its valuation analyses, which may result in subsequent revisions to the allocation.
The following unaudited pro forma data summarizes the results of operations for the years ended December 31, 2007 and 2006 as if the aforementioned acquisitions had taken place at the beginning of the periods presented. Pro forma adjustments to the historical results of Petroflax and Besin are not material. The pro forma information is not necessarily indicative of the results that actually would have been attained if the acquisitions had occurred as of the beginning of the period presented or that may be attained in the future.
In May 2006, the Company acquired a business in Bulgaria for $4.9 million to complement its hospital supplies business. The purchase price was allocated based on estimated fair values at the date of acquisition. The impact of the acquisition was not significant to the Company’s operations or financial position.
5. INVENTORIES
The major components of net inventories are as follows:
6. PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment consists of the following:
7. GOODWILL
Changes in the Predecessor’s carrying value of goodwill from January 1, 2005 to October 12, 2005 are summarized below:
In the second quarter of 2005, Pactiv initiated the sale of the Predecessor. The initial price agreed for the sale was less than book value, which triggered the Predecessor to test its recorded goodwill for impairment, according to the provisions of SFAS No. 142. Goodwill was subsequently determined to be impaired in the Protective Packaging and Rigid Packaging segments. Consequently, the Predecessor recognized a pretax impairment charge of $35,654 in the second quarter of 2005.
The Company initially recorded goodwill of $141,379 as a result of the Acquisition. Changes in the Company’s carrying value of goodwill from October 13, 2005 to December 31, 2007 are summarized below:
At December 31, 2005, the Company based the fair value of its property, plant and equipment and acquired intangible assets on preliminary valuation results. These valuations were finalized in 2006, resulting in net increases to the fair value of these assets totaling $6,363, which resulted in a corresponding reduction to goodwill. Final adjustments to the estimated fair values of other assets and liabilities reduced goodwill by $2,877.
The Stock Purchase Agreement also provided for certain adjustments of the purchase price, including adjustments based on the closing working capital and indebtedness and cash levels (as defined in the Stock Purchase Agreement) of the Company at the date of the Acquisition. In 2006, the Company paid to Pactiv $1.8 million for excess cash held in the businesses at the closing date, net of a shortfall in capital spending by the businesses in comparison to their annual budgets, and Pactiv paid $1.3 million to the Company, reflecting an adjustment to the
purchase price based on the level of closing working capital. The net amount of $451 has been reflected as an adjustment to goodwill in 2006.
In 2007, the Protective Packaging segment acquired two businesses, resulting in purchased goodwill totaling $13,575. See further discussion in Note 4. Other adjustments relate primarily to the reversal of valuation allowances established against deferred tax assets in purchase accounting, based on the current expected utilization of such deferred tax assets.
8. OTHER INTANGIBLE ASSETS
The Company’s other intangible assets are summarized as follows:
Amortization expense related to intangible assets totaled $5,425, $5,202, $1,180 and $1,602 for the years ended December 31, 2007 and 2006, the period from October 13, 2005 to December 31, 2005, and the period from January 1, 2005 to October 12, 2005, respectively. Amortization expense for each of the five years ending December 31, 2008 through December 31, 2012 is estimated to be $4,968, $4,274, $4,024, $4,024, and $4,024, respectively.
9. DEBT
The Company’s long-term debt consists of the following:
In connection with the Acquisition, on October 13, 2005, Pregis issued senior secured notes and senior subordinated notes in a private offering and entered into new senior secured credit facilities.
The senior secured notes were issued in the principal amount of 100.0 million and bear interest at a floating rate equal to EURIBOR (as defined) plus 5.00% per year (for a total rate of 9.72% as of December 31, 2007). Interest resets quarterly and is payable quarterly on January 15, April 15, July 15 and October 15. The senior subordinated notes were issued in the principal amount of $150.0 million and bear interest at the rate of 12.375% annually. Interest on the senior subordinated notes is payable semi-annually on April 15 and October 15. The senior subordinated notes were issued at 98.149%, resulting in an initial discount of $2.8 million, which is being amortized using the effective interest method over the term of the notes. The senior secured notes and senior subordinated notes do not have required principal payments prior to maturity.
Pregis Holding II and Pregis’s domestic subsidiaries have guaranteed the obligations under the senior secured notes and the senior subordinated notes on a senior secured basis and senior subordinated basis, respectively. Additionally, the senior secured notes are secured on a second priority basis by liens on all of the collateral (subject to certain exceptions) securing Pregis’s senior secured credit facilities. In the event that secured creditors exercise remedies with respect to Pregis and its guarantors’ pledged assets, the proceeds of the liquidation of those assets will first be applied to repay obligations secured by the first priority liens under the new senior secured credit facilities and any other first priority obligations.
At its option, the Company may redeem some or all of the senior secured notes on or after October 15, 2006 and some or all of the senior subordinated notes on or after October 15, 2009, in each case, at the redemption prices set forth below (expressed as percentages of principal amount), plus accrued interest, if any, if redeemed during the twelve-month period beginning on October 15 of the years indicated below:
The Company may redeem some or all of the senior secured notes at any time prior to October 15, 2006 and some or all of the senior subordinated notes at any time prior to October 15, 2009, in each case, at the principal amount of the notes, plus a specified “make-whole” premium. In addition, at any time prior to October 15, 2008, the Company may redeem up to 35% of the aggregate principal amount of the senior subordinated notes with the net proceeds of certain equity offerings.
On October 13, 2005, Pregis entered into senior secured credit facilities which provided for a revolving credit facility and two term loans: an $88.0 million term B-1 facility and a 68.0 million term loan B-2 facility. The revolving credit facility provides for borrowings of up to $50.0 million, a portion of which may be made available to the Company’s non-U.S. subsidiary borrowers in euros and/or pounds sterling. The revolving credit facility also includes a swing-line loan sub-facility and a letter of credit sub-facility. The revolving credit facility bears interest at a rate equal to, at the Company’s option (1) an alternate base rate or (2) LIBOR or EURIBOR, plus an applicable margin of 0.375% to 1.00% for base rate advances and 1.375% to 2.00% for LIBOR or EURIBOR advances, depending on the leverage ratio of the Company, as defined in the credit agreement. In addition, the Company is required to pay an annual commitment fee of 0.375% to 0.50% on the revolving credit facility depending on the leverage ratio of the Company, as well as customary letter of credit fees. As of December 31, 2007, the Company had $6.1 million in letters of credit outstanding and had $43.9 million of availability under the revolving credit facility.
The term B-1 loan interest is equal to, at the Company’s option (1) an alternate base rate plus 1.25% per annum, or (2) LIBOR plus 2.25% per annum, and the term B-2 loan interest rate is EURIBOR plus 2.50% per annum. The
annual interest rates on the Company’s term B-1 facility and term B-2 facility were 7.08% and 7.27%, respectively, as of December 31, 2007, and 7.61% and 6.22%, respectively, as of December 31, 2006.
Pregis’s senior secured credit facilities are guaranteed by Pregis Holding II Corporation and all of Pregis’s current and future domestic subsidiaries (collectively, the “Guarantors”). The repayment of these facilities is secured by a first priority security interest in substantially all of the assets of the Guarantors, and a first priority pledge of their capital stock and 66% of the capital stock of the Pregis’s first tier foreign subsidiary.
Subject to certain exceptions, the senior secured credit facilities require mandatory prepayments of the loans from excess cash flows, asset sales and dispositions and issuances of debt and equity. Additionally, the loans may be prepaid at the election of the Company.
From time to time, certain of the foreign businesses utilize various lines of credit in their operations. These lines of credit are generally used as overdraft facilities or for issuance of trade letters of credit and are in effect until cancelled by one or both parties. Amounts available under these lines of credit were $12,762 and $11,973 at December 31, 2007 and 2006, respectively. At December 31, 2007, no borrowings were drawn under these lines, but trade letters of credit totaling $3,627 were issued and outstanding.
The senior secured credit facilities, senior secured notes and subordinated notes contain a number of covenants that, among other things, restrict or limit, subject to certain exceptions, Pregis’s ability and the ability of its subsidiaries, to incur, assume or permit to exist additional indebtedness, guaranty obligations or hedging arrangements; incur liens or agree to negative pledges in other agreements; engage in sale and leaseback transactions; make capital expenditures; make loans and investments; declare dividends, make payments or redeem or repurchase capital stock; in the case of subsidiaries, enter into agreements restricting dividends and distributions; engage in mergers, acquisitions and other business combinations; prepay, redeem or purchase certain indebtedness including the notes; amend or otherwise alter the terms of its organizational documents, or its indebtedness including the notes and other material agreements; sell assets or engage in receivables securitization; transact with affiliates; and alter the business that it conducts. In addition, the senior secured credit facilities require that Pregis complies on a quarterly basis with certain financial covenants, including a maximum leverage ratio test and minimum cash interest coverage ratio test. As of December 31, 2007, Pregis was in compliance with all of these covenants.
Furthermore, the senior secured notes and subordinated notes limit Pregis’s ability to incur additional indebtedness beyond that allowed within certain defined debt baskets and our ability to declare certain dividends or repurchase equity securities, unless we meet a minimum fixed charge coverage ratio and a maximum senior secured indebtedness leverage ratio, both determined on a pro forma basis. Therefore, Pregis’s ability to maintain these ratios, as well as those included within its senior secured credit facility, ensures that it is able to maintain sufficient liquidity.
The following table presents the scheduled annual maturities of the Company’s long-term debt, for years after 2007:
At December 31, 2007 and 2006, the revaluation of the Company’s euro-denominated debt resulted in an unrealized foreign exchange loss of $23,306 and $22,656, respectively. This unrealized loss has been offset by unrealized gains of $(28,860) and $(27,799) relating to revaluation of the Company’s euro-denominated intercompany notes receivable at December 31, 2007 and 2006, respectively. These amounts are reported within the net foreign exchange gains in the Company’s statement of operations.
10. DERIVATIVE INSTRUMENTS
In order to manage its interest rate risk and to achieve a targeted ratio of variable-rate versus fixed-rate debt, the Company entered into an interest rate swap arrangement to swap a notional amount of 65.0 million euros from EURIBOR-based floating rates to fixed rates over the period of January 2006 to January 2010. The swap arrangement was designated as a cash flow hedge, resulting in a gain of $240 and $1,257 and a loss of $336, each net of tax, being recorded in other comprehensive income (loss) for the years ended December 31, 2007 and 2006 and the period from October 13, 2005 to December 31, 2005, respectively. There was no ineffective portion of the hedge recognized in earnings during these periods. At December 31, 2007 and 2006, the Company had no other derivative instruments outstanding.
In advance of the October 2005 Acquisition, Pregis entered into a foreign-exchange forward contract to fix the dollar-equivalent cost of the euro denominated debt. This contract was contingent on the Acquisition taking place prior to a defined date, at which time it would otherwise expire. This contract did not qualify for hedge accounting treatment under SFAS No. 133. The contract settled concurrent with the Acquisition, at which time the Company realized a pre-tax gain of $5,441 due to favorable impact of the dollar to the euro at the time the Acquisition closed, relative to the rate inherent in the contract.
The Company is exposed to credit risk in the event of nonperformance by the counterparty on its interest rate swap contract. However, the Company minimizes its credit risk by dealing only with leading, credit-worthy financial institutions and, therefore, does not anticipate nonperformance.
11. FAIR VALUE OF FINANCIAL INSTRUMENTS
The carrying values of current assets and liabilities approximate fair value due to their short-term maturities.
The carrying value of amounts outstanding under the Company’s senior secured credit facilities is considered to approximate fair value as interest rates vary, based on prevailing market rates. The fair value of the Company’s senior secured notes and senior subordinated notes are based on quoted market prices.
The fair value of the Company’s interest rate swap was estimated based on quoted market prices, representing the amount that would be received or paid to terminate the agreement as of year-end.
The carrying values and estimated fair values of the Company’s financial instruments at December 31, 2007 and 2006 are as follows:
The carrying value of the Company’s senior secured floating-rate notes as well as the Term B-2 portion of the Company’s senior secured credit facilities, both of which are euro-denominated, increased $13,970 and $9,336, respectively, during 2007 due to the strengthening of the euro to the U.S. dollar.
The Company is contingently liable under letters of credit (see Note 9). It is not practicable to estimate the fair value of these financial instruments; however, the Company does not expect any material losses to result from these financial instruments since performance is not likely to be required.
12. LEASES
The Company leases certain facilities, equipment, and other assets under non-cancelable long-term operating leases. Rent expense totaled $19,073, $17,505, $3,632 and $13,480 for the years ended December 31, 2007 and 2006, the period from October 13, 2005 to December 31, 2005, and the period from January 1, 2005 to October 12, 2005, respectively, including short-term rentals.
Future minimum rental payments for operating leases with remaining terms in excess of one year, are as follows:
13. RELATED PARTY TRANSACTIONS
The Predecessor utilized various wholly-owned affiliates of Pactiv to provide administrative services and to finance operations. Transactions with such affiliates enabled the Predecessor to manufacture and sell products, earn revenue, maintain adequate operating working capital, and fund obligations that arose in the normal course of business. The monthly fees charged to the Predecessor for the administrative services were allocated to the businesses using several methods. Costs that were directly identified as having been incurred for these businesses were charged 100% to the Predecessor. Certain shared or common expenses, including information technology, procurement, and health and safety were allocated based on management’s estimate of the level of effort spent by those functions supporting the Predecessor’s businesses. Shared human resource and facility costs were allocated based on the headcount of the Predecessor’s businesses. Shared expenses of corporate functions and overhead, legal, finance, and accounting were allocated to the Predecessor’s businesses on a percentage of sales basis. Management believes these allocation methods were reasonable.
For the period from January 1, 2005 to October 12, 2005, aggregate administrative fees charged to the Company were $16,564. Of this amount, $4,813 was charged to the Predecessor in the period and was paid as part of its operations. The remaining portion of this corporate allocation, or $11,751, was allocated to the Predecessor for purposes of the combined financial statements. For purposes of preparing the financial statements of the Predecessor on a stand-alone basis, tax provisions were also allocated to these businesses along with balances of liabilities or assets directly related to these businesses that had been previously maintained at a corporate level. Additionally, on a periodic basis, Pactiv offset intercompany balances between its North American-based businesses of the Predecessor and other Pactiv subsidiaries that would not be otherwise settled in cash. In such cases, these intercompany balances were transferred directly to equity to reflect their settlement.
Settlement of the allocation of these expenses and balances to the Predecessor are reflected within capital contributions (distributions), net in the combined statement of owner’s equity and comprehensive income, to reflect that they were settled by Pactiv on behalf of the Predecessor. The cash contributions, net relate primarily to payments made by Pactiv to certain of the Predecessor’s foreign businesses to enable them to pay intercompany loans, net of excess cash distributions paid by certain subsidiaries to Pactiv, in advance of the Transaction.
A summary of the cash and non-cash capital contributions, net, included the Predecessor financial statements for the period from January 1, 2005 to October 12, 2005 is as follows:
Related-party transactions between affiliated companies of the Predecessor were eliminated from the combined predecessor statements, while related-party transactions with affiliated companies outside of the Predecessor businesses were not eliminated from the Predecessor financial statements.
The Predecessor recognized sales to affiliates of Pactiv of $604, and purchases of goods from Pactiv of $7,406 for the period from January 1, 2005 to October 12, 2005, respectively. The Predecessor incurred $2,186 of interest expense for financing provided to it by Pactiv for the period from January 1, 2005 to October 12, 2005.
Affiliated long-term debt consisted of borrowings by the Predecessor’s individual operating companies from Pactiv and its 100% owned affiliates, principally Pactiv’s European treasury operation, PIFCO (Pactiv Irish Finance, Ltd. or “PIFCO”). The debt was incurred by the Predecessor principally to fund investments in plant and equipment and to make acquisitions. Typically, working capital needs were funded by short-term debt, some of which was also financed by PIFCO. Interest rates on both long and short-term debt for European operating companies were the Interbank Offer Rate in the country in which the unit operated, plus 1.25%. If there was no local interbank offer rate then the Euro Interbank Offer rate (EURIBOR) plus 1.25% was used. For business units in North America, the interest rate on long and short-term debt was set by the monthly “Applicable Federal Rate” published by the U.S. Internal Revenue Service. The Predecessor’s weighted average interest rate on affiliate debt was approximately 4.90% for the period from January 1, 2005 to October 12, 2005. All outstanding loans with PIFCO were settled prior to the Acquisition.
In connection with the Acquisition, the Company entered into a management agreement with its Sponsors, for the provision of various advisory and consulting services. The Company incurred fees, and related expenses, totaling $1,894, $1,777 and $329, for services provided under this agreement for the years ended December 31, 2007 and 2006, and the period from October 13, 2005 to December 31, 2005, respectively. Such amounts are included within selling, general and administrative expenses.
The Company had sales to affiliates of AEA Investors LLP totaling $3,531 and $2,164 for the years ended December 31, 2007 and 2006, respectively. For the same periods, the Company made purchases from affiliates of AEA Investors LLP totaling $8,022 and $4,500, respectively.
In 2007 and 2006, certain members of the Company’s management purchased shares in Pregis Holding I through the Pregis Holding I Corporation Employee Stock Purchase Plan. Shares were purchased at estimated fair value at the date of purchase. As of December 31, 2007, management held 324.2 shares in Pregis Holding I, representing 2.1% of Pregis Holding I’s issued and outstanding equity.
14. INCOME TAXES
For U.S. income tax purposes, the Predecessor’s income or loss was included in Pactiv’s consolidated federal income tax return. For periods subsequent to the Acquisition, the Company files a consolidated federal income tax return with Pregis Holding I Corporation, its ultimate parent. The provision for income taxes in the Successor consolidated financial statements and the Predecessor combined financial statements reflects income taxes as if the businesses were stand-alone entities and filed separate income tax returns.
The domestic and foreign components of income (loss) before income taxes were as follows:
The components of the Company’s income tax expense (benefit) are as follows:
Reconciliation of the difference between the effective rate of the expense (benefit) and the U.S. federal statutory rate is shown in the following table:
Deferred tax assets and liabilities are recognized for the expected future tax consequences of temporary differences between the financial statement basis and the tax basis of assets and liabilities using enacted statutory tax rates applicable to future years. The Company’s net deferred income tax assets (liabilities) are as follows:
These deferred tax assets and liabilities are classified in the balance sheets based on the balance sheet classification of the related assets and liabilities. Pursuant to the Stock Purchase Agreement, Pactiv has provided an indemnity for certain tax liabilities that relate to periods prior to October 13, 2005.
Management believes it is more likely than not that current and long-term deferred tax assets, with the exception of certain foreign tax-loss carryforwards and pension assets, will be realized through the reduction of future taxable income. Although realization is not assured, management has concluded that other deferred tax assets, for which a valuation allowance was determined to be unnecessary, will be realized in the ordinary course of operations based on scheduling of deferred tax liabilities. As of December 31, 2007, valuation allowances totaling $8,253 will result in a reduction to goodwill to the extent such allowances are reduced in 2008 (see Note 3 regarding SFAS No. 141(R), Business Combinations).
U.S. federal net operating loss carryforwards at December 31, 2007 and 2006 were $16,404 and $12,794, respectively. State tax-loss carryforwards, net of federal benefit, at December 31, 2007 and 2006, were $630 and $526, respectively, and will expire at various dates from 2008 to 2024. Foreign tax-loss carryforwards at December 31, 2007 and 2006 were $55,131 and $55,442, respectively, of which $27,045 will expire at various dates from 2008 to 2022, with the remainder having unlimited lives. The valuation allowance above includes unrecognized tax benefits related to both state and foreign tax-loss carryforwards.
Tax Contingencies
Effective January 1, 2007, the Company adopted FIN 48, Accounting for Uncertainty in Income Taxes. The Company is subject to income taxes in the U.S. and numerous foreign jurisdictions. Significant judgment is required in evaluating our tax positions and determining our provision for income taxes. During the ordinary course of business, there are many transactions and calculations for which the ultimate tax determination is uncertain. The Company established reserves for tax-related uncertainties based on estimates of whether, and the extent to which, additional taxes will be due. These reserves are established when the Company believes that certain positions might be challenged despite our belief that our tax return positions are fully supportable. The reserves are adjusted in light of changing facts and circumstances, such as the outcome of tax audit. The provision for income taxes includes the impact of reserve provisions and changes to reserves that are considered appropriate. Accruals for tax contingencies are provided in accordance with the requirements of FIN 48.
As of December 31, 2007, the Company had non-current liabilities totaling $9,585 for unrecognized tax benefits including interest and net of indirect benefits, of which $2,483 would affect the effective tax rate, if recognized. Included within the Company’s liabilities for unrecognized tax benefits at December 31, 2007 is $7,102 subject to indemnification under the Stock Purchase Agreement with Pactiv. The indemnified amounts are included within the amounts due from Pactiv. The reconciliation of the beginning and ending amount of gross unrecognized tax benefits as of December 31, 2007 is as follows:
The Company is subject to U.S. federal income tax as well as income tax in multiple state and non-U.S. jurisdictions. The U.S. federal income tax returns for the years 2004 through 2007 are subject to potential examination by the Internal Revenue Service. The Company is currently subject to examination in Germany for the years 2001 to 2005, Belgium for the year 2005, and Egypt for the years 2003 to 2005. The Company remains subject to potential
examination in Germany for the years 2002 to 2007, Belgium for the years 2006 and 2007, the United Kingdom for the years 2006 and 2007, and Italy for the years 2003 to 2007. The Company paid settlements to the German government during 2007 for tax audits relating to tax years 1999 to 2001 and certain issues remain outstanding. The Company is fully indemnified by Pactiv on these liabilities and received reimbursement for the full amount paid.
The Company accounts for interest and penalties related to income tax matters in income tax expense. For the years ended December 31, 2007 and 2006, the amount of interest and penalties recorded in income tax expense was insignificant. As of December 31, 2007, the total amount of accrued interest and penalties recorded in the Company’s balance sheet was $2,289, of which $2,275 is subject to indemnification under the Stock Purchase Agreement.
It is reasonably possible that the total amounts of unrecognized tax benefits will increase or decrease within the next twelve months; however, the Company does not expect such increases or decreases to be significant.
15. OTHER OPERATING EXPENSE (INCOME)
A summary of the items comprising other operating expense (income) is as follows:
In connection with the Company’s ongoing efforts to optimize its business and work processes, in the fourth quarter of 2007 the Company incurred costs of $2,926, representing mostly employee severance and related costs, pursuant to a plan to restructure the workforce within its flexible packaging operations. These amounts are expected to be substantially paid out in 2008.
During the first quarter of 2007, a printing machine utilized by the Company’s flexible packaging business in Egypt was destroyed by a fire. The net book value of the equipment was negligible. The Company has purchased a replacement printer, which is expected to be commissioned by mid-2008. During 2007, the Company recorded a gain of $2,873 on the insurance settlement. As of December 31, 2007, the Company had collected insurance proceeds of $884, representing reimbursement of its initial payments towards the replacement cost of the new machine. The remaining insurance receivable totaling $1,989 is recorded in Other Receivables.
16. RETIREMENT BENEFITS
Defined Contribution Plans
The Company sponsors three 401(k) defined contribution plans, one each for salaried employees, hourly union employees and hourly nonunion employees, in which its U.S. employees are eligible to participate. Under these plans, employees may contribute a percentage of compensation and the Company will match a portion of the employees’ contributions. Additionally, the salaried and hourly nonunion plans include a non-elective component, permitting the Company to make discretionary employer contributions to all eligible employees of the plans. The Company’s contributions to these plans during the years ended December 31, 2007 and 2006 and the period from October 13, 2005 to December 31, 2005 totaled $2,431, $1,290 and $178, respectively.
The Company also sponsors several small, defined contribution plans at certain of its operating units. The Company contribution is a defined percentage of eligible salary and in certain of the plans the employees also make contributions. The total expense for these plans was $358, $298, $60, and $307 for the years ended December 31, 2007 and 2006, the period from October 13, 2005 to December 31, 2005, and the period from January 1, 2005 to October 12, 2005, respectively.
Pension Benefits
The Company has three defined benefit pension plans covering the majority of its employees located in the United Kingdom and the Netherlands. Plan benefits are generally based upon age at retirement, years of service and the level of compensation. In most cases, the employees also make contributions based on a percentage of eligible salary. The trustees of these plans, in consultation with their respective actuaries, recommend annual funding to be made to the plans at a level they believe to be appropriate for the plans to meet their long-term obligations. The Company also has three small, unfunded defined benefit pension plans covering certain current or former employees of its German businesses. The Company funds the obligations for these plans with insurance contracts.
In connection with the Acquisition, the Company used an October 12, 2005 measurement date to determine the appropriate expense to be attributed to the Predecessor. The Company also applied purchase accounting in accordance with SFAS No. 141; therefore, its successor-basis pension liabilities were recorded at fair value. Subsequent to the Acquisition, the Company adopted a December 31 measurement date, which has been used to determine its 2007 and 2006 year-end obligations.
In connection with the Acquisition, it was agreed that Pactiv would contribute an additional $14.2 million to two under-funded defined benefit pension plans sponsored by Pregis’ U.K. businesses. The Sponsors also agreed to contribute $20.1 million to the plans. Pactiv’s contribution was made prior to October 13, 2005 and the Predecessor’s plan assets at October 13, 2005 reflect this funding. The Sponsors’ contribution was a component of the purchase consideration and is reflected in the fair value of the Company’s plan assets acquired.
The following tables detail the changes in the funded status of the defined benefit pension plans and set forth amounts recognized in the balance sheets:
Presented below are the components of net periodic benefit costs:
In the period January 1, 2005 to October 12, 2005, the Predecessor recognized a reduction of $480 in its projected benefit obligation resulting from a curtailment in accordance with SFAS No. 88. This occurred for the Netherlands pension plan as a result of a reduction in its workforce from restructuring activities. This curtailment did not have a material impact on net periodic benefit expense in 2005.
As permitted under paragraph 26 of SFAS No. 87, the amortization of any prior service cost is determined using a straight-line amortization of the cost over the average remaining service period of employees expected to receive benefits under the plans.
Adoption of SFAS No. 158
Effective December 31, 2007, the Company adopted SFAS No. 158, which requires that the consolidated balance sheets reflect the funded status of the pension plans. The funded status of the plans is measured as the difference between the plan assets at fair value and the projected benefit obligation.
At December 31, 2007, previously unrecognized differences between actual amounts and estimates based on actuarial assumptions are included in accumulated other comprehensive income in the Company’s consolidated balance sheets as required by SFAS No. 158. In future reporting periods, the difference between actual amounts and estimates based on actuarial assumptions will be recognized in other comprehensive income or loss in the period in which they occur.
The following table shows the incremental effect of the adoption of SFAS No. 158 on the Company’s consolidated balance sheet at December 31, 2007:
No amounts are estimated to be amortized from accumulated other comprehensive income into net periodic benefit cost in 2008.
The accumulated benefit obligation for all defined benefit pension plans was $91,706 and $100,902 at December 31, 2007 and 2006, respectively. Plans with projected benefit obligations and accumulated benefit obligations in excess of the fair value of plan assets at year-end are as follows:
Plan Assumptions
The weighted average rates used to determine the Company’s defined benefit obligations as of the end of the last two years were as follows:
The weighted average assumptions used to determine net periodic benefit costs were as follows:
In developing assumptions regarding the rate of return on pension plan assets, the Company receives independent input in each of the relevant countries in which the trust assets are invested on asset-allocation strategies and projections of long-term rates of return on various asset classes, risk-free rates of return and long-term inflation projections. The discount rate assumption for each country is based on an index of high-quality corporate bonds with maturities in excess of ten years. The Company uses a market-related method for calculating the value of its pension assets. This method recognizes the difference between actual and expected returns on plan assets over five years. The resulting unrecognized gains or losses, along with other actuarial gains and losses, are amortized using the “corridor approach” outlined in SFAS No. 87.
The weighted average asset allocations by asset category for the Company’s pension plan assets were as follows as of the end of the last two years:
The Company employs a total return investment approach whereby a mixture of equity and fixed-income investments are used to maximize the long-term return on plan assets for a prudent level of risk. Risk tolerance is established through careful consideration of plan liabilities, plan funded status, and business financial condition. The investment portfolio contains a diversified blend of equity and fixed-income investments. Upon receiving the additional funding provided in connection with the Acquisition, the trustees of the U.K. pension plans elected to reallocate a significant portion of their respective plans’ assets to fixed-income securities.
The Company expects to contribute $3,167 to its pension plans in 2008.
Following are the estimated future benefit payments to be made in the years indicated:
Pension and related liabilities, as reflected in the balance sheets, also include the obligations for termination liabilities established at certain of the Company’s foreign subsidiaries. These amounts are payable to the employees when they separate from the companies. The liabilities are calculated in accordance with civil and labor laws based on each employee’s length of service, employment category and remuneration, and are calculated at the amount that the employee would be entitled to, if the employee terminated immediately. The liabilities related to these arrangements totaled $2,821 and $2,435 at December 31, 2007 and 2006, respectively.
Predecessor
Prior to the Acquisition, the Company’s U.S. employees participated in Pactiv-sponsored U.S. pension plans. All of these plans’ assets and liabilities are accounted for in Pactiv’s financial statements. The Predecessor’s combined financial statements for the period from January 1, 2005 to October 12, 2005 include pension expense of $1,881 allocated to it by Pactiv for the Predecessor’s participating employees. The expense allocated by Pactiv includes the service cost for the Predecessor’s active employees and a pro-rata portion of the interest expense, expected return on assets and amortization of gains and losses. The proration was based on the projected benefit obligation of the Predecessors’ employees to the total projected benefit obligation of the plans. Upon consummation of the Acquisition, the Company’s U.S. employees ceased to participate in Pactiv’s plans. These employees are still entitled to the benefits that had vested under Pactiv’s plans; however, any subsequent cost or liability of these plans will be borne by Pactiv. The Predecessor’s U.S. employees also participated in Pactiv-sponsored U.S. defined contribution plans. The total expense for the Company’s contribution to these plans was $1,370 for the period from January 1, 2005 to October 12, 2005.
Certain salaried U.S. employees of the Company may also be eligible for postretirement health care and life insurance benefits under plans sponsored by Pactiv, if they retire in accordance with the various provisions of such plans. These postretirement plans are not funded and the liabilities are accounted for in Pactiv’s consolidated financial statements. The Predecessor’s combined financial statements for the period from January 1, 2005 to October 12, 2005 include postretirement-benefit expenses of $189 allocated to it by Pactiv for eligible employees. The Company does not offer any postretirement health care benefits.
17. STOCK-BASED COMPENSATION
In October 2005, Pregis Holding I Corporation, the Company’s ultimate parent company, established the Pregis Holding I Corporation 2005 Stock Option Plan (the “Pregis Plan”) to provide for the grant of nonqualified and incentive stock options to key employees, consultants and directors of the Company. At December 31, 2007, the number of shares available for award under the Pregis Plan was 1,841.62, including 884.96 options that were initially granted to certain key employees and directors in December 2005 prior to adoption of SFAS No. 123R, at which time the Company applied the fair value disclosure provisions of SFAS No. 123 applicable to nonpublic companies (including public debt issuers).
The majority of the options issued pursuant to the Pregis Plan are subject to a five year vesting schedule; however, certain options issued in 2007 vest over three years, conditioned upon achievement of specific performance objectives as defined in the agreements. Vesting may be accelerated at any time as determined by the committee
administering the Pregis Plan. The options expire if not exercised within ten years of the date of grant. Additionally, vested options will generally terminate 45 days after termination of employment.
The fair value of each option award granted after adoption of SFAS No. 123R has been estimated on the date of grant using the Black-Scholes option-valuation model, using the following assumptions:
The expected terms of the option grants were estimated, based on the vesting periods for the grants. Since the Company has minimal historical experience with respect to exercise behavior for its options, this was considered to be a reasonable estimate in relation to exercise behavior experienced by similar private-equity owned entities. The risk-free interest rate assumption is based on U.S. Treasury security yields for issues with a remaining term equal to the option’s expected life at the time of grant. The Company does not have publicly traded equity, so it does not have historical data regarding the volatility of its common stock. Therefore, the expected volatility used for 2007 and 2006 was based on volatility of similar entities, referred to as “guideline” companies. In determining similarity, the Company considered industry, stage of life cycle, size and financial leverage. The dividend yield on the Company’s stock is assumed to be zero since the Company has not paid dividends and has no current plans to do so in the future. Based on our minimal historical experience of pre-vesting cancellations, the Company has assumed an annual forfeiture rate of 5% for most of its options. These assumptions are evaluated, and revised as necessary, based on changes in market conditions and historical experience.
The Company’s stock option activity for the years ended December 31, 2007 and 2006 under the Pregis Plan is as follows:
A summary of the Company’s non-vested options issued subsequent to adoption of SFAS No. 123R is as follows for the years ended December 31, 2007 and 2006:
As of December 31, 2007, there was $4,573 of unrecognized compensation cost related to non-vested options granted in 2006 and 2007 under the plans. This cost is expected to be amortized over a weighted-average service period of approximately 3.9 years. For the years ended December 31, 2007 and 2006, the Company recognized share-based compensation expense of $558 ($381, net of tax) and $97 ($65, net of tax), respectively.
In December 2005, Pregis Holding I Corporation also adopted the Pregis Holding I Corporation Employee Stock Purchase Plan (the “Stock Purchase Plan”) to provide key employees of the Company the opportunity to purchase shares at an initial price of $10,000 per share, equal to the per share price paid by the Sponsors in the Acquisition. New executives joining the Company have also been given the opportunity to purchase shares at the then-current fair market value. The Company has recognized no compensation expense related to shares sold under this plan, since the price paid by management approximates fair value.
At the time of the Acquisition, certain of Pregis’ employees also held options to purchase shares of Pactiv common stock granted under the Pactiv Stock Option Plan. In connection with the Acquisition, any unvested options held by Pregis employees participating in the Pactiv Stock Option Plan became fully vested, and the Pregis employees were given one year from the date of the Acquisition in which to exercise the options. All outstanding options held by Pregis employees under this plan fully vested and became exercisable at the time of the Acquisition, and relevant expenses were allocated to Pregis in the Predecessor periods. Therefore, there is no subsequent expense to be borne by Pregis related to this plan. Any options that were exercised by Pregis employees related to this plan were funded by Pactiv. If the Company had applied the fair value recognition provisions of SFAS 123 to stock-based employee compensation under this plan in the Predecessor periods, its net loss for the period from January 1, 2005 to October 12, 2005 would have been increased by $2,917.
18. SEGMENT AND GEOGRAPHIC INFORMATION
The Company’s operations are currently classified into four principal reportable segments, which are determined on the basis of the types of products produced by each segment. Separate management of each segment is required because each business unit is subject to different pricing, production, and marketing strategies. The Company’s segments are as follows:
Protective Packaging - This segment manufactures, markets, sells and distributes protective packaging products in North America and Europe. Its protective mailers, air-encapsulated bubble products, sheet foam, engineered foam, inflatable airbag systems, honeycomb products and other protective packaging products are manufactured and sold for use in cushioning, void-fill, surface-protection, containment and blocking & bracing applications.
Flexible Packaging - This segment produces customized barrier films and converted products for niche segments of the food, medical, and non-food markets in Europe and Egypt.
Hospital Supplies - This segment manufactures and supplies customizable operating drape products, procedure packs, protection products, and sterilization packaging for the healthcare industry in Europe.
Rigid Packaging - This segment provides customized packaging products and solutions to the food and foodservice sectors in Europe.
The Company’s North American protective packaging business, European protective packaging business, and Hexacomb product line each have its own management and sales staff. However, all of these businesses have product offerings that serve similar functions, undergo similar production processes, are marketed and distributed to like end users, and have comparable economic characteristics. Therefore, on the basis of these similarities, the Company has aggregated the North American and European protective packaging businesses and the Hexacomb product line to present one Protective Packaging reportable segment.
The Company evaluates performance and allocates resources to its segments based on segment EBITDA, which is calcluated internally as gross margin (defined as net sales, less cost of sales excluding amortization and depreciation), less selling, general and administrative expenses. Management believes that segment EBITDA provides useful information for analyzing and evaluating the underlying operating results of each segment. However, segment EBITDA should not be considered in isolation or as a substitute for net income or other measures of financial performance prepared in accordance with generally accepted accounting principles in the United States. Additionally, the Company’s computation of segment EBITDA may not be comparable to other similarly titled measures computed by other companies. Prior to 2007, the Company had presented operating income as its segment measure of performance. The prior year presentation has been restated to conform to the 2007 presentation.
Information regarding the Company’s reportable segments is as follows:
(1)
Corporate expenses include the costs of corporate support functions, such as information technology, finance, human resources, legal and executive management which have not been allocated to the segments. Additionally, corporate expenses may include other non-recurring or non-operational activity that the chief operating decision maker excludes in assessing business unit performance. These expenses, along with depreciation and amortization and other non-operating activity such as interest expense/income and foreign exchange gains/losses are not considered in the measure of the segments’ operating performance, but are shown herein as reconciling items to the Company’s consolidated income (loss) before income taxes.
(2)
Corporate assets include goodwill, deferred financing costs, and other assets attributed to the corporate support functions.
The Company manufactures and distributes its products in numerous countries. The following table provides certain geographic-area information, as determined based on the country from which the sales originate and in which the assets are based:
(a)
Includes Belgium and the Netherlands.
(b)
Includes Spain, Italy, and France.
(c)
Includes Poland, Hungary, the Czech Republic, Bulgaria, and Romania.
(d)
Includes Canada, Mexico, and Egypt.
(e)
Total long-lived assets are total assets, excluding intercompany notes and investments, less current assets.
19. OTHER COMPREHENSIVE INCOME
The Company reports comprehensive income in its consolidated statement of equity and comprehensive income (loss). Total comprehensive income consists of net income and other non-owner changes in stockholder’s equity. It includes the Company’s currency translation gains and losses, unrealized gains and losses from its derivative instrument designated as a cash flow hedge, and in 2007, its pension adjustment resulting from the adoption of SFAS No. 158.
The components of accumulated other comprehensive income, net of taxes, are as follows:
20. COMMITMENTS AND CONTINGENCIES
Capital commitments
At December 31, 2007, the Company had outstanding commitments totaling approximately $6.5 million for the purchase of equipment and machinery. Delivery and installation of such equipment should be substantially complete in 2008.
Legal matters
The Company is party to legal proceedings arising from its operations. Related reserves are recorded when it is probable that liabilities exist and where reasonable estimates of such liabilities can be made. While it is not possible to predict the outcome of any of these proceedings, the Company’s management, based on its assessment of the facts and circumstances now known, does not believe that any of these proceedings, individually or in the aggregate, will have a material adverse effect on the Company’s financial position. However, actual outcomes may be different than expected and could have a material effect on the company’s results of operations or cash flows in a particular period.
Environmental matters
The Company is subject to a variety of environmental and pollution-control laws and regulations in all jurisdictions in which it operates. Where it is probable that related liabilities exist and where reasonable estimates of such liabilities can be made, associated reserves are established. Estimated liabilities are subject to change as additional information becomes available regarding the magnitude of possible clean-up costs, the expense and effectiveness of alternative clean-up methods, and other possible liabilities associated with such situations. However, management believes that any additional costs that may be incurred as more information becomes available will not have a material adverse effect on the Company’s financial position, although such costs could have a material effect on the Company’s results of operations or cash flows in a particular period.
On July 13, 2007, July 24, 2007 and August 28, 2007, the Kentucky Department for Environmental Protection (DEP) issued notices of violation against our Wurtland, Kentucky manufacturing facility. The DEP alleged that we discharged excessive levels of chemical emissions into public waters without valid permits. The Company filed timely responses to the notifications substantially denying the allegations. Following an administrative hearing with the DEP in December 2007, the Company settled the matter by agreeing to pay a civil penalty of $125 and to undertake certain remedial measures to prevent any improper releases into the environment.
21. QUARTERLY RESULTS OF OPERATIONS (UNAUDITED)
22. SUPPLEMENTAL GUARANTOR CONDENSED FINANCIAL INFORMATION
In connection with the Acquisition, Pregis Holding II (presented as Parent in the following tables of the Successor), through its 100%-owned subsidiary, Pregis Corporation (presented as Issuer in the following Successor tables), issued senior secured notes and senior subordinated notes. The senior notes are fully, unconditionally and jointly and severally guaranteed on a senior secured basis and the senior subordinated notes are fully, unconditionally and jointly and severally guaranteed on an unsecured senior subordinated basis, in each case, by Pregis Holding II and substantially all existing and future 100%-owned domestic restricted subsidiaries of Pregis Corporation (collectively, the “Guarantors”). All other subsidiaries of Pregis Corporation, whether direct or indirect, do not guarantee the senior secured notes and senior subordinated notes (the “Non-Guarantors”). The Guarantors also unconditionally guarantee the Company’s borrowings under its senior secured credit facilities on a senior secured basis.
Additionally, the senior secured notes are secured on a second priority basis by liens on all of the collateral (subject to certain exceptions) securing Pregis Corporation’s new senior secured credit facilities. In the event that secured creditors exercise remedies with respect to Pregis and its guarantors’ pledged assets, the proceeds of the liquidation of those assets will first be applied to repay obligations secured by the first priority liens under the new senior secured credit facilities and any other first priority obligations.
The following Successor period condensed consolidating financial statements present the results of operations, financial position and cash flows of (1) the Parent, (2) the Issuer, (3) the Guarantors, (4) the Non-Guarantors, and (5) eliminations to arrive at the information for Pregis Holding II on a consolidated and combined basis. Separate financial statements and other disclosures concerning the Guarantors are not presented because management does not believe such information is material to investors. Therefore, each of the Guarantors is combined in the presentation below. The information that follows for the Predecessor periods presents the combining information of the businesses comprising the Guarantors and Non-Guarantors.
Pregis Holding II Corporation
Condensed Consolidating Balance Sheet
December 31, 2007
Pregis Holding II Corporation
Condensed Consolidating Balance Sheet
December 31, 2006
Pregis Holding II Corporation
Condensed Consolidating Statement of Operations
For the Year Ended December 31, 2007
(Successor)
Pregis Holding II Corporation
Condensed Consolidating Statement of Operations
For the Year Ended December 31, 2006
(Successor)
Pregis Holding II Corporation
Condensed Consolidating Statement of Operations
For the Period October 13, 2005 to December 31, 2005
(Successor)
Pregis Holding II Corporation
Condensed Combining Statement of Operations
For the Period January 1, 2005 to October 12, 2005
(Predecessor)
Pregis Holding II Corporation
Condensed Consolidating Statement of Cash Flows
For the Year Ended December 31, 2007
(Successor)
Pregis Holding II Corporation
Condensed Consolidating Statement of Cash Flows
For the Year Ended December 31, 2006
(Successor)
Pregis Holding II Corporation
Condensed Consolidating Statement of Cash Flows
For the Period October 13, 2005 to December 31, 2005
(Successor)
Pregis Holding II Corporation
Condensed Combining Statement of Cash Flows
For the Period January 1, 2005 to October 12, 2005
(Predecessor)
Schedule II - Valuation and Qualifying Accounts
(dollars in thousands)
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
The Company maintains disclosure controls and procedures, as defined in Rule 13a-15 under the Securities Exchange Act of 1934, as amended, that are designed to ensure that information required to be disclosed in the Company’s reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms and that the Company’s employees accumulate this information and communicate it to the Company’s management, including its Chief Executive Officer (its principal executive officer) and its Chief Financial Officer (its principal financial officer), as appropriate, to allow timely decisions regarding the required disclosure. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily must apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.
As required by paragraph (b) of Rule 13a-15 under the Exchange Act, our management, under the supervision and with the participation of our Chief Executive Officer and our Chief Financial Officer, have evaluated the effectiveness of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of December 31, 2007. Based upon that evaluation, our management, including our Chief Executive Officer and our Chief Financial Officer, concluded that as of December 31, 2007 the Company’s disclosure controls and procedures were effective.
In addition, during the fourth quarter of fiscal year 2007, there have been no changes in our internal controls over financial reporting that have materially affected or are reasonably likely to materially affect our internal control over financial reporting.
The Company’s Registration Statement on Form S-4 was declared effective by the SEC on May 11, 2007. Therefore, this is the Company’s first Annual Report on Form 10-K that is required to be filed with the SEC. This Annual Report does not include a report of management’s assessment regarding internal control over financial reporting or an attestation report of the Company’s registered public accounting firm due to a transition period established by rules of the SEC for newly public companies.
ITEM 9B.
ITEM 9B. OTHER INFORMATION
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
The following table provides information about the directors of Pregis Holding II and the executive officers of Pregis Holding II and Pregis Corporation.
Michael T. McDonnell became our President and Chief Executive Officer and a director of our company and our parent companies on October 6, 2006. Prior to that, Mr. McDonnell served as Group Vice President of the Environment Technologies Group of Engelhard Corporation, a surface and materials science company that was acquired by BASF Aktiengesellschaft in June 2006. Mr. McDonnell joined Engelhard in 2002 as Vice President, Enterprise Technologies. Previously, from 1998 to 2002, Mr. McDonnell was with Cytec Industries, a specialty chemicals and materials company, as Vice President, Coating and Performance Chemicals and Vice President, Specialty Resins.
D. Keith LaVanway became our Vice President and Chief Financial Officer on September 19, 2007. Prior to joining Pregis, Mr. LaVanway held the position of Chief Financial Officer at Associated Materials Incorporated (“AMI”), an Ohio-based building materials company, since 2001. Prior to AMI, Mr. LaVanway served as Vice President, Finance at various operating divisions of Nortek, Inc. and also held financial management roles at Abbott Laboratories and Ernst & Young.
Kevin J. Baudhuin became Pregis’s President, Protective Packaging North America, effective December 10, 2007. Prior to joining Pregis, Mr. Baudhuin worked with The BOC Group plc for over 20 years, most recently serving as President, Industrial & Special Projects, North America and previous to that as Global Market Director, Special Products and in other positions of general management, sales and marketing.
Fernando De Miguel became Pregis’s President, Protective Packaging Europe, effective June 1, 2007. Mr. De Miguel joined Pregis from Alstom , where he served as Senior Vice President, North Europe since April 2006. Prior to Alstom, Mr. De Miguel worked with Johnson Controls Automotive Systems Group for over 11 years in numerous senior management positions, most recently serving as Group Vice President Electronics, Europe and International.
C. William McBee became Pregis’s President, Hexacomb in October 2005 upon consummation of the Acquisition. Mr. McBee served as General Manager of the Hexacomb business upon joining Pactiv in 2003 until October 2005. Prior to joining Pactiv, Mr. McBee was President and Chief Operating Officer of Liqui-Box Corporation from 1997 to 2001. During that time he also served as Director and Corporate Secretary. From 1994 to 1997, he was Vice President of Manufacturing and Administration. From 1988 to 1994, Mr. McBee was a General
Manager at Smurfit-Stone Corporation. He also held various management positions at Boise Cascade Corporation from 1986 to 1988 and at Smurfit-Stone Corporation from 1972 to 1986.
Hartmut Scherf became Pregis’s President, Flexible Packaging in October 2005 upon consummation of the Acquisition. Mr. Scherf served as Managing Director of Flexible Packaging at Pactiv from 2004 until October 2005. Before joining Pactiv, Mr. Scherf spent 27 years with the flexible packaging firm, Bischof & Klein, where Mr. Scherf held a variety of senior positions, eventually being appointed to the position of Managing Director.
Dieter Eberle became Pregis’s President, Hospital Supplies in October 2005 upon consummation of the Acquisition. Mr. Eberle joined KNPBT / Sengewald Klinikprodukte in 1994 as Technical Director and served as Managing Director from 1995 until October 2005. Before joining KNPBT, Mr. Eberle held several senior positions such as Plant Manager, Production Manager and Technical Director in German and Swiss engineering companies from 1971 to 1993.
Gary Rehwinkel became Pregis’s President, Rigid Packaging UK & Europe, on January 1, 2008. Prior to joining Pregis in mid-2007, Mr. Rehwinkel worked in the plastic packaging industry for over 15 years, most recently serving as Director of Operations for Pactiv. Before joining Pactiv, Mr. Rehwinkel held a variety of management positions with Mobil Corporation.
John L. Garcia became the Chairman of the board of directors of Pregis Holding II on May 18, 2005. Mr. Garcia has been President of AEA Investors LLC and its predecessor since 2002 and was a Managing Director of AEA Investors Inc. from 1999 through 2002. From 1994 to 1999, Mr. Garcia was a Managing Director with Credit Suisse First Boston LLC, formerly known as Credit Suisse First Boston Corporation, where he served as Global Head of the Chemicals Investment Banking Group and Head of the European Acquisition and Leveraged Finance and Financial Sponsor Groups. Before joining Credit Suisse First Boston, Mr. Garcia worked at Wertheim Schroder in New York as an investment banker and at ARCO Chemicals in research, strategic planning and commercial development. Mr. Garcia is currently a director of AEA Investors LLC and Convenience Food Systems B.V. and is on the supervisory board of Symrise GmbH.
Glenn Fischer became a director of Pregis Holding II in October 2005 upon consummation of the Acquisition and served as our Interim Chief Executive Officer from January 1, 2006 to February 5, 2006. Mr. Fischer is an operating partner with AEA Investors LLC, which he joined in 2005. From 2000 to 2005 he was President and Chief Operating Officer of Airgas, Inc., the largest U.S. distributor of industrial, medical and specialty gases, welding, safety and related products. Mr. Fischer joined Airgas after spending 19 years with The BOC Group in a wide range of positions leading to his appointment in 1997 as President of BOC Gases, North America. In addition to his responsibility for all North American operations, Mr. Fischer served on The BOC Group Executive Management Board. Prior to joining BOC in 1981, Mr. Fischer served at W.R. Grace in a variety of finance, planning and management roles. He is currently a director of Henry Corporation.
Brian R. Hoesterey became a director of Pregis Holding II on May 18, 2005. Mr. Hoesterey is a partner with AEA Investors LLC, which he joined in 1999. Prior to joining AEA Investors, he was with BT Capital Partners, the private equity investment vehicle of Bankers Trust. Mr. Hoesterey has also previously worked for McKinsey & Co. and the investment banking division of Morgan Stanley. He is currently a director of Henry Corporation, CPG International Inc., Unifrax Corporation, and Houghton International.
James W. Leng became a director of Pregis Holding II in October 2005 upon consummation of the Acquisition. Mr. Leng currently serves as Deputy Chairman of Tata Steel Limited of India and Chairman of Corus Group plc, an international steel company which provides products and services to customers worldwide. He has been a non-executive director of Corus since 2001. Mr. Leng also serves as Chairman of Docasters plc and is a non-executive director of Alstom B.V., where he chairs the Nominations and Remuneration Committee, and Convenience Food Systems B.V. He is also a Governor of the National Institute of Economic and Social Research. From 1998 to 2006, Mr. Leng was a non-executive director of Pilkington plc and Chairman of their Remuneration Committee, and from 2004 to 2007, he was a non-executive director of Hanson plc, where he was the Senior Independent Director. Mr. Leng served as Chief Executive of Laporte plc, the international specialty chemicals company, from 1995 until June 2001 when the acquisition of the company by Degussa AG was completed. Prior to
joining Laporte, Mr. Leng was Chief Executive of Low & Bonar plc, the international packaging and specialist materials group. He joined Low & Bonar in 1984 as Managing Director of one of its principal UK subsidiaries, was appointed to the main Board in 1989 and served as Low & Bonar’s Chief Executive from 1992 to 1995.
James D. Morris became a director of Pregis Holding II in October 2005 upon consummation of the Acquisition and served as our Chief Executive Officer from October 12, 2005 to December 31, 2005. Mr. Morris served as Senior Vice President and General Manager, Protective and Flexible Packaging for Pactiv from January 2000 until becoming our Chief Executive Officer. Prior to 2000, and since he joined Pactiv in 1995, Mr. Morris was Vice President, Manufacturing and Engineering of Pactiv’s Consumer and North American Foodservice divisions. In 1993, he became Vice President of Operations for Plastics Packaging at Mobil Corporation and served in that role until that business was acquired by Tenneco in 1995. He began his career as an engineer at Mobil Corporation in 1975.
John P. O’Leary, Jr. became a director of Pregis Holding II in October 2005 upon consummation of the Acquisition. Mr. O’Leary served as Senior Vice President, SCA North America, a packaging supplier, from 2002 through 2004. From 2001 through 2004, he was President and Chief Executive Officer of Tuscarora Incorporated, a wholly-owned subsidiary of SCA Packaging International B.V. and a division of SCA North America. Tuscarora is a producer and manufacturer of custom design protective packaging. Prior to SCA’s acquisition of Tuscarora, Mr. O’Leary was Tuscarora’s CEO, President, from 1989 to 2001, and its Chairman of the Board from 1992 through 2001. Mr. O’Leary currently serves on the Board of Directors of Matthews International Corp.
Thomas J. Pryma became a director of Pregis Holding II on May 18, 2005. Mr. Pryma is a partner with AEA Investors LLC, which he joined in 1999. Prior to joining AEA, Mr. Pryma worked in the Financial Sponsors and Corporate Banking Groups in the investment banking division of Merrill Lynch. He is currently a director of Unifrax Corporation and Houghton International.
James E. Rogers became a director of Pregis Holding II in October 2005 upon consummation of the Acquisition. Since 1993, Mr. Rogers has served as president of SCI Investors Inc., a private equity investment firm. From 1993 to 1996, Mr. Rogers served as Chairman of Custom Papers Group, Inc., a paper manufacturing company. From 1991 to 1993, he was President and Chief Executive Officer of Specialty Coatings International, Inc., a manufacturer of specialty paper and film products. Prior to 1991, Mr. Rogers was Senior Vice President, Group Executive of James River Corporation, a paper and packaging manufacturer. Mr. Rogers also serves as a director of Wellman, Inc., Caraustar Industries, Inc., Owens & Minor, Inc., and New Market Corporation.
On August 27, 2007, we announced that D. Keith LaVanway was appointed as our new Vice President and Chief Financial Officer, effective September 19, 2007. Mr. LaVanway replaced Timothy J. Cunningham, who served as our Chief Financial Officer from May 1, 2006 to September 18, 2007.
On March 15, 2007, we announced that Fernando De Miguel was appointed as our new President, Protective Packaging Europe, effective June 1, 2007. On March 8, 2007, we announced that Peter Lewis, our former President, Protective Packaging Europe and Rigid Packaging, would be leaving the Company as of April 30, 2007. Mr. Lewis provided certain consulting services on a limited basis through December 31, 2007.
On December 12, 2007, we announced that Kevin J. Baudhuin was appointed as our new President, Protective Packaging North America, effective December 11, 2007. Mr. Baudhuin replaced Andy Brewer, who left Pregis effective November 19, 2007.
Audit Committee
The board of directors of Pregis Holding II has formed an audit committee. The members of the audit committee are Thomas J. Pryma, Brian R. Hoesterey, and Glenn Fischer. The board of directors has determined that Messrs. Pryma and Hoesterey are audit committee financial experts, based on their education and professional
experience. Neither Mr. Pryma nor Mr. Hoesterey is an independent director as such term is defined by the rules of the New York Stock Exchange and The Nasdaq Stock Market.
Code of Ethics
Pregis Corporation has adopted a code of ethics that applies to its principal executive officer, principal financial officer, principal accounting officer or controller and persons performing similar functions. A copy of the code of ethics has been posted on our website at www.pregis.com. In the event that we amend or waive provisions of this code of ethics with respect to such officers, we intend to also disclose the same on our website.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
Executive Compensation
Compensation Discussion and Analysis
General Philosophy. Our primary objectives with respect to executive compensation are to attract and retain the best possible executive talent, to tie annual and long-term cash compensation and stock option awards to achievement of measurable corporate, business unit and individual performance objectives, and to align executives’ incentives with shareholder value creation. To achieve these objectives, we expect to implement and maintain compensation plans that tie a substantial portion of executives’ overall compensation to our financial performance and the value of our common stock. Overall, the total compensation opportunity is intended to create an executive compensation program that is set at competitive levels to comparable employers. Hiring and compensation decisions for our executives were approved by the compensation committee of Pregis Holding II. The compensation committee also considered compensation programs at AEA’s other portfolio companies.
Our senior management compensation programs consist of three primary components:
1. Annual cash compensation. The annual cash compensation component is comprised of base salary and cash bonuses and is intended to motivate annual performance.
Base salary. Base salaries for our executives are established based on the scope of their responsibilities, taking into account competitive market compensation paid by other companies for similar positions. Base salaries are reviewed annually, and may be adjusted from time to time to realign salaries with market levels after taking into account inflation and individual responsibilities, performance and experience.
In 2007 our senior executives were awarded performance-based stock options in lieu of salary increases for the years 2007 through 2009. By transitioning from fixed salary increases to variable rewards, our executives are incentivized to continue to drive company performance, with upside earnings potential if their performance targets are achieved.
As we developed compensation programs for new executives hired in 2007, we gave consideration to the competitive marketplace and the compensation for these executives relative to that of their individual compensation histories and other members of our senior management.
Annual cash bonus. Depending on our performance, a significant portion of cash compensation can be in the form of an annual cash incentive bonus based on the achievement of objective performance metrics established soon after the beginning of the year. For 2007, the performance goals for all of our senior executives, including the chief executive officer and chief financial officer, were achievement of target levels of EBITDA and of working capital as a percentage of sales. EBITDA under the annual cash incentive bonus plan is calculated as gross margin (defined as net sales, less cost of sales, excluding depreciation and amortization) less selling, general and administrative expenses. Extraordinary and non-recurring items may be added back or deducted at the discretion of the compensation committee. Working capital as used in the target performance metric is defined as trade receivables, plus inventories, less trade payables. The working capital metric uses a thirteen-month average working capital, divided by net sales for the respective fiscal year.
Under the annual cash incentive bonus plan, the compensation committee approves a target award level and performance objectives for each executive officer. The target award level for each executive officer is generally stated as a percentage of base annual salary. The following table outlines the 2007 target bonus opportunity for our named executive officers, other than Mr. Lewis who separated from the company on April 30, 2007 and was not provided an annual incentive bonus:
Each annual performance goal is assigned a percentage of the target award, so that attainment of the target amount of all performance objectives would entitle the executive to receive an award equal to his target level. For the chief executive officer and chief financial officer, these performance objectives were weighted 80% on the EBITDA performance of our company as a whole, and 20% based on the company’s working capital as a percentage of consolidated net sales. For our senior divisional managers, these targets were weighted 60% based on the EBITDA performance of their division, 15% based on their division’s working capital as a percentage of net sales, 20% based on the EBITDA performance of the company as a whole, and 5% based on the company’s working capital as a percentage of consolidated net sales.
Our executives’ target cash incentive bonus awards for 2007 were based on achievement of the following 2007 financial targets:
The target levels of performance are intended to be achievable. Our executives and divisional managers work closely with the compensation committee and board of directors to determine performance targets. In order to enhance our annual performance, the annual bonus opportunity increases as the performance targets are exceeded. For example, if actual performance is less than 85% of budget, no bonus is payable. If actual performance equals budget, 100% of the target bonus is payable, and if actual performance exceeds budget, the bonus is increased by two percent for every one percent increase in performance over budget. Within each target threshold, the bonus amount is interpolated based on the actual target level achieved. For the year ended December 31, 2007, each of the executives was very close to achieving his target bonus award; however, only Messrs. Scherf and Brewer exceeded their target bonus awards, due to the strong financial performance of their respective divisions.
2. Pregis stock option plan. Participation in our 2005 Stock Option Plan has been offered to executives to align their interests with the long-term growth objectives of our shareholders. Under the standard option agreement, participants vest in their option awards equally over a five-year period, so the maximum value from the options cannot be achieved until five years of service has been provided, other than in the event of a change in control of our company as described below. The exercise price of options has typically been set at or above the fair market value of the underlying shares as of the date of grant. Accordingly, management is rewarded only after appreciation in the value of our common stock.
As mentioned previously, in 2007 our senior executives were awarded performance-based options in lieu of salary increases. Per the terms of the performance-based option agreements, the executives will vest in the option grants in three equal installments at the beginning of 2008, 2009 and 2010, if defined performance objectives are met for each or any of the years 2007, 2008, and 2009, respectively. The performance objective set forth in the performance-based option grant awards corresponds to the respective year’s EBITDA target as established for each executive’s annual cash incentive bonus. For the chief executive officer and chief financial officer, the performance objective is the EBITDA performance target established for the company as a whole. For divisional managers, the performance objective is the EBITDA performance target established for their respective divisions. For the year ended December 31, 2007, only Mr. Scherf met his 2007 EBITDA performance objective.
3. Pregis share purchase plan. Similar to the Stock Option Plan, the Employee Stock Purchase Plan is intended to serve as a long-term incentive to drive growth. Shares of our common stock were offered for purchase for a limited period of time subsequent to the Acquisition to a broad group of our employees in an effort to encourage employee performance, and therefore our performance, through share ownership. The shares were offered for purchase at $10,000 per share, the fair market value per share paid at the time of the Acquisition, so that employee participants would be given the opportunity to participate on equal terms with non-employee shareholders in the growth of our company. We continue to offer new executives joining the company the opportunity to purchase shares at the then-current fair market value. See “Benefit Plans-Employee Stock Purchase Plan” for the terms of this plan.
Our senior executives are parties to employment agreements. These agreements were individually negotiated and will continue in their current forms until such time as the compensation committee determines in its discretion that revisions are advisable. In addition, consistent with our pay-for-performance compensation philosophy, we intend to continue to maintain modest executive benefits and perquisites for officers; however, the compensation committee in its discretion may revise, amend or add to an officer’s executive benefits and perquisites if it deems it advisable. We believe these benefits and perquisites are currently competitive with levels established by comparable companies. We have no current plans to make changes to either the employment agreements or levels of benefits and perquisites provided. See “Employment Agreements” for terms of the employment agreements.
We provide standard employee health and reimbursement benefits to our senior management which we believe is industry competitive and necessary to attract and retain key individuals. Our domestic executive officers participate in a company-sponsored 401(k) plan. Effective January 1, 2007, the company-sponsored 401(k) plan matches 100% of employee contributions up to the first 1% of eligible compensation and 50% of employee contributions up to the next 5% of eligible compensation. Additionally, the company may make a discretionary profit sharing contribution of up to 4% of the executive officer’s eligible compensation, depending on our performance. Our foreign division executives participate in private pension plans to which our company makes an annual contribution, as was individually negotiated with the respective executives.
SUMMARY COMPENSATION TABLE
The table below summarizes compensation information for all individuals who served as our chief executive officer or our chief financial officer during 2007, our next three most highly compensated executive officers serving as of December 31, 2007, and any executive officer that would have been included as one of the three most highly compensated except for the fact that he was not serving as an executive officer as of December 31, 2007.
The following table provides information about plan-based awards made to the named executive officers during fiscal 2007.
GRANTS OF PLAN-BASED AWARDS IN FISCAL YEAR 2007
(1)
These are the grant dates for the equity based awards. Annual bonus awards were made throughout 2007.
(2)
Represents amount of payout if threshold is attained with respect to both EBITDA and ratio of working capital to sales.
(3)
If actual performance is less than 85% of budget, no bonus is payable. If actual performance equals budget, 100% of target bonus is payable and if actual performance exceeds budget, the bonus is increased by two percent for every one percent increase in performance over budget. The amounts set forth in this column are the amounts payable upon achievement of 125% of budget.
(4)
These options were granted pursuant to the Pregis Holding I Corporation 2005 Stock Option Plan, with performance-based vesting requirements. See “Benefit Plans - 2005 Stock Option Plan.” One-third of these option grants will vest in each of 2007, 2008 and 2009 if performance criteria are met for the applicable year. If performance criteria are not met for one year, the options for that year will be cancelled, but the options for the subsequent years may still vest, if performance criteria are met for either or both of those years. If performance criteria are not met for any year, no options will vest. The threshold includes the amount of options to vest if performance objectives are achieved for the 2007 year. Target and maximum amounts are based on performance being met for each of the three respective years. Options eligible to vest based on 2007 performance did not vest and were subsequently forfeited for all of the executives except Mr. Scherf. The exercise price per share of these options was greater than or equal to the per share fair market value of the common stock of Pregis Holding I on the date of the initial grant in 2007.
(5)
Since Mr. Cunningham separated at the end of 2007, only one-third of his performance-based grant was eligible to vest, if his performance objectives for 2007 were achieved. Therefore, the number of options and related fair value relates to only one-third of the grant.
(6)
Mr. Brewer separated from the Company during 2007. Pursuant to the terms of his separation agreement, all of his outstanding option grants were cancelled.
(7)
These options were granted pursuant to the Pregis Holding I Corporation 2005 Stock Option Plan, with time vesting requirements. See “Benefit Plans - 2005 Stock Option Plan.” The exercise price per share of these options was greater than or equal to the per share fair market value of the common stock of Pregis Holding I on the date of grant.
(8)
These amounts represent the grant date fair value, computed in accordance with SFAS No. 123R, of options granted to the named executive officers in 2007. The grant date fair value was determined using a Black-
The following table sets forth information concerning outstanding awards of options to purchase shares of common stock of Pregis Holding I which have been granted to the named executive officers as of December 31, 2007.
OUTSTANDING EQUITY AWARDS AT 2007 FISCAL YEAR END
As of December 31, 2007, none of our executive officers had exercised options to acquire our stock.
Employment Agreements
The compensation paid to our executive officers derives substantially from their individually negotiated employment agreements.
Michael T. McDonnell
On October 2, 2006, Michael T. McDonnell, our President and Chief Executive Officer, entered into an employment agreement, providing for a three-year term at an annual base salary of $500,000. Commencing with the fiscal year beginning January 1, 2007, Mr. McDonnell is eligible to receive an annual incentive bonus upon achievement of performance goals, consistent with the terms of the annual cash bonus plan described previously. Mr. McDonnell’s target annual bonus is 100% of his base salary. He participates in our standard benefit programs, including health, dental, life insurance and vision programs. Mr. McDonnell is entitled to severance benefits in connection with certain terminations of his employment (see “Potential Payments Upon Termination or Change in Control”). Pursuant to his employment agreement, Mr. McDonnell was granted an option to purchase 382.36 shares of Pregis Holding I common stock at a purchase price of $13,000 per share. The stock option grant was made pursuant to our 2005 Stock Option Plan and vests equally over five years, subject to accelerated vesting upon a change in control of our company. Under the terms of his employment agreement, Mr. McDonnell also purchased 30 shares of the common stock of Pregis Holding I Corporation, pursuant to the terms of the Employee Stock Purchase Plan. Mr. McDonnell is also a party to a noncompetition agreement that restricts him for one year following his termination of employment from rendering any services to a competitor or soliciting our customers or employees.
D. Keith LaVanway
On August 15, 2007, D. Keith LaVanway, our Chief Financial Officer, entered into an employment agreement providing for a three-year term at an annual base salary of $360,000, with employment to commence no later than September 4, 2007. We paid Mr. LaVanway a one-time signing bonus of $100,000 as an inducement to join us and for compensation foregone from his previous employer. Because Mr. LaVanway’s employment commenced in the latter portion of 2007, he will receive for 2007 a fixed cash bonus of $150,000. Commencing with the fiscal year beginning January 1, 2008, Mr. LaVanway is eligible to receive an annual incentive bonus upon achievement of performance goals, consistent with the terms of the annual cash bonus plan described previously. Mr. LaVanway’s target annual bonus is 60% of his base salary. In addition, Mr. LaVanway was eligible to receive a temporary housing allowance of $5,000 per month and reimbursement of reasonable related costs until he relocated to the Chicago, Illinois area. He participates in our standard benefit programs, including health, dental, life insurance and vision programs. Mr. LaVanway is entitled to severance benefits in connection with certain terminations of his employment (see “Potential Payments Upon Termination or Change in Control”). Pursuant to his employment agreement, Mr. LaVanway was granted an option to purchase 200.00 shares of Pregis Holding I common stock at a purchase price of $20,000 per share. The stock option grant was made pursuant to our 2005 Stock Option Plan and vests equally over five years, subject to accelerated vesting upon a change in control of our company. Under the terms of his employment agreement, Mr. LaVanway also purchased 25 shares of the common stock of Pregis Holding I Corporation, pursuant to the terms of the Employee Stock Purchase Plan. Mr. LaVanway is also a party to a noncompetition agreement that restricts him for one year following his termination of employment from rendering any services to a competitor or soliciting our customers or employees.
Hartmut Scherf
Hartmut Scherf, General Manager, Flexibles, entered into an employment agreement providing for an annual salary of $306,500. Mr. Scherf is eligible to receive an annual incentive bonus upon achievement of performance goals, consistent with the terms of the annual cash bonus plan described previously. Mr. Scherf’s target annual bonus is $137,000. Mr. Scherf is provided with the use of an automobile and an accident insurance policy. Mr. Scherf’s agreement requires six months notice (or our payment of six months of base salary in lieu thereof) prior to a termination and he is subject to a noncompetition covenant for a period of twelve months following termination of his employment. In 2007, Mr. Scherf deferred compensation pursuant to a noncontributory nonqualified defined contribution benefit plan (see “Nonqualified Deferred Compensation”). Pursuant to his employment agreement, Mr. Scherf was granted an option to purchase 82.77 shares of Pregis Holding I common stock at a purchase price of $13,000 per share. The stock option grant was made pursuant to our 2005 Stock Option Plan and vests equally over five years, subject to accelerated vesting upon a change in control of our company.
C. William McBee
On January 23, 2006, C. William McBee, President, Hexacomb, entered into an employment agreement providing for a three-year term, under which his current annual base salary is $275,000. Mr. McBee is also eligible to receive an annual incentive bonus upon achievement of performance goals, consistent with the terms of the annual cash bonus plan described previously. Mr. McBee’s target annual bonus is 40% of his base salary. Mr. McBee is entitled to severance benefits in connection with certain terminations of his employment (see “Potential Payments Upon Termination or Change in Control”). He participates in our company’s benefit programs, including health, dental, life insurance and vision programs. Mr. McBee receives a $12,000 annual allowance for perquisites. Pursuant to his employment agreement, Mr. McBee was granted an option to purchase 62.91 shares of Pregis Holding I common stock at a purchase price of $13,000 per share. The stock option grant was made pursuant to our 2005 Stock Option Plan, and vests equally over five years, subject to accelerated vesting upon a change in control of our company. Mr. McBee is also a party to a noncompetition agreement that restricts him for one year following his termination of employment from rendering any services to a competitor or soliciting our customers or employees.
Fernando De Miguel
Fernando De Miguel, General Manager, Protective Packaging Europe, entered into an employment agreement, effective June 1, 2007, providing for an annual salary of $342,500. Mr. De Miguel is eligible to receive an annual incentive bonus upon achievement of performance goals, consistent with the terms of the annual cash bonus plan described previously. Mr. De Miguel’s target annual bonus is 40% of his base salary. Mr. De Miguel is provided with the use of an automobile and is eligible for group insurance benefits. Mr. De Miguel’s agreement requires twelve months notice (or our payment of $342,500 in lieu thereof) prior to a termination and he is subject to a noncompetition covenant for a period of twelve months following termination of his employment. Pursuant to his employment agreement, Mr. De Miguel was granted an option to purchase 132.16 shares of Pregis Holding I common stock at a purchase price of $13,000 per share. The stock option grant was made pursuant to our 2005 Stock Option Plan and vests equally over five years, subject to accelerated vesting upon a change in control of our company.
Separation Agreements
On March 13, 2007, we entered into a separation agreement with Peter Lewis, our former President, Protective Packaging Europe and Rigid Packaging. Pursuant to the agreement, the employment of Mr. Lewis with the Company terminated on April 30, 2007. Under the Agreement, Mr. Lewis received a payment of 123,638 pounds sterling, which amount consisted of (i) five months of base salary (75,000 pounds sterling), (ii) eight months of car allowance ((12,950 pounds sterling), (iii) eight months of defined contribution pension payments (22,006 pounds sterling), (iv) 8,013 pounds sterling for life insurance, (v) 4,502 pounds sterling for income protection insurance, (vi) 487 pounds sterling for private health insurance, and (vii) 680 pounds sterling for telephone costs. The Company also made a contribution to a defined benefit scheme on behalf of Mr. Lewis, as if he were employed by the
Company through December 31, 2007, of 24,978 pounds sterling. Mr. Lewis will also receive a payment of 45,000 pounds sterling (three months of base salary), payable within 14 days of April 30, 2008, provided he complies with the terms of certain restrictive covenants. On March 13, 2007, Mr. Lewis entered into a consulting agreement with the Company, under which he provided certain consulting services to the Company through December 31, 2007. Pursuant to the agreement, Mr. Lewis is eligible to receive a payment of 36,000 pounds sterling on or before March 31, 2008, subject to completion of certain initiatives.
On August 27, 2007, we entered into a separation agreement with Timothy J. Cunningham, our former Vice President and Chief Financial Officer. Pursuant to the agreement, Mr. Cunningham remained employed by the Company in a transitional role until December 31, 2007. Under the Agreement, Mr. Cunningham will receive (i) an amount equal to his annual base salary of $350,000 payable over a twelve-month period following his date of termination, (ii) a full annual performance bonus for 2007 of $172,074, calculated on the same terms that would have otherwise applied, (iii) continued medical benefits for the twelve month period immediately following his separation at an estimated cost of $7,261, and (iv) payment for four weeks of accrued vacation, totaling $26,923. In consideration of his separation benefits, Mr. Cunningham executed a standard release in favor of our company and continues to be subject to a noncompetition agreement which restricts him for one year following his termination of employment from rendering any services to a competitor or soliciting our customers or employees.
We entered into a separation agreement on January 9, 2008 with Andy J. Brewer, our former President, Protective Packaging North America, pursuant to which we paid or will pay and provide to Mr. Brewer (i) base compensation for the period commencing on the separation date, which was November 19, 2007, through March 19, 2008, at such times and in such amounts as would have been paid in accordance with the Company’s normal payroll procedures (calculated to be $100,000), (ii) a pro rata portion of the amount of bonus he would have received based on our actual 2007 performance, which was determined to be $117,489, payable in equal annual installments over a twelve-month period beginning with the first payroll period of April 2008, and (iii) continued medical and dental benefits from the separation date until March 19, 2008 at an estimated cost of $2,420. In consideration of his separation benefits, Mr. Brewer executed a standard release in favor of our company and continues to be subject to a noncompetition agreement which restricts him for one year following his termination of employment from rendering any services to a competitor or soliciting our customers, and for two years from soliciting our employees.
Benefit Plans
2005 Stock Option Plan
On December 20, 2005, Pregis Holding I ratified the Pregis Holding I Corporation 2005 Stock Option Plan to provide for the grant of nonqualified and incentive stock options to key employees, consultants and directors of Pregis Holding I and its subsidiaries (including Pregis) and affiliates. The maximum number of shares of Pregis Holding I common stock underlying the options that are available for award under the stock option plan is 1,841.62. If any options terminate or expire unexercised, the shares subject to such unexercised options will again be available for grant.
The stock option plan is administered by a committee of the board of directors of Pregis Holding I. Generally, the committee interprets and implements the stock option plan, grants options, exercises all powers, authority and discretion of the board under the stock option plan, and determines the terms and conditions of option grants, including vesting provisions, exercise price and termination date of options.
Each option is evidenced by an agreement between an optionee and Pregis Holding I containing such terms as the committee determines. Unless determined otherwise by the committee, 20% of the shares subject to the option vest on each of the first five anniversaries of the grant date subject to continued employment. In 2007, the committee modified the vesting terms for certain option grants to require vesting equally over three years, dependant upon achieving certain performance-based targets. The committee may accelerate the vesting of options at any time. Unless determined otherwise by the committee, the option price will not be less than the fair market value of the underlying shares on the grant date. Generally, unless otherwise set forth in an agreement or as determined by the
committee, vested options will terminate forty-five days after termination of employment (180 days in the event of termination by reason of death or disability).
In the event of a transaction that constitutes a change in control of Pregis Holding I as described in the stock option plan, unless otherwise set forth in an agreement or as determined by the committee, each outstanding option will vest immediately prior to the occurrence of the transaction, and Pregis Holding I will have the right to cancel any options which have not been exercised as of the date of the transaction, subject to payment of the fair market value of the common stock underlying the option less the aggregate exercise price of the option.
The stock option plan provides that the aggregate number of shares subject to the stock option plan and any option, the purchase price to be paid upon exercise of an option, and the amount to be received in connection with the exercise of any option may be appropriately adjusted to reflect any stock splits, reverse stock splits or dividends paid in the form of Pregis Holding I common stock, and equitably adjusted as determined by the committee for any other increase or decrease in the number of issued shares of Pregis Holding I common stock resulting from the subdivision or combination of shares or other capital adjustments, or the payment of any other stock dividend or other extraordinary dividend, or any other increase or decrease in the number of shares of Pregis Holding I common stock.
The Pregis Holding I board of directors may amend, alter, or terminate the stock option plan. Any board action may not adversely alter outstanding options without the consent of the optionee. The stock option plan will terminate ten years from its effective date, but all outstanding options will remain effective until satisfied or terminated under the terms of the stock option plan.
Employee Stock Purchase Plan
On December 20, 2005, Pregis Holding I adopted the Pregis Holding I Corporation Employee Stock Purchase Plan to provide key employees of Pregis Holding I and its subsidiaries (including Pregis) an opportunity to purchase shares of Pregis Holding I common stock. The purchase price per share of stock sold under the plan when it was initiated was $10,000, which is the price per share that AEA Investors LP and its affiliates paid when they purchased Pregis Holding I. We have continued to offer new executives joining the company the opportunity to purchase shares at the then-current fair market value. Employees who desire to participate in the plan are required to purchase at least 0.25 shares.
Shares of stock sold under the plan are evidenced by a subscription agreement between a subscriber and Pregis Holding I which contains terms and conditions regarding the ownership of shares sold under the plan. The subscription agreement contains standard transfer restrictions. In addition, if a subscriber’s employment with our company is terminated, Pregis Holding I generally has the opportunity to purchase all of the subscriber’s shares purchased under the plan at the then-current fair market value of the shares, or at cost in certain circumstances.
Pension Benefits
Mr. Lewis participates in the Baldwin Group Pension Scheme, a defined benefit pension plan maintained in the United Kingdom. Under the plan, on retirement at a normal pension age of 65 years, the annual retirement benefit is equal to 1/60th of the sum of base salary and bonus, times the number of complete years of service, up to a maximum of 40 years of service, where base salary and bonus are calculated as the average of the three highest consecutive years of base salary and bonus within the last ten years of employment. The present value of the accumulated benefit under this plan was determined by a third-party actuary as of December 31, 2007, assuming a discount rate of 5.75%, compensation increases of 3.50% and a pension indexation of 2.75%.
PENSION BENEFITS AT DECEMBER 31, 2007
Nonqualified Deferred Compensation
Mr. Scherf participates in a noncontributory, nonqualified defined contribution plan exclusively for his benefit. The company makes a fixed annual contribution of 25,000 euros to fund the plan as well as pays supplemental life insurance and occupational disability insurance premiums. Annual contributions are to be made until Mr. Scherf reaches normal retirement age of 65 or his employment with our company ceases, whichever occurs sooner, at which time he has the option to receive a lump-sum distribution or monthly payments.
NONQUALIFIED DEFERRED COMPENSATION
Mr. Lewis also participated in two noncontributory, nonqualified defined contribution benefit plans, including an executive pension scheme for the benefit of certain members of senior management and a supplementary plan exclusively for his benefit. During the year ended December 31, 2007, the Company made contributions totaling $84,068 to these plans, including a contribution of $44,012 pursuant to the terms of Mr. Lewis’ separation agreement. These total contributions are also included within all other compensation in the Summary Compensation Table.
Potential Payments Upon Termination or Change in Control
The following sets forth potential payments to our named executive officers upon termination of employment or upon a change in control under their employment agreements and our other compensation programs. All payments assume a termination and change in control date of December 31, 2007 and an estimated value per share of approximately $20,000 as of December 31, 2007. The estimated value per share is based on an estimated enterprise value of the Company determined using an EBITDA multiple of approximately 7.00 times, which approximates the EBITDA multiple paid at the time of the Acquisition.
Michael T. McDonnell
Pursuant to his employment agreement, if Mr. McDonnell were terminated “without cause,” if he were to terminate his employment for “good reason,” or if the term of his employment were not renewed, Mr. McDonnell would be entitled to (A) a cash payment of $500,000, payable over twelve months, (B) an incentive bonus for the year of termination, which at target performance would equal $500,000, (C) all accrued but unpaid amounts payable under his employment agreement and any other employee benefit plan and (D) the continuation of medical benefits
until the earlier of one year following termination at a cost of $7,261 and the date Mr. McDonnell becomes eligible for medical benefits from a subsequent employer. The termination payment is conditioned on the execution by Mr. McDonnell of a release of claims, and our obligation to provide the termination payment, the incentive bonus and the continued medical benefits is conditioned upon Mr. McDonnell’s continued compliance with his obligations under a noncompetition agreement. The provisions of the noncompetition agreement pertaining to noncompetition and nonsolicitation apply for one year following Mr. McDonnell’s termination of employment. Assuming that a change in control took place on December 31, 2007 and vesting of all of Mr. McDonnell’s outstanding unvested option grants accelerated, the excess of the estimated value of the company shares over the exercise price of the options would be approximately $2,201,000.
D. Keith LaVanway
Pursuant to his employment agreement, if Mr. LaVanway were terminated “without cause,” if he were to terminate his employment for “good reason,” or if the term of his employment were not renewed, Mr. LaVanway would be entitled to (A) a cash payment of $360,000, payable over twelve months, (B) an incentive bonus for the year of termination, which at target performance would equal $60,480 (based on Mr. LaVanway having commenced employment on September 19, 2007), (C) all accrued but unpaid amounts payable under his employment agreement and any other employee benefit plan and (D) the continuation of medical benefits until the earlier of one year following termination at a cost of $7,261 and the date Mr. LaVanway becomes eligible for medical benefits from a subsequent employer. The termination payment is conditioned on the execution by Mr. LaVanway of a release of claims, and our obligation to provide the termination payment, the incentive bonus and the continued medical benefits is conditioned upon Mr. LaVanway’s continued compliance with his obligations under a noncompetition agreement. The provisions of the noncompetition agreement pertaining to noncompetition and nonsolicitation apply for one year following Mr. LaVanway’s termination of employment. In addition, Mr. LaVanway holds options to acquire our common stock that vest upon a change in control as defined in the 2005 Stock Option Plan. Assuming that a change in control took place on December 31, 2007, these options would be at the money.
Hartmut Scherf
If Mr. Scherf is terminated by us without six months prior written notice, he will receive a payment equal to six months of his base salary. Assuming that a change in control took place on December 31, 2007 and vesting of all of Mr. Scherf’s outstanding unvested option grants accelerated, the excess of the estimated value of the company shares over the exercise price of the options would be approximately $401,000.
C. William McBee
Pursuant to his employment agreement, if Mr. McBee were terminated “without cause,” he would be entitled to (A) a cash payment of $275,000, payable over twelve months, (B) an incentive bonus for the year of termination, which at target performance would equal $110,000 and (C) all accrued but unpaid amounts payable under his employment agreement and any other employee benefit plan. The termination payment is conditioned upon the execution by Mr. McBee of a release of claims and our obligation to make the termination payment and pay the incentive bonus is conditioned upon Mr. McBee’s continued compliance with his obligations under a noncompetition agreement. The provisions of the noncompetition agreement pertaining to noncompetition and nonsolicitation apply for one year following Mr. McBee’s termination of employment. Assuming that a change in control took place on December 31, 2007 and vesting of all of Mr. McBee’s outstanding unvested option grants accelerated, the excess of the estimated value of the company shares over the exercise price of the options would be approximately $297,000.
Fernando De Miguel
If Mr. De Miguel is terminated by us without twelve months prior written notice, he will receive a payment equal to $342,500. Assuming that a change in control took place on December 31, 2007 and vesting of all of Mr. De Miguel’s outstanding unvested option grants accelerated, the excess of the estimated value of the company shares over the exercise price of the options would be approximately $965,000.
Timothy J. Cunningham
On August 27, 2007, we entered into a separation agreement with Timothy J. Cunningham, our former Vice President and Chief Financial Officer. Pursuant to the agreement, Mr. Cunningham remained employed by the Company in a transitional role until December 31, 2007. Under the Agreement, Mr. Cunningham will receive (i) an amount equal to his annual base salary of $350,000 payable over a twelve-month period following his date of termination, (ii) a full annual performance bonus for 2007 of $172,074, calculated on the same terms that would have otherwise applied, (iii) continued medical benefits for the twelve month period immediately following his separation at an estimated cost of $7,261, and (iv) payment for four weeks of accrued vacation, totaling $26,923. In consideration of his separation benefits, Mr. Cunningham executed a standard release in favor of our company and continues to be subject to a noncompetition agreement which restricts him for one year following his termination of employment from rendering any services to a competitor or soliciting our customers or employees.
Peter Lewis
On March 13, 2007, we entered into a separation agreement with Peter Lewis, our former President, Protective Packaging Europe and Rigid Packaging. Pursuant to the agreement, the employment of Mr. Lewis with the Company terminated on April 30, 2007. Under the Agreement, Mr. Lewis received a payment of 123,638 pounds sterling, which amount consisted of (i) five months of base salary (75,000 pounds sterling), (ii) eight months of car allowance ((12,950 pounds sterling), (iii) eight months of defined contribution pension payments (22,006 pounds sterling), (iv) 8,013 pounds sterling for life insurance, (v) 4,502 pounds sterling for income protection insurance, (vi) 487 pounds sterling for private health insurance, and (vii) 680 pounds sterling for telephone costs. The Company also made a contribution to a defined benefit scheme on behalf of Mr. Lewis, as if he were employed by the Company through December 31, 2007, of 24,978 pounds sterling. Mr. Lewis will also receive a payment of 45,000 pounds sterling (three months of base salary), payable within 14 days of April 30, 2008, provided he complies with the terms of certain restrictive covenants. On March 13, 2007, Mr. Lewis entered into a consulting agreement with the Company, under which he provided certain consulting services to the Company through December 31, 2007. Pursuant to the agreement, Mr. Lewis is eligible to receive a payment of 36,000 pounds sterling on or before March 31, 2008, subject to completion of certain initiatives.
Andy J. Brewer
We entered into a separation agreement on January 9, 2008 with Andy J. Brewer, our former President, Protective Packaging North America, pursuant to which we paid or will pay and provide to Mr. Brewer (i) base compensation for the period commencing on the separation date, which was November 19, 2007, through March 19, 2008, at such times and in such amounts as would have been paid in accordance with the Company’s normal payroll procedures (calculated to be $100,000), (ii) a pro rata portion of the amount of bonus he would have received based on our actual 2007 performance, which was determined to be $117,489, payable in equal annual installments over a twelve-month period beginning with the first payroll period of April 2008, and (iii) continued medical and dental benefits from the separation date until March 19, 2008 at an estimated cost of $2,420. In consideration of his separation benefits, Mr. Brewer executed a standard release in favor of our company and continues to be subject to a noncompetition agreement which restricts him for one year following his termination of employment from rendering any services to a competitor or soliciting our customers, and for two years from soliciting our employees.
Director Compensation
DIRECTOR COMPENSATION FOR 2007
(1)
During 2005, each of Messrs. Leng, Morris, O’Leary, Jr. and Rogers were granted an option to acquire 41.380 shares of Pregis Holding I common stock at an exercise price of $13,000 per share vesting in equal installments over five years. The amount shown represents the amount of compensation cost that would be recognized for fiscal 2007 as computed in accordance with SFAS No. 123R utilizing the modified prospective transition method. A discussion of the assumptions underlying the valuation is provided in Note 17 to the audited financial statements included within this report.
(2)
Mr. McDonnell received no compensation for serving as a director. See the “Summary Compensation Table” for amounts paid to him as compensation for serving as President and Chief Executive Officer.
None of our directors currently receive any cash compensation for their services on the board of directors or committee of the board of directors. The Company currently reimburses them for all out-of-pocket expenses incurred in the performance of their duties as directors.
Compensation Committee Interlocks and Insider Participation
The board of directors of Pregis Holding II has formed a compensation committee. The members of the committee are Messrs. Pryma, Garcia, Hoesterey, and O’Leary. During fiscal 2007 none of the members of the compensation committee was an officer or employee of Pregis Holding II or any of its subsidiaries. Messrs. Pryma, Garcia and Hoesterey are partners of AEA Investors LLC. See Item 13, “Certain Relationships and Related Transactions, and Director Independence - AEA Investors.”
Compensation Committee Report
The compensation committee of the Company has reviewed and discussed the Compensation Discussion and Analysis required by Item 402(b) of Regulation S-K with management and, based on such review and discussions, the compensation committee recommended to the board of directors that the Compensation Discussion and Analysis be included in this report.
ITEM 12.
ITEM 12.
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
All of our issued and outstanding common stock is held by Pregis Holding I Corporation. The following table sets forth information, as of December 31, 2007, with respect to the beneficial ownership of Pregis Holding I by (a) any person or group who will beneficially own more than five percent of the outstanding common stock of Pregis Holding I, (b) each of the directors of Pregis and Pregis Holding II and the executive officers of Pregis and Pregis Holding II named in Item 11, “Executive Compensation” and (c) all of the directors of Pregis and Pregis Holding II and the executive officers of Pregis and Pregis Holding II as a group.
*
Represents ownership of less than one percent.
(1)
As used in this table, each person or entity with the power to vote or direct the disposition of shares of common stock is deemed to be a beneficial owner.
(2)
Consists of shares of common stock held by investment vehicles managed by AEA Investors LLC and AEA Management (Cayman) Ltd. The address for AEA Investors LLC is 65 East 55th Street, New York, New York 10022. The address for AEA Management (Cayman) Ltd. is c/o Walkers SPV Limited, P.O. Box 908GT, George Town, Grand Cayman, Cayman Islands.
(3)
Does not include approximately 395 shares of common stock subject to options which have been granted, of which 76 are exercisable.
(4)
Does not include approximately 200 shares of common stock subject to options which have been granted which are not immediately exercisable.
(5)
Does not include approximately 20 shares of common stock subject to options which have been granted, of which 17 may be exercised by Mr. Cunningham up to the date six months from his date of separation, per the terms of his separation agreement.
(6)
Does not include approximately 90 shares of common stock subject to options which have been granted, of which 33 are exercisable.
(7)
Does not include approximately 70 shares of common stock subject to options which have been granted, of which 25 are exercisable.
(8)
Does not include approximately 141 shares of common stock subject to options which have been granted which are not immediately exercisable.
(9)
Both Messrs. Lewis and Brewer still own shares of common stock as of December 31, 2007; however all of their option grants have been forfeited.
(10)
Messrs. Garcia, Fischer, Hoesterey and Pryma serve on the board of directors of Pregis Holding II as representatives of AEA Investors LLC. Mr. Garcia is President of AEA Investors LLC, Messrs. Hoesterey and Pryma are partners of AEA Investors LLC and Mr. Fischer is an operating partner of AEA Investors LLC. Messrs. Garcia, Fischer, Hoesterey and Pryma disclaim beneficial ownership of common stock owned by investment vehicles managed by AEA Investors LLC and AEA Management (Cayman) Ltd., except to the extent of their respective pecuniary interests therein.
(11)
Does not include approximately 41 shares of common stock subject to options which have been granted, of which 17 are exercisable.
(12)
Does not include approximately 1,415 shares of common stock subject to options which have been granted, of which 225 are exercisable. Also excludes shares held by investment vehicles managed by AEA Investors LLC and AEA Management (Cayman) Ltd. Messrs. Garcia, Fischer, Hoesterey and Pryma serve on the board of directors of Pregis Holding II as representatives of AEA Investors LLC. Mr. Garcia is President of AEA Investors LLC, Messrs. Hoesterey and Pryma are partners of AEA Investors LLC and Mr. Fischer is an operating partner of AEA Investors LLC. Messrs. Garcia, Fischer, Hoesterey and Pryma disclaim beneficial ownership of common stock owned by investment vehicles managed by AEA Investors LLC and AEA Management (Cayman) Ltd., except to the extent of their respective pecuniary interests therein.
The following table summarizes information, as of December 31, 2007, relating to equity compensation plans of Pregis Holding I pursuant to which grants of options, restricted stock, or certain other rights to acquire shares of Pregis Holding I may be granted from time to time.
Equity Compensation Plan Information
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
Policies for Review and Approval of Related Party Transactions
We have adopted a formal written policy regarding the review and approval of related party transactions. In accordance with this policy, our audit committee must review all such transactions, and may approve related party transactions if the audit committee determines that they are on terms, including levels of service and quality, that are at least as favorable to our company as could be obtained from unaffiliated parties.
AEA Investors
Upon consummation of the Acquisition, we entered into a management agreement with AEA Investors LLC relating to the provision of advisory and consulting services. Under the management agreement, we pay AEA Investors LLC an annual fee of $1.5 million, plus reasonable out-of-pocket expenses. We also agreed to indemnify AEA Investors LLC and its affiliates for liabilities arising from their actions under the management agreement. For the years ended December 31, 2007 and 2006 and the period October 13, 2005 to December 31, 2005, we paid fees, and related expenses, to AEA Investors of $1.9 million, $1.8 million and $0.3 million, respectively, pursuant to this agreement. In addition, in consideration of services performed in connection with the Acquisition and the related financings, we paid a $6.5 million fee to AEA Investors LLC upon closing of the Acquisition. We believe that the management agreement and the services above mentioned are or were on terms at least as favorable to us as we would expect to negotiate with unrelated third parties.
Other Related Party Transactions
The Company had sales to affiliates of AEA Investors LLP totaling $3.5 million and $2.2 million for the years ended December 31, 2007 and 2006, respectively. For the same periods, the Company made purchases from affiliates of AEA Investors LLP totaling $8.0 million and $4.5 million, respectively.
Board of Directors
The board of directors of Pregis Holding II consists of 9 members, including four members who are representatives of AEA Investors, Messrs. Garcia, Fischer, Hoesterey and Pryma, and three members who are investors in AEA Investors funds, Messrs. Leng, O’Leary, Jr., and Rogers.
As a private company, whose securities are not listed on any national securities exchange, Pregis Holding II is not required to have a majority of, or any, independent directors. Further, even if Pregis Holding II were listed on a national securities exchange, because AEA Investors owns more than 50% of the common stock of Pregis Holding I, and Pregis Holding I owns all of the common stock of Pregis Holding II, Pregis Holding II would be deemed a “controlled company” under the rules of the NYSE and Nasdaq, and, therefore, would not need to have a majority of independent directors or all-independent compensation and nominating committees. However, the rules of the SEC require us to disclose in this Form 10-K which of our directors would be considered independent within the meaning of the rules of a national securities exchange that we may choose. Pregis Holding II currently has three directors who would be considered independent within the definitions of either the NYSE or Nasdaq: Messrs. Leng, O’Leary and Rogers. Four of our directors are partners of AEA Investors: Messrs. Garcia, Fischer, Hoesterey and Pryma. One of our directors is our CEO (Michael McDonnell) and one of our directors was our CEO during a part of the last three years (James Morris).
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
The following table presents by category of service the total fees for services rendered by Ernst & Young LLP, the Company’s principal accountant, for the years ended December 31, 2007 and 2006.
(1)
Includes fees for professional services rendered in connection with the audit of the Company’s annual combined and consolidated financial statements, as well as other statutory audit services. Amount also includes fees for reviews of quarterly financial statements, and consents and reviews of documents filed with the Securities and Exchange Commission.
(2)
Tax fees include primarily tax planning and structuring advice related to transfer pricing matters and acquisitions.
Pre-Approval Policies and Procedures
The Audit Committee annually engages and pre-approves the audit and audit-related services provided by the independent registered public accounting firm, for the following year, to assure that the provision of such services does not impair the auditor’s independence. All allowable non-audit services are regularly required to be specifically identified and submitted to the Audit Committee for approval during regularly scheduled meetings.
For 2007, the Audit Committee discussed the non-audit services with Ernst & Young LLP and management to determine that they are permitted under the rules and regulations concerning auditor independence promulgated by the SEC and Public Accounting Oversight Board. Following such discussions, the Audit Committee determined that the provision of such non-audit services by Ernst & Young LLP was compatible with maintaining their independence.
PART IV
ITEM 15.
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a) Documents Filed as Part of this Annual Report:
1.
Financial Statements.
See Index to Financial Statements on page 41 of this report.
2.
Financial Statement Schedules.
See Schedule II - Valuation and Qualifying Allowances on page 89 of this report. All other schedules are not required under the relevant instructions or are inapplicable and therefore have been omitted.
3.
List of Exhibits.
See Exhibit Index beginning on page 115 of this report.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Date: March 24, 2008
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacity and on the dates indicated.
EXHIBIT INDEX
Exhibit
Number
Description
2.1
Stock Purchase Agreement, dated as of June 23, 2005, as amended, among Pactiv Corporation and certain of its affiliates, as sellers, and PFP Holding II Corporation, as purchaser. (1)
2.2
Sale and Purchase Agreement dated as of July 4, 2007 between Mirto Trading LTD, Mr. Birliba Mihai, Ms. Olariu Angelica, Mr. Mitrea Florin, Pro Logistics S.R.L, and Pregis GmbH. (6)
3.1
Certificate of Incorporation of Pregis Holding II Corporation. (1)
3.2
By-laws of Pregis Holding II Corporation. (1)
4.1
Indenture, dated October 12, 2005, among Pregis Corporation, Pregis Holding II Corporation, Pregis Management Corporation, Pregis Innovative Packaging Inc., Hexacomb Corporation, The Bank of New York, as trustee and collateral agent, The Bank of New York, as registrar and paying agent, and RSM Robson Rhodes LLP, as Irish paying agent. (1)
4.2
Indenture, dated October 12, 2005, among Pregis Corporation, Pregis Holding II Corporation, Pregis Management Corporation, Pregis Innovative Packaging Inc., Hexacomb Corporation, and The Bank of New York, as trustee. (1)
4.3
Form of Initial Notes and Form of Exchange Notes (included within the Indentures filed as Exhibit 4.1 and Exhibit 4.2). (1)
4.4
Registration Rights Agreement, dated October 12, 2005, among Pregis Corporation, Pregis Holding II Corporation, Pregis Management Corporation, Pregis Innovative Packaging Inc., Hexacomb Corporation, Credit Suisse First Boston (Europe) Limited, Credit Suisse First Boston LLC, Lehman Brothers International (Europe), and Lehman Brothers Inc. (1)
10.1
Credit Agreement, dated October 12, 2005, among Pregis Corporation, Pregis Holding II Corporation, Pregis Management Corporation, Pregis Innovative Packaging Inc., Hexacomb Corporation, the several banks, other financial institutions and related funds as may from time to time become parties thereto, Credit Suisse, as collateral agent and administrative agent, Lehman Brothers Inc., as syndication agent, and CIT Lending Services, Inc. and JPMorgan Chase Bank, N.A., as co-documentation agents. (1)
10.1(a)
Waiver Letter No. 2 and Amendment No. 1, dated as of May 31, 2006, to Credit Agreement, dated October 12, 2005, among Pregis Corporation and Credit Suisse, Cayman Islands Branch, as Agent and as a Lender. (2)
10.2
First Lien Security Agreement, dated October 12, 2005, by Pregis Corporation, Pregis Holding II Corporation, Pregis Management Corporation, Pregis Innovative Packaging Inc., and Hexacomb Corporation, to Credit Suisse, as collateral agent. (1)
10.3
Second Lien Security Agreement, dated October 12, 2005, by Pregis Corporation, Pregis Holding II Corporation, Pregis Management Corporation, Pregis Innovative Packaging Inc., and Hexacomb Corporation, to The Bank of New York, as trustee and collateral agent. (1)
10.4
Senior Pledge Agreement, dated October 12, 2005, between Pregis Corporation, as pledgor, and Credit Suisse, as security agent. (1)