Item 1.
Business
Our Company
Horizon Lines, Inc., a Delaware corporation, (the “Company” and together with its subsidiaries, “We”) operates as a holding company for Horizon Lines, LLC (“HL”), a Delaware limited liability company and wholly-owned subsidiary, Horizon Logistics Holdings, LLC (“Horizon Logistics”), a Delaware limited liability company and wholly-owned subsidiary, and Horizon Lines of Puerto Rico, Inc. (“HLPR”), a Delaware corporation and wholly-owned subsidiary. The Company was formed as an acquisition vehicle to acquire, on July 7, 2004, the equity interest in Horizon Lines Holding Corp., a Delaware corporation (“HLHC” or “Horizon Lines Holding”). The foregoing acquisition and related financing and other transactions, referred to in this Form 10-K collectively as the “Acquisition-Related Transactions” or “merger,” included a merger whereby Horizon Lines Holding became a direct wholly-owned subsidiary of the Company. The Company was formed at the direction of Castle Harlan Partners IV. L.P. (“CHP IV”), a private equity investment fund managed by Castle Harlan, Inc. (“Castle Harlan”). During 2006, the Company completed three secondary offerings, including a secondary offering (pursuant to a shelf registration) whereby CHP IV and other affiliated private equity investment funds managed by Castle Harlan divested their ownership in the Company.
Our long operating history dates back to 1956, when Sea-Land Service, Inc. (“Sea-Land”) pioneered the marine container shipping industry and established our business. In 1958 we introduced container shipping to the Puerto Rico market, and in 1964 we pioneered container shipping in Alaska with the first year-round scheduled vessel service. In 1987, we began providing container shipping services between the U.S. west coast and Hawaii and Guam through our acquisition from an existing carrier of all of its vessels and certain other assets that were already serving that market. In December 1999, HLHC’s former parent, CSX Corporation sold the international marine container operations of Sea-Land to the A.P. Møller Maersk Group (“Maersk”) and HLHC continued to be owned and operated as CSX Lines, LLC, a subsidiary of CSX Corporation. On February 27, 2003, HLHC (which at the time was indirectly majority-owned by Carlyle-Horizon Partners, L.P.) acquired from CSX Corporation, which was the successor to Sea-Land, 84.5% of CSX Lines, LLC (“Predecessor A”), and 100% of CSX Lines of Puerto Rico, Inc., which together constitute our business today. CSX Lines, LLC is now known as Horizon Lines, LLC and CSX Lines of Puerto Rico, Inc. is now known as Horizon Lines of Puerto Rico, Inc. Today, as the only Jones Act vessel operator with one integrated organization serving Alaska, Hawaii and Puerto Rico, we are uniquely positioned to serve customers requiring shipping and logistics services in more than one of these markets.
We believe that we are the nation’s leading Jones Act container shipping and integrated logistics company, accounting for approximately 38% of total U.S. marine container shipments from the continental U.S. to Alaska, Puerto Rico and Hawaii, constituting the three non-contiguous Jones Act markets; and to Guam and Micronesia. We own or lease 21 vessels, 16 of which are fully qualified Jones Act vessels, and approximately 22,000 cargo containers. We also provide comprehensive shipping and sophisticated logistics services in our markets. We have long-term access to terminal facilities in each of our ports, operating our terminals in Alaska, Hawaii, and Puerto Rico and contracting for terminal services in our six ports in the continental U.S. and in the ports in Guam, Hong Kong, Yantian and Taiwan. We, through our wholly owned subsidiary, Horizon Logistics, offer inland transportation for our customers through our own trucking operations on the U.S. west coast and Alaska, and our integrated logistics services including relationships with third-party truckers, railroads, and barge operators in our markets.
We ship a wide spectrum of consumer and industrial items used everyday in our markets, ranging from foodstuffs (refrigerated and non-refrigerated) to household goods and auto parts to building materials and various materials used in manufacturing. Many of these cargos are consumer goods vital to the expanding populations in our markets, thereby providing us with a stable base of growing
demand for our shipping and logistics services. We have many long-standing customer relationships with large consumer and industrial products companies, such as Costco Wholesale Corporation, Johnson & Johnson, Lowe’s Companies, Inc., Safeway, Inc., Toyota Motor Corporation and Wal-Mart Stores, Inc. We also serve several agencies of the U.S. government, including the Department of Defense and the U.S. Postal Service. Our customer base is broad and diversified, with our top ten customers accounting for approximately 35% of revenue and our largest customer accounting for approximately 8% of revenue.
Current Developments
On February 1, 2008, the Company filed a shelf registration on Form S-3. The registration statement, which became effective upon filing with the U.S. Securities and Exchange Commission, registered for resale the $330.0 million aggregate principal amount of 4.25% convertible senior notes due 2012 and the shares issuable upon conversion of the notes that were part of a private placement completed on August 8, 2007. The notes pay interest semiannually at a rate of 4.25% per annum. The notes are convertible under certain circumstances into cash up to the principal amount of the notes, and shares of the Company’s common stock or cash (at the option of the Company) for any conversion value in excess of the principal amount at an initial conversion rate of 26.9339 shares of the Company’s common stock per $1,000 principal amount of notes. This represents an initial conversion price of approximately $37.13 per share. Concurrent with the issuance of the notes, the Company entered into separate note hedge and warrant transactions which were structured to reduce the potential future share dilution associated with the conversion of notes. The cost of the note hedge transactions was approximately $52.5 million, $33.4 million net of tax benefits, and the Company received proceeds of $11.9 million related to the sale of the warrants.
The issuance of the convertible senior notes was part of a series of transactions by which the Company refinanced its capital structure. On August 8, 2007, the Company entered into a credit agreement providing for a $250.0 million five year revolving credit facility and a $125.0 million term loan with various financial lenders (the “Senior Credit Facility”). The Senior Credit Facility obligations are secured by substantially all of the Company’s assets. The terms of the Senior Credit Facility also provide for a $20.0 million swingline subfacility and a $50.0 million letter of credit subfacility.
On July 17, 2007, the Company launched a cash tender offer for any and all of its outstanding 9% senior notes and 11% senior discount notes. On August 13, 2007, the Company completed the cash tender offer with 100% of the outstanding principal amount of the notes validly tendered. The Company used proceeds from the sale of the convertible notes and borrowings under the Senior Credit Facility to fund the cash tender offer for the 9% senior notes and the 11% senior discount notes.
On November 19, 2007, the Company’s Board of Directors authorized the Company to commence a stock repurchase program to buy back up to $50.0 million worth of its common stock. The program allowed the Company to purchase shares through open market repurchases and privately negotiated transactions at a price of $26.00 per share or less until the program’s expiration on December 31, 2008. The Company acquired 1,172,700 shares at a total cost of $20.6 million under this program during the fourth quarter of 2007. The Company completed its share repurchase program in the first quarter of 2008, acquiring an additional 1,627,500 shares at a total cost of $29.4 million. Although the Company does not currently intend to repurchase additional shares, the Company will continue to evaluate market conditions and may, subject to approval by the Company’s Board of Directors, repurchase additional shares of its common stock in the future.
On August 22, 2007, the Company completed the acquisition of Montebello Management, LLC (D/B/A Aero Logistics) (“Aero Logistics”), a full service third party logistics provider, for approximately $27.3 million in cash. As of December 23, 2007, $0.5 million is held in escrow pending achievement of 2008 earnings targets and has been excluded from the purchase price. In addition, subsequent to December 23, 2007, the Company completed its assessment of the working capital received and
released $0.4 million originally placed into escrow and paid an additional $0.2 million. The additional $0.2 million increased the total purchase to $27.5 million. Aero Logistics designs and manages custom freight shipping and special handling programs for customers in service-sensitive industries including high-tech, healthcare, energy, mining, retail and apparel. Aero Logistics offers an array of multi-modal transportation services and fully integrated logistics solutions to satisfy the unique needs of its customers. Aero Logistics also operates a fleet of approximately 90 GPS-equipped trailers under the direction of their Aero Transportation division, which provides expedited less-than-truckload (LTL) and full truckload (FTL) service throughout North America.
On June 26, 2007, the Company completed the purchase of Hawaii Stevedores, Inc. (“HSI”) for approximately $4.1 million in cash, net of cash acquired. HSI, which operates as a subsidiary of the Company, is a full service provider of stevedoring and marine terminal services in Hawaii.
In 2007, a draft of a Technical Corrections Act proposed redefining the Puerto Rico trade such that it would not qualify for application of the tonnage tax. However, the Technical Corrections Act, as passed, did not include any language that will adversely affect our utilization of the tonnage tax regime.
During the first half of 2007, the Company modified its trade route between the U.S. west coast and Asia and Guam commencing with the deployment of newly acquired vessels. This deployment enabled the Company to redeploy Jones Act qualified active vessels to other Jones Act routes and to commence a new U.S. west coast to Hawaii trade route with two of the vessels previously deployed in the Guam trade route.
The Jones Act
During 2007, over 85% of our revenues were generated from our shipping and logistics services in markets where the marine trade is subject to the coastwise laws of the United States, also known as the Jones Act, or other U.S. maritime cabotage laws.
The Jones Act is a long-standing cornerstone of U.S. maritime policy. Under the Jones Act, all vessels transporting cargo between covered U.S. ports must, subject to limited exceptions, be built in the U.S., registered under the U.S. flag, manned by predominantly U.S. crews, and owned and operated by U.S.-organized companies that are controlled and 75% owned by U.S. citizens. U.S.-flagged vessels are generally required to be maintained at higher standards than foreign-flagged vessels and are supervised by, as well as subject to rigorous inspections by, or on behalf of the U.S. Coast Guard, which requires appropriate certifications and background checks of the crew members. Our trade routes between Alaska, Hawaii and Puerto Rico and the continental U.S. represent the three non-contiguous Jones Act markets. Vessels operating on these trade routes are required to be fully qualified Jones Act vessels. Other U.S. maritime laws require vessels operating on the trade routes between Guam, a U.S. territory, and U.S. ports to be U.S.-flagged and predominantly U.S.-crewed, but not U.S.-built.
Cabotage laws, which reserve the right to ship cargo between domestic ports to domestic vessels, are not unique to the United States; similar laws are common around the world and exist in over 40 countries. In general, all interstate and intrastate marine commerce within the U.S. falls under the Jones Act, which is a cabotage law. The Jones Act enjoys broad support from both major political parties in both houses of Congress. We believe that the ongoing war on terrorism has further solidified political support for the Jones Act, as a vital and dedicated U.S. merchant marine is a cornerstone for a strong homeland defense, as well as a critical source of trained U.S. mariners for wartime support.
Market Overview and Competition
The Jones Act distinguishes the U.S. domestic shipping market from international shipping markets. Given the limited number of existing Jones Act qualified vessels, the high capital investment and long delivery lead times associated with building a new containership in the U.S., the substantial
investment required in infrastructure and the need to develop a broad base of customer relationships, the markets in which we operate have been less vulnerable to over capacity and volatility than international shipping markets.
Although the U.S. container shipping industry is affected by general economic conditions, the industry does not tend to be as cyclical as other sectors within the shipping industry. Specifically, most of the cargos shipped via container vessels consist of a wide range of consumer and industrial items as well as military and postal loads. Since many of these types of cargos are consumer goods vital to the expanding populations in our markets, they provide us with a stable base of growing demand for our shipping and logistics services.
The Jones Act markets are not as fragmented as international shipping markets. We are one of only two major container shipping operators currently serving the Alaska market, each accounting for approximately 41% of total container loads traveling from the continental U.S. to Alaska. Horizon Lines and TOTE serve the Alaska market. We are also only one of two container shipping companies currently serving the Hawaii and Guam markets with an approximate 36% share of total domestic marine container shipments from the continental U.S. to these markets. This percentage reflects 35% and 52% shares of total domestic marine container shipments from the continental U.S. to Hawaii and Guam markets, respectively. Horizon Lines and Matson Navigation Co (“Matson”) serve the Hawaii and Guam market. In Puerto Rico, we are the largest provider of marine container shipping, accounting for approximately 34% of Puerto Rico’s total container loads from the continental U.S. The Puerto Rico market is currently served by two containership companies, Horizon Lines and Sea Star Lines (“Sea Star”). Sea Star is an independently operated company majority-owned by an affiliate of TOTE. Two barge operators, Crowley and Trailer Bridge, Inc., also currently serve this market.
The U.S. container shipping industry as a whole is experiencing rising customer expectations for real-time shipment status information and the on-time pick-up and delivery of cargo, as customers seek to optimize efficiency through greater management of the delivery process of their products. Commercial and governmental customers are increasingly requiring the tracking of the location and status of their shipments at all times and have developed a strong preference to retrieve information and communicate using the Internet. During 2007, we established a fully-functional intermodal active radio frequency identification (“RFID”) solution providing customers in our Alaska trade real-time shipment visibility during all phases of transit. The active RFID-based real-time tracking system, when matched with Horizon’s industry-leading web-based event management system, offers shipment visibility and supply chain efficiencies by providing real-time detailed shipment information throughout the container’s transit from origin loading facility through to final destination. A broad range of domestic and foreign governmental agencies are also increasingly requiring access to shipping information in automated formats for customs oversight and security purposes.
To ensure on-time pick-up and delivery of cargo, shipping companies must maintain strict vessel schedules and efficient terminal operations for expediting the movement of containers in and out of terminal facilities. The departure and arrival of vessels on schedule is heavily influenced by both vessel maintenance standards (i.e., minimizing mechanical breakdowns) and terminal operating discipline. Marine terminal gate and yard efficiency can be enhanced by efficient yard layout, high-quality information systems, and streamlined gate processes.
Sales and Marketing
We manage a sales and marketing team of 117 employees strategically located in our various ports, as well as in six regional offices across the continental U.S., from our headquarters in Charlotte, North Carolina. Senior sales and marketing professionals are responsible for developing sales and marketing strategies and are closely involved in servicing our largest customers. All pricing activities are also centrally coordinated from Charlotte and from Renton, Washington, enabling us to manage our customer relationships. The marketing team located in Charlotte is responsible for providing appropriate market intelligence and direction to the Puerto Rico sales organization. The marketing
team located in Renton is responsible for providing appropriate market intelligence and direction to the members of the team who focus on the Hawaii, Guam and Alaska markets.
Our regional sales and marketing presence ensures close and direct interaction with customers on a daily basis. Many of our regional sales professionals have been servicing the same customers for over ten years. We believe that we have the largest sales force of all container shipping and logistics companies active in our markets. Unlike our competitors, our sales force cross-sells our shipping and logistics services across all of these markets. We believe that the breadth and depth of our relationships with our customers is the principal driver of repeat business from our customers.
Customers
We serve a diverse base of long-standing, established customers consisting of many of the world’s largest consumer and industrial products companies. Such customers include Costco Wholesale Corporation, Johnson & Johnson, Lowe’s Companies, Inc., Safeway, Inc., Toyota Motor Corporation and Wal-Mart Stores, Inc. In addition, we serve several agencies of the U.S. government, including the Department of Defense and the U.S. Postal Service.
We believe that we are uniquely positioned to serve these and other large national customers due to our position as the only shipping and logistics company serving all three non-contiguous Jones Act markets and Guam and Asia. Approximately 60% of our transportation revenue in 2007 was derived from customers shipping with us in more than one of our markets and approximately 33% of our transportation revenue in 2007 being derived from customers shipping with us in all three markets.
We generate most of our revenue through customer contracts with pre-specified rates and volumes and with durations ranging from one to six years, providing stable revenue streams. The majority of our customer contracts contain provisions that allow us to implement fuel surcharges based on fluctuations in our fuel costs. In addition, our relationships with our customers extend far beyond the length of any given contract. For example, some of our customer relationships extend back over 40 years and our top ten customer relationships average 30 years.
We serve customers in numerous industries and carry a wide variety of cargos, mitigating our dependence upon any single customer or single type of cargo. Our customer base is broad with no significant concentration by customer or type of cargo shipped. For 2007, our top ten largest customers represented approximately 32% of transportation revenue, with the largest customer accounting for approximately 8% of transportation revenue. During 2007, our top ten largest customers comprised approximately 35% of total revenue, with our largest customer accounting for approximately 8% of total revenue. Total revenue includes transportation, non-transportation and other revenue.
Industry and market data used throughout this Form 10-K, including information relating to our relative position in the shipping and logistics industries are approximations based on the good faith estimates of our management, which are generally based on internal surveys and sources, and other publicly available information, including local port information. Unless otherwise noted, financial data and industry and market data presented herein are for a period ending in December 2007.
Operations Overview
Our operations share corporate and administrative functions such as finance, information technology and sales and marketing. Centralized functions are performed primarily at our headquarters and at our operations center in Irving, Texas.
We book and monitor all of our shipping and logistics services with our customers through the Horizon Information Technology System (“HITS”). HITS, our proprietary ocean shipping and logistics information technology system, provides a platform to accomplish a shipping transaction from start to finish in a cost-effective, streamlined manner. HITS provides an extensive database of information relevant to the shipment of containerized cargo and captures all critical aspects of every shipment
booked with us. In a typical transaction, our customers go on-line to make a booking or call, fax or e-mail our customer service department. Once applicable shipping information is input into the booking system, a booking number is generated. The booking information then downloads into other systems used by our dispatch team, terminal personnel, vessel planners, documentation team, logistics team and other teams and personnel who work together to produce a seamless transaction for our customers.
Our dispatch team coordinates truck and/or rail shipping from inland locations to the port on intermodal bookings. We currently purchase rail services directly from the railroads involved through confidential transportation service contracts, except for services from CSX Transportation which are obtained through our contract with CSX Intermodal, an affiliate of CSX Transportation. Our terminal personnel schedule equipment availability for containers picked up at the port. Our vessel planners develop stowage plans and our documentation teams process the cargo bill. We review space availability and inform our other teams and personnel when additional bookings are needed and when bookings need to be changed or pushed to the next vessel. After containers arrive at the port of loading, they are loaded on board the vessel. Once the containers are loaded and are at sea, our destination terminal staff initiates their process of receiving and releasing containers to our customers. Customers accessing HITS via our internet portal have the option to receive e-mail alerts as specific events take place throughout this process. All of our customers have the option to call our customer service department or to access HITS via our internet portal, 24 hours a day, seven days a week, to track and trace shipments. Customers may also view their payment histories and make payments on-line.
Insurance
We maintain insurance policies to cover risks related to physical damage to our vessels and vessel equipment, other equipment (including containers, chassis, terminal equipment and trucks) and property, as well as with respect to third-party liabilities arising from the carriage of goods, the operation of vessels and shoreside equipment, and general liabilities which may arise through the course of our normal business operations. We also maintain workers compensation insurance, business interruption insurance, and directors’ and officers’ insurance providing indemnification for our directors, officers, and certain employees for some liabilities.
Vessel Fleet
Our management team adheres to an effective strategy for the maintenance of our vessels. Early in our 50-year operating history, when we pioneered Jones Act container shipping, we recognized the vital importance of maintaining our valuable Jones Act qualified vessels. Our on-shore vessel management team carefully manages all of our ongoing regular maintenance and drydocking activity. We maintain our vessels according to our own strict maintenance procedures, which meet or exceed U.S. government requirements. All of our vessels are regulated pursuant to rigorous standards promulgated by the U.S. Coast Guard and subject to periodic inspection and certification, for compliance with these standards, by the American Bureau of Shipping, on behalf of the U.S. Coast Guard. Our procedures protect and preserve our fleet to the highest standards in our industry and enable us to preserve the usefulness of our ships. During each of the last four years, our vessels have been in operational condition, ready to sail, over 99% of the time when they were required to be ready to sail.
The table below lists our vessel fleet, which is the largest containership fleet within the Jones Act markets, as of December 23, 2007. Our vessel fleet consists of 21 vessels of varying classes and specification, 16 of which are Jones Act qualified. Of the 16 vessels that are actively deployed, 11 are Jones Act qualified and five Jones Act qualified vessels are spare vessels available for seasonal and dry-dock needs and to respond to potential new revenue opportunities.
(1)
Twenty-foot equivalent unit, or TEU, is a standard measure of cargo volume correlated to the volume of a standard 20-foot dry cargo container.
(2)
Reefer capacity, or refrigerated container capacity, refers to the total number of 40-foot equivalent units, or FEUs, which the vessel can hold. The FEU is a standard measure of refrigerated cargo volume correlated to the volume of a standard 40-foot reefer, or refrigerated cargo container.
(3)
Serves as a spare vessel available for deployment in any of our markets and also serves the Alaska trade from June through August.
(4)
Were deployed in the Hawaii & Guam market during 2007. Are currently deployed in the Puerto Rico market.
(5)
Vessels are available for seasonal needs, dry-dock relief and to respond to potential new revenue opportunities, and thus are not specific to any given market.
Our Vessel Charters
Eight of our vessels, the Horizon Anchorage, Horizon Tacoma, Horizon Kodiak, Horizon Hunter, Horizon Hawk, Horizon Eagle, Horizon Falcon and Horizon Tiger are leased, or chartered, under charters that are due to expire in January 2015 for the Horizon Anchorage, Horizon Tacoma and Horizon Kodiak, in 2018 for the Horizon Hunter and in 2019 for the Horizon Hawk, Horizon Eagle, Horizon Falcon and Horizon Tiger. Under the charter for each chartered vessel, we generally have the following options in connection with the expiration of the charter: (i) purchase the vessel for its fair
market value, (ii) extend the charter for an agreed upon period of time at a fair market value charter rate or, (iii) return the vessel to its owner.
The obligations under the existing charters for the Horizon Anchorage, Horizon Tacoma and Horizon Kodiak are guaranteed by our former parent, CSX Corporation, and certain of its affiliates. In turn, certain of our subsidiaries are parties to the Amended and Restated Guarantee and Indemnity Agreement, referred to herein as the GIA, with CSX Corporation and certain of its affiliates, pursuant to which these subsidiaries have agreed to indemnify these CSX entities if any of them should be called upon by any owner of the chartered vessels to make payments to such owner under the guarantees referred to above.
Our Container Fleet
As summarized in the table below, our container fleet consists of owned and leased containers of different types and sizes as of December 23, 2007:
All of our container leases are operating leases.
Maersk Arrangements
In connection with the sale of the international marine container operations of Sea-Land by our former parent, CSX Corporation, to Maersk, in December 1999, our predecessor, CSX Lines, LLC and certain of its subsidiaries entered into a number of commercial agreements with Maersk that encompass terminal services, equipment sharing, sales agency services, trucking services, cargo space charters, and transportation services. These agreements, which were renewed and amended in December 2006, generally are now scheduled to expire at the end of 2010. Maersk is our terminal service provider in the continental U.S., at our ports in Elizabeth, New Jersey, Jacksonville, Florida, Houston, Texas, Tacoma, Washington, and Oakland and Los Angeles, California. We are Maersk’s terminal operator in Hawaii, Guam, Alaska and Puerto Rico. We share containers with Maersk and also pool chassis and generator sets with Maersk. We are Maersk’s sales agent in Alaska and Puerto
Rico, and Maersk serves as our sales agent in Canada. On the U.S. west coast, we provide trucking services for Maersk.
Under our cargo space charter and transportation service agreements with Maersk, we currently operate five foreign built U.S.-flagged vessels that sail from the U.S. west coast to Hawaii, continuing from Hawaii on to Guam, and then from Guam on to Yantian, China, Hong Kong and Kaohsiung, Taiwan, with a return trip to Tacoma, Washington, and Oakland, California. We utilize Maersk containers to carry a portion of our cargo westbound to Hawaii and Guam, where the contents of these containers are then unloaded. We then ship the empty Maersk containers onwards to the three ports in Asia. When these vessels arrive in Asia, Maersk unloads these empty containers and replaces them with loaded containers on our vessels for the return trip to the U.S. west coast. We use Maersk equipment on our service to Hawaii from our U.S. west coast ports as well as from select U.S. inland locations. We achieve significantly greater vessel capacity utilization and revenue on this route as a result of this arrangement. We do not transport any domestic cargo between the U.S. mainland and Hawaii on these vessels. We do carry some international cargo to and from Hawaii for Maersk.
Security
Heightened awareness of maritime security needs, brought about by the events of September 11, 2001 and several maritime attacks around the globe, have caused the United Nations through its International Maritime Organization (“IMO”), the U.S. Department of Homeland Security, through its Coast Guard arm, and the states and local ports to adopt a more stringent set of security procedures relating to the interface between port facilities and vessels. In addition, the U.S. Congress and the current administration have enacted legislation requiring the implementation of Coast Guard approved vessel and facility security plans.
Certain aspects of our security plans require our investing in infrastructure upgrades to ensure compliance. We have applied in the past and will continue to apply going forward for federal grants to offset the incremental expense of these security investments. While we were successful through two early rounds of funding to secure substantial grants for specific security projects, the current grant award criteria favor the largest ports and stakeholder consortia applications, limiting the available funds for stand alone private maritime industry stakeholders. In addition, the current administration is continuously reviewing the criteria for awarding such grants. Such changes could have a negative impact on our ability to win grant funding in the future. Security surcharges are evaluated regularly and we may at times incorporate these surcharges into the base transportation rates that we charge.
Capital Construction Fund
The Merchant Marine Act, 1936, as amended, permits the limited deferral of U.S. federal income taxes on earnings from eligible U.S.-built and U.S.-flagged vessels and U.S.-built containers if the earnings are deposited into a Capital Construction Fund (“CCF”), pursuant to an agreement with the U.S. Maritime Administration, (“MARAD”). The amounts on deposit in a CCF can be withdrawn and used for the acquisition, construction or reconstruction of U.S.-built and U.S.-flagged vessels or U.S.-built containers.
Horizon Lines has a CCF agreement with MARAD under which it occasionally deposits into the CCF earnings attributable to the operation of 16 of its vessels and makes withdrawals of funds from the CCF to acquire U.S.-built and U.S.-flagged vessels and U.S.-built refrigeration units for our containers. During 2005, Horizon Lines acquired with available cash of $25.2 million and the assumption of debt of $4.5 million, the rights and beneficial interests of the sole owner participant in two separate trusts, the assets of which consist primarily of the Horizon Enterprise and the Horizon Pacific, and the charters related thereto under which Horizon Lines operates such vessels. These vessels were subject to mortgages in the aggregate amount of $4.5 million, which were paid on January 2, 2007. Four used U.S.-built and U.S.-flagged vessels (Horizon Hawaii, Horizon Fairbanks,
Horizon Navigator, and Horizon Trader) were acquired by Horizon Lines in 2003 and 2004 for a total of $25.2 million through the exercise of purchase options under the charters for these vessels.
Amounts on deposit in Horizon Lines’ CCF cannot be withdrawn for other than the qualified purposes specified in the CCF agreement. Any nonqualified withdrawals are subject to federal income tax at the highest marginal rate. In addition, such tax is subject to an interest charge based upon the number of years the funds have been on deposit. If Horizon Lines’ CCF agreement was terminated, funds then on deposit in the CCF would be treated as nonqualified withdrawals for that taxable year. In addition, if a vessel built, acquired, or reconstructed with CCF funds is operated in a nonqualified operation, the owner must repay a proportionate amount of the tax benefits as liquidated damages. These restrictions apply (i) for 20 years after delivery in the case of vessels built with CCF funds, (ii) ten years in the case of vessels reconstructed or acquired with CCF funds more than one year after delivery from the shipyard, and (iii) ten years after the first expenditure of CCF funds in the case of vessels in regard to which qualified withdrawals from the CCF fund have been made to pay existing indebtedness (five years if the vessels are more than 15 years old on the date the withdrawal is made). In addition, the sale or mortgage of a vessel acquired with CCF funds requires MARAD’s approval. Our consolidated balance sheets at December 23, 2007 and December 24, 2006 include liabilities of approximately $13.1 million and $14.1 million, respectively, for deferred taxes on deposits in our CCF.
Employees
As of December 23, 2007, we had 2,162 employees, of which approximately 1,459 were represented by seven labor unions.
The table below sets forth the unions which represent our employees, the number of employees represented by these unions as of December 23, 2007 and the expiration dates of the related collective bargaining agreements:
(1)
Our employees who are covered under this agreement are continuing to work under an old agreement while we negotiate a new agreement.
(2)
Multi-employer arrangement representing workers in the industry, including workers who may perform services for us but are not our employees.
The table below provides a breakdown of headcount by non-contiguous Jones Act market and function for our non-union employees as of December 23, 2007.
(a)
Corporate headcount includes employees in both Charlotte, North Carolina (headquarters) and in Irving, Texas and other locations.
(b)
Administration headcount includes customer service and documentation personnel.
Available Information
The mailing address of the Company’s Executive Office is 4064 Colony Road, Suite 200, Charlotte, North Carolina 28211 and the telephone number at that location is (704) 973-7000. The Company’s most recent SEC filings can be found on the SEC’s website, www.sec.gov, and on the Company’s website, www.horizonlines.com. The Company’s 2007 annual report on Form 10-K will be available on the Company’s website as soon as reasonably practicable. All such filings are available free of charge. The contents of our website are not incorporated by reference into this Form 10-K. The public may read and copy any materials the Company files with the SEC at the SEC’s Public Reference Room at 450 Fifth Street, N.W., Washington, DC 20549. The public may obtain information on the operation of the Public Reference Room by calling 1-800-SEC-0330.
Item 1A.
Item 1A.
Risk Factors
Rising Fuel Prices May Adversely Affect Our Profits.
Fuel is a significant operating expense for our shipping operations. The price and supply of fuel is unpredictable and fluctuates based on events outside our control, including geopolitical developments, supply and demand for oil and gas, actions by OPEC and other oil and gas producers, war and unrest in oil producing countries and regions, regional production patterns and environmental concerns. As a result, increases in the price of fuel, such as we are currently experiencing, may adversely affect profitability. There can be no assurance that our customers will agree to bear such fuel price increases via fuel surcharges without a reduction in their volumes of business with us nor any assurance that our future fuel hedging efforts, if any, will be successful.
In addition, a bill has been introduced in the Senate that will limit the sulphur content of fuel used by vessels that enter or leave U.S. ports. As a result of any such legislation or other laws affecting emissions of marine vessels, we may be required to use more expensive fuels or modify our vessels which will result in an increase in our cost of operations.
A decrease in Shipping Volume in Our Markets Will Adversely Affect Our Business.
Demand for our shipping services depends on levels of shipping in our Jones Act markets and in the Guam market, as well as on economic and trade growth and logistics. Cyclical or other recessions in the continental U.S. or in these markets can negatively affect our operating results as customers may ship fewer containers or may ship containers only at reduced rates. For example, shipping volume in Puerto Rico was down 8% in 2007 as compared to 2006 as a result of economic conditions
in Puerto Rico. The economic downturn in Puerto Rico negatively affected our earnings. We cannot predict whether or when such downturns will occur.
Change in Tax Laws or the Interpretation Thereof, Adverse Tax Audits and Other Tax Matters Related to Our Tonnage Tax Election or Such Tax May Adversely Affect Our Future Results.
During 2006, after evaluating the merits and requirements of the tonnage tax, we elected the application of the tonnage tax instead of the federal corporate income tax on income from our qualifying shipping activities. Changes in tax laws or the interpretation thereof, adverse tax audits, and other tax matters related to such tax election or such tax may adversely affect our future results.
During the fourth quarter of 2007, a draft of a Technical Corrections Act proposed redefining the Puerto Rico trade to not qualify for application of the tonnage tax. The tax writing committee in Congress removed the tonnage tax repeal language from the Technical Corrections Act before its passage, but we cannot assure you that there will not be future efforts to repeal all, or any portion of, the tonnage tax as it applies to our shipping activities.
If We are Unable to Implement Our Business Strategy, Our Future Results Could be Adversely Affected.
Our future results of operations will depend in significant part on the extent to which we can implement our business strategy successfully. Our business strategy includes continuing to organically grow our revenue, providing complete shipping and logistics services, leveraging our capabilities to serve a broad range of customers, leveraging our brand, maintaining industry-leading information technology, pursuing strategic acquisitions and reducing operating costs. Our strategy is subject to business, economic and competitive uncertainties and contingencies, many of which are beyond our control. As a consequence, we may not be able to fully implement our strategy or realize the anticipated results of our strategy.
Repeal, Substantial Amendment, or Waiver of the Jones Act or its Application Could Have a Material Adverse Effect on Our Business.
If the Jones Act were to be repealed, substantially amended, or waived and, as a consequence, competitors with lower operating costs were to enter any of our Jones Act markets, our business would be materially adversely affected. In addition, our advantage as a U.S.-citizen operator of Jones Act vessels could be eroded by periodic efforts and attempts by foreign interests to circumvent certain aspects of the Jones Act. If maritime cabotage services were included in the General Agreement on Trade in Services, the North American Free Trade Agreement or other international trade agreements, or if the restrictions contained in the Jones Act were otherwise altered, the shipping of maritime cargo between covered U.S. ports could be opened to foreign-flag or foreign-built vessels.
In September 2005, the Department of Homeland Security issued limited temporary waivers of the Jones Act solely to permit the transport of petroleum and refined petroleum products in the United States in response to the damage caused to the nation’s oil and gas production facilities and pipelines by Hurricanes Katrina and Rita. There can be no assurance as to the timing of any future waivers of the Jones Act or that any such waivers will be limited to the transport of petroleum and refined petroleum products.
Our Failure to Renew Our Commercial Agreements With Maersk in the Future Could Have a Material Adverse Effect on Our Business.
We have several commercial agreements with Maersk, an international shipping company, that encompass terminal services, equipment sharing, cargo space charters, sales agency services, trucking services, and transportation services. For example, under these agreements, Maersk provides us with terminal services at six ports located in the continental U.S. (Elizabeth, New Jersey; Jacksonville, Florida; Houston, Texas; Los Angeles and Oakland, California; and Tacoma,
Washington). In general, these agreements, which were renewed and amended in December 2006, are currently scheduled to expire at the end of 2010. If we fail to renew these agreements in the future, the requirements of our business will necessitate that we enter into substitute commercial agreements with third parties for at least some portion of the services contemplated under our existing commercial agreements with Maersk, such as terminal services at our ports located in the continental U.S. There can be no assurance that, if we fail to renew our commercial agreements with Maersk, we will be successful in negotiating and entering into substitute commercial agreements with third parties and, even if we succeed in doing so, the terms and conditions of these new agreements, individually or in the aggregate, may be significantly less favorable to us than the terms and conditions of our existing agreements with Maersk or others. Furthermore, if we do enter into substitute commercial agreements with third parties, changes in our operations to comply with the requirements of these new agreements (such as our use of other terminals in our existing ports in the continental U.S. or our use of other ports in the continental U.S.) may cause disruptions to our business, which could be significant, and may result in additional costs and expenses and possible losses of revenue.
Our Industry is Unionized and Strikes By Our Union Employees or Others in the Industry May Disrupt our Services and Adversely Affect Our Operations.
As of December 23, 2007, we had 2,162 employees, of which 1,459 were unionized employees represented by seven different labor unions. Our industry is susceptible to work stoppages and other adverse employee actions due to the strong influence of maritime trade unions. We may be adversely affected by future industrial action against efforts by our management or the management of other companies in our industry to reduce labor costs, restrain wage increases or modify work practices. For example, in 2002 our operations at our U.S. west coast ports were significantly affected by a 10-day labor interruption by the International Longshore and Warehouse Union. This interruption affected ports and shippers throughout the U.S. west coast.
In addition, in the future, we may not be able to negotiate, on terms and conditions favorable to us, renewals of our collective bargaining agreements with unions in our industry and strikes and disruptions may occur as a result of our failure or the failure of other companies in our industry to negotiate collective bargaining agreements with such unions successfully.
One of our collective bargaining agreements with our unions has expired. Our employees who are covered under this agreement are continuing to work under the old agreement while we negotiate a new agreement. Our other collective bargaining agreements are scheduled to expire from 2008-2012.
Our Employees are Covered by Federal Laws that May Subject us to Job-Related Claims in Addition to Those Provided by State Laws.
Some of our employees are covered by several maritime statutes, including provisions of the Jones Act, the Death on the High Seas Act, the Seamen’s Wage Act and general maritime law. These laws typically operate to make liability limits established by state workers’ compensation laws inapplicable to these employees and to permit these employees and their representatives to pursue actions against employers for job-related injuries in federal courts. Because we are not generally protected by the limits imposed by state workers’ compensation statutes for these employees, we may have greater exposure for any claims made by these employees than is customary in the United States.
Due to Our Participation in Multi-Employer Pension Plans, We May Have Exposure Under Those Plans that Extends Beyond What Our Obligations Would be with Respect to Our Employees.
We contribute to fifteen multi-employer pension plans. In the event of a partial or complete withdrawal by us from any plan which is underfunded, we would be liable for a proportionate share of such plan’s unfunded vested benefits. Based on the limited information available from plan
administrators, which we cannot independently validate, we believe that our portion of the contingent liability in the case of a full withdrawal or termination would be material to our financial position and results of operations. In the event that any other contributing employer withdraws from any plan which is underfunded, and such employer (or any member in its controlled group) cannot satisfy its obligations under the plan at the time of withdrawal, then we, along with the other remaining contributing employers, would be liable for our proportionate share of such plan’s unfunded vested benefits. We have no current intention of taking any action that would subject us to any withdrawal liability and cannot assure you that no other contributing employer will take such action.
In addition, if a multi-employer plan fails to satisfy the minimum funding requirements, the Internal Revenue Service, pursuant to Section 4971 of the Internal Revenue Code of 1986, as amended, referred to herein as the Code, will impose an excise tax of five (5%) percent on the amount of the accumulated funding deficiency. Under Section 413(c)(5) of the Code, the liability of each contributing employer, including us, will be determined in part by each employer’s respective delinquency in meeting the required employer contributions under the plan. The Code also requires contributing employers to make additional contributions in order to reduce the deficiency to zero, which may, along with the payment of the excise tax, have a material adverse impact on our financial results.
Compliance With Safety and Environmental Protection and Other Governmental Requirements May Adversely Affect Our Operations.
The shipping industry in general and our business and the operation of our vessels and terminals in particular are affected by extensive and changing safety, environmental protection and other international, national, state and local governmental laws and regulations. For example, our vessels, as U.S.-flagged vessels, generally must be maintained “in class” and are subject to periodic inspections by the American Bureau of Shipping or similar classification societies, and must be periodically inspected by, or on behalf of, the U.S. Coast Guard. In addition, the United States Oil Pollution Act of 1990 (referred to as OPA), the Comprehensive Environmental Response, Compensation & Liability Act of 1980 (referred to as CERCLA), and certain state laws require us, as a vessel operator, to obtain certificates of financial responsibility and to adopt procedures for oil or hazardous substance spill prevention, response and clean up. In complying with these laws, we have incurred expenses and may incur future expenses for ship modifications and changes in operating procedures. Changes in enforcement policies for existing requirements and additional laws and regulations adopted in the future could limit our ability to do business or further increase the cost of our doing business.
We believe our vessels are maintained in good condition in compliance with present regulatory requirements, are operated in compliance in all material respects with applicable safety/environmental laws and regulations and are insured against the usual risks for such amounts as our management deems appropriate. Our vessels’ operating certificates and licenses are renewed periodically during the required annual surveys of the vessels. However, there can be no assurance that such certificates and licenses will be renewed. Also, in the future, we may have to alter existing equipment, add new equipment to, or change operating procedures for, our vessels to comply with changes in governmental regulations, safety or other equipment standards to meet our customers’ changing needs. If any such costs are material, they could adversely affect our financial condition.
We are Subject to New Statutory and Regulatory Directives in the United States Addressing Homeland Security Concerns that May Increase Our Costs and Adversely Affect Our Operations.
Various government agencies within the Department of Homeland Security (“DHS”), including the Transportation Security Administration, the U.S. Coast Guard, and U.S. Bureau of Customs and Border Protection, have adopted, and may adopt in the future, new rules, policies or regulations or changes in the interpretation or application of existing laws, rules, policies or regulations, compliance with which could increase our costs or result in loss of revenue.
The Coast Guard’s new maritime security regulations, issued pursuant to the Maritime Transportation Security Act of 2002 (“MTSA”), require us to operate our vessels and facilities pursuant to both the maritime security regulations and approved security plans. Our vessels and facilities are subject to periodic security compliance verification examinations by the Coast Guard. A failure to operate in accordance with the maritime security regulations or the approved security plans may result in the imposition of a fine or control and compliance measures, including the suspension or revocation of the security plan, thereby making the vessel or facility ineligible to operate. We are also required to audit these security plans on an annual basis and, if necessary, submit amendments to the Coast Guard for its review and approval. Failure to timely submit the necessary amendments may lead to the imposition of the fines and control and compliance measures mentioned above. Failure to meet the requirements of the maritime security regulations could have a material adverse effect on our results of operations.
DHS may adopt additional security-related regulations, including new requirements for screening of cargo and our reimbursement to the agency for the cost of security services. These new security-related regulations could have an adverse impact on our ability to efficiently process cargo or could increase our costs. In particular, our customers typically need quick shipping of their cargos and rely on our on-time shipping capabilities. If these regulations disrupt or impede the timing of our shipments, we may fail to meet the needs of our customers, or may increase expenses to do so.
Increased Inspection Procedures and Tighter Import and Export Controls Could Increase Costs and Disrupt Our Business.
Domestic and international container shipping is subject to various security and customs inspection and related procedures, referred to herein as inspection procedures, in countries of origin and destination as well as in countries in which transshipment points are located. Inspection procedures can result in the seizure of containers or their contents, delays in the loading, offloading, transshipment or delivery of containers and the levying of customs duties, fines or other penalties against exporters or importers (and, in some cases, shipping and logistics companies such as us). Failure to comply with these procedures may result in the imposition of fines and/or the taking of control or compliance measures by the applicable governmental agency, including the denial of entry into U.S. waters.
We understand that, currently, only a small proportion of all containers delivered to the United States are physically inspected by U.S., state or local authorities prior to delivery to their destinations. The U.S. government, foreign governments, international organizations, and industry associations have been considering ways to improve and expand inspection procedures. There are numerous proposals to enhance the existing inspection procedures, which if implemented would likely affect shipping and logistics companies such as us. Such changes could impose additional financial and legal obligations on us, including additional responsibility for physically inspecting and recording the contents of containers we are shipping. In addition, changes to inspection procedures could impose additional costs and obligations on our customers and may, in certain cases, render the shipment of certain types of cargo by container uneconomical or impractical. Any such changes or developments may have a material adverse effect on our business, financial condition and results of operations.
Restrictions on Foreign Ownership of Our Vessels Could Limit Our Ability to Sell Off Any Portion of Our Business or Result in the Forfeiture of Our Vessels.
The Jones Act restricts the foreign ownership interests in the entities that directly or indirectly own the vessels which we operate in our Jones Act markets. If we were to seek to sell any portion of our business that owns any of these vessels, we would have fewer potential purchasers, since some potential purchasers might be unable or unwilling to satisfy the foreign ownership restrictions described above. As a result, the sales price for that portion of our business may not attain the amount that could be obtained in an unregulated market. Furthermore, at any point Horizon Lines, LLC, our indirect wholly-owned subsidiary and principal operating subsidiary, ceases to be controlled
and 75% owned by U.S. citizens, we would become ineligible to operate in our current Jones Act markets and may become subject to penalties and risk forfeiture of our vessels.
No Assurance Can Be Given that Our Insurance Costs Will Not Escalate.
Certain of our insurance coverage is provided by mutual clubs. Mutual clubs rely on member premiums, investment reserves and income, and reinsurance to manage liability risks on behalf of its members. Increased investment losses, underwriting losses, or reinsurance costs could cause insurance clubs to substantially raise the cost of premiums, resulting not only in higher premium costs but also higher levels of deductibles and self-insurance retentions.
Catastrophic Losses and Other Liabilities Could Adversely Affect Our Results of Operations and Such Losses and Liability May Be Beyond Insurance Coverage.
The operation of any oceangoing vessel carries with it an inherent risk of catastrophic maritime disaster, mechanical failure, collision, and loss of or damage to cargo. Also, in the course of the operation of our vessels, marine disasters, such as oil spills and other environmental mishaps, cargo loss or damage, and business interruption due to political or other developments, as well as maritime disasters not involving us, labor disputes, strikes and adverse weather conditions, could result in loss of revenue, liabilities or increased costs, personal injury, loss of life, severe damage to and destruction of property and equipment, pollution or environmental damage and suspension of operations. Damage arising from such occurrences may result in lawsuits asserting large claims.
Although we maintain insurance, including retentions and deductibles, at levels that we believe are consistent with industry norms against the risks described above, including loss of life, there can be no assurance that this insurance would be sufficient to cover the cost of damages suffered by us from the occurrence of all of the risks described above or the loss of income resulting from one or more of our vessels being removed from operation. We also cannot assure you that a claim will be paid or that we will be able to obtain insurance at commercially reasonable rates in the future. Further, if we are negligent or otherwise responsible in connection with any such event, our insurance may not cover our claim.
In the event that any of the claims arising from any of the foregoing possible events were assessed against us, all of our assets could be subject to attachment and other judicial process.
As a result of the significant insurance losses incurred in the September 11, 2001 attack and related concern regarding terrorist attacks, global insurance markets increased premiums and reduced or restricted coverage for terrorist losses generally. Accordingly, premiums payable for terrorist coverage have increased substantially and the level of terrorist coverage has been significantly reduced.
Additionally, new and stricter environmental regulations have led to higher costs for insurance covering environmental damage or pollution, and new regulations could lead to similar increases or even make this type of insurance unavailable.
The Reliability of Our Service May Be Adversely Affected if Our Spare Vessels Reserved For Relief are Not Deployed Efficiently Under Extreme Circumstances, Which Could Damage Our Reputation and Harm Our Operating Results.
We generally keep spare vessels in reserve available for relief if one of our vessels in active service suffers a maritime disaster or must be unexpectedly removed from service for repairs. However, these spare vessels may require several days of sailing before it can replace the other vessel, resulting in service disruptions and loss of revenue. If more than one of our vessels in active service suffers a maritime disaster or must be unexpectedly removed from service, we may have to redeploy vessels from our other trade routes, or lease one or more vessels from third parties. We may
suffer a material adverse effect on our business if we are unable to rapidly deploy one of our spare vessels and we fail to provide on-time scheduled service and adequate capacity to our customers.
Interruption or Failure of Our Information Technology and Communications Systems Could Impair Our Ability to Effectively Provide Our Shipping and Logistics Services, Especially HITS, Which Could Damage Our Reputation and Harm Our Operating Results.
Our provision of our shipping and logistics services depends on the continuing operation of our information technology and communications systems, especially HITS. We have experienced brief system failures in the past and may experience brief or substantial failures in the future. Any failure of our systems could result in interruptions in our service reducing our revenue and profits and damaging our brand. Some of our systems are not fully redundant, and our disaster recovery planning does not account for all eventualities. The occurrence of a natural disaster, or other unanticipated problems at our facilities at which we maintain and operate our systems could result in lengthy interruptions or delays in our shipping and logistics services, especially HITS.
Our Vessels Could Be Arrested By Maritime Claimants, Which Could Result in Significant Loss of Earnings and Cash Flow.
Crew members, suppliers of goods and services to a vessel, shippers of cargo, lenders and other parties may be entitled to a maritime lien against a vessel for unsatisfied debts, claims or damages. In many jurisdictions, a claimant may enforce its lien by either arresting or attaching a vessel through foreclosure proceedings. Moreover, crew members may place liens for unpaid wages that can include significant statutory penalty wages if the unpaid wages remain overdue (e.g., double wages for every day during which the unpaid wages remain overdue). The arrest or attachment of one or more of our vessels could result in a significant loss of earnings and cash flow for the period during which the arrest or attachment is continuing.
In addition, international vessel arrest conventions and certain national jurisdictions allow so-called sister-ship arrests, which allow the arrest of vessels that are within the same legal ownership as the vessel which is subject to the claim or lien. Certain jurisdictions go further, permitting not only the arrest of vessels within the same legal ownership, but also any associated vessel. In nations with these laws, an association may be recognized when two vessels are owned by companies controlled by the same party. Consequently, a claim may be asserted against us or any of our vessels for the liability of one or more of the other vessels that we own.
We are Susceptible to Severe Weather and Natural Disasters.
Our operations are vulnerable to disruption as a result of weather and natural disasters such as bad weather at sea, hurricanes, typhoons and earthquakes. Such events will interfere with our ability to provide the on-time scheduled service our customers demand resulting in increased expenses and potential loss of business associated with such events. In addition, severe weather and natural disasters can result in interference with our terminal operations, and may cause serious damage to our vessels, loss or damage to containers, cargo and other equipment and loss of life or physical injury to our employees. Terminals in the South Pacific Ocean, particularly in Guam, and terminals on the east coast of the continental U.S. and in the Caribbean are particularly susceptible to hurricanes and typhoons. In the recent past, the terminal at our port in Guam was seriously damaged by a typhoon and our terminal in Puerto Rico was seriously damaged by a hurricane. These storms resulted in damage to cranes and other equipment and closure of these facilities. Earthquakes in Anchorage and in Guam have also damaged our terminal facilities resulting in delay in terminal operations and increased expenses. Any such damage will not be fully covered by insurance.
We May Face New Competitors.
Other established or start-up shipping operators may enter our markets to compete with us for business.
Existing non-Jones Act qualified shipping operators whose container ships sail between ports in Asia and the U.S. west coast could add Hawaii, Guam or Alaska as additional stops on their sailing routes for non-U.S. originated or destined cargo. Shipping operators could also add Puerto Rico as a new stop on sailings of their vessels between the continental U.S. and ports in Europe, the Caribbean, and Latin America for non-U.S.
originated or destined cargo. Further, shipping operators could introduce U.S.-flagged vessels into service sailing between Guam and U.S. ports, including ports on the U.S. west coast or in Hawaii. On these routes to and from Guam no limits would apply as to the origin or destination of the cargo dropped off or picked up. In addition, current or new U.S. citizen shipping operators may order the building of new vessels by U.S. shipyards and may introduce these U.S.-built vessels into Jones Act qualified service on one or more of our trade routes. These potential competitors may have access to financial resources substantially greater than our own. The entry of a new competitor on any of our trade routes could result in a significant increase in available shipping capacity that could have a material adverse effect on our business, financial condition, results of operations and cash flows.
We May Not Exercise Our Purchase Options For Our Chartered Vessels.
We intend to exercise our purchase options for up to three of the vessels that we have chartered upon the expiration of their charters in January 2015. In addition, we have not determined whether we will exercise our scheduled purchase options for the five newly built U.S.-flag vessels that we have chartered. There can be no assurance that, when these options for these eight vessels become exercisable, the price at which these vessels may be purchased will be reasonable in light of the fair market value of these vessels at such time or that we will have the funds required to make these purchases. As a result, we may not exercise our options to purchase these vessels. If we do not exercise our options, we may need to renew our existing charters for these vessels or charter replacement vessels. There can be no assurance that our existing charters will be renewed, or, if renewed, that they will be renewed at favorable rates, or, if not renewed, that we will be able to charter replacement vessels at favorable rates.
We May Face Significant Costs As the Vessels Currently in Our Fleet Age.
We believe that each of the vessels we currently operate has an estimated useful life of approximately 45 years from the year it was built. As of the date hereof, the average age of our active vessels is approximately 21 years and the average age of our Jones Act vessels is approximately 31 years. We expect to incur increasing costs to operate and maintain the vessels in good condition as they age. Eventually, these vessels will need to be replaced. We may not be able to replace all of our existing vessels with new vessels based on uncertainties related to financing, timing and shipyard availability.
We May Face Unexpected Substantial Drydocking Costs For Our Vessels.
Our vessels are drydocked periodically to comply with regulatory requirements and to affect maintenance and repairs, if necessary. The cost of such repairs at each drydocking are difficult to predict with certainty and can be substantial. Our established processes have enabled us to make on average six drydockings per year over the last five years with a minimal impact on schedule. In addition, our vessels may have to be drydocked in the event of accidents or other unforeseen damage. Our insurance may not cover all of these costs. Large unpredictable repair and drydocking expenses could significantly decrease our profits.
Loss of Our Key Management Personnel Could Adversely Affect Our Business.
Our future success will depend, in significant part, upon the continued services of Charles G. Raymond, our Chairman of the Board, President and Chief Executive Officer, M. Mark Urbania, our Executive Vice President and Chief Financial Officer , John W. Handy, our Executive Vice President, John V. Keenan, our President, Horizon Lines, LLC, and Brian W. Taylor, our President, Horizon Logistics, LLC. The loss of the services of any of these executive officers could adversely affect our future operating results because of their experience and knowledge of our business and customer relationships. If key employees depart, we may have to incur significant costs to replace them and our ability to execute our business model could be impaired if we cannot replace them in a timely manner. We do not expect to maintain key person insurance on any of our executive officers.
We are Subject to, and May in the Future be Subject to, Disputes, or Legal or Other Proceedings, That Could Have a Material Adverse Effect On Us.
The nature of our business exposes us to the potential for disputes, or legal or other proceedings, from time to time relating to labor and employment matters, personal injury and property damage, environmental matters and other matters, as discussed in the other risk factors disclosed in this prospectus. In addition, as a common carrier, our tariffs, rates, rules and practices in dealing with our customers are governed by extensive and complex foreign, federal, state and local regulations which are the subject of disputes or administrative and/or judicial proceedings from time to time. These disputes, individually or collectively, could harm our business by distracting our management from the operation of our business. If these disputes develop into proceedings, these proceedings, individually or collectively, could involve significant expenditures by us or result in significant changes to our tariffs, rates, rules and practices in dealing with our customers that could have a material adverse effect on our future revenue and profitability.
Integrating Acquisitions May Be Time-Consuming and Create Costs That Could Reduce Our Net Income and Cash Flows.
Part of our growth strategy may include pursuing acquisitions. Any integration process may be complex and time-consuming, may be disruptive to our business and may cause an interruption of, or a distraction of our management’s attention from our business as a result of a number of obstacles, including but not limited to:
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the loss of key customers of the acquired company;
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the incurrence of unexpected expenses and working capital requirements;
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a failure of our due diligence process to identify significant issues or contingencies;
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difficulties assimilating the operations and personnel of the acquired company;
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difficulties effectively integrating the acquired technologies with our current technologies;
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our inability to retain key personnel of acquired entities;
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a failure to maintain the quality of customer service;
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our inability to achieve the financial and strategic goals for the acquired and combined businesses; and
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difficulty in maintaining internal controls, procedures and policies.
Any of the foregoing obstacles, or a combination of them, could negatively impact our net income and cash flows.
We completed two acquisitions in 2007. We may not be able to consummate acquisitions in the future on terms acceptable to us, or at all. In addition, future acquisitions are accompanied by the risk that the obligations and liabilities of an acquired company may not be adequately reflected in the
historical financial statements of that company and the risk that those historical financial statements may be based on assumptions which are incorrect or inconsistent with our assumptions or approach to accounting policies. Any of such obligations, liabilities or incorrect or inconsistent assumptions could adversely impact our results of operations.
We May Not Realize the Expected Benefits of Our Horizon Edge Initiative.
Our Horizon Edge employee team was formed in 2006 to develop and implement a program over a two and a half year period, extending through 2008, with the combined goals of reducing operating costs and enhancing customer focus and service efficiency. With the assistance of outside advisors, we are targeting improvements in maintenance management, marine productivity, supply chain management and information technology. There can be no assurance that we will realize the anticipated cost savings related to this initiative. Also, we may not be able to sustain any realized costs savings resulting from the Horizon Edge program in subsequent years.
Our Cash Flows and Capital Resources May Be Insufficient to Make Required Payments On Our Substantial Indebtedness and Future Indebtedness.
As of December 23, 2007, on a consolidated basis, we had (i) approximately $579.1 million of outstanding long-term debt (exclusive of outstanding letters of credit with an aggregate face amount of $6.3 million), including capital lease obligations, (ii) approximately $192.8 million of aggregate trade payables, accrued liabilities and other balance sheet liabilities (other than the long-term debt referred to above) and (iii) a debt-to-equity ratio of approximately 3.7:1.0.
Because we have substantial debt, we require significant amounts of cash to fund our debt service obligations. Our ability to generate cash to meet scheduled payments or to refinance our obligations with respect to our debt depends on our financial and operating performance which, in turn, is subject to prevailing economic and competitive conditions and to the following financial and business factors, some of which may be beyond our control:
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operating difficulties;
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increased operating costs;
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increased fuel costs;
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general economic conditions;
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decreased demand for our services;
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market cyclicality;
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tariff rates;
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prices for our services;
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the actions of competitors;
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regulatory developments; and
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delays in implementing strategic projects.
If our cash flow and capital resources are insufficient to fund our debt service obligations, we could face substantial liquidity problems and might be forced to reduce or delay capital expenditures, dispose of material assets or operations, seek to obtain additional equity capital, or restructure or refinance our indebtedness. Such alternative measures may not be successful and may not permit us to meet our scheduled debt service obligations. In particular, in the event that we are required to dispose of material assets or operations to meet our debt service obligations, we cannot be sure as to the timing of such dispositions or the proceeds that we would realize from those dispositions. The value realized from such dispositions will depend on market conditions and the availability of buyers,
and, consequently, any such disposition may not, among other things, result in sufficient cash proceeds to repay our indebtedness. Also, the senior credit facility contains covenants that may limit our ability to dispose of material assets or operations or to restructure or refinance our indebtedness. Further, we cannot provide assurance that we will be able to restructure or refinance any of our indebtedness or obtain additional financing, given the uncertainty of prevailing market conditions from time to time, our high levels of indebtedness and the various debt incurrence restrictions imposed by the senior credit facility. If we are able to restructure or refinance our indebtedness or obtain additional financing, the economic terms on which such indebtedness is restructured, refinanced or obtained may not be favorable to us.
We may incur substantial indebtedness in the future. The terms of the senior credit facility permit us to incur or guarantee additional indebtedness under certain circumstances. As of December 23, 2007, we had approximately $121.7 million of additional borrowing availability under the revolving credit facility, subject to compliance with the financial and other covenants and the other terms set forth therein. In addition, our senior credit facility allows for additional term loan borrowing availability of up to $150.0 million if certain covenants are met. Our incurrence of additional indebtedness would intensify the risk that our future cash flow and capital resources may not be sufficient for payments of interest on and principal of our substantial indebtedness.
Financial and Other Covenants Under Our Current and Future Indebtedness Could Significantly Impair Our Ability to Operate Our Business.
The senior credit facility contains covenants that, among other things, restrict the ability of us and our subsidiaries to:
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dispose of assets;
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incur additional indebtedness, including guarantees;
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prepay other indebtedness or amend other debt instruments;
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pay dividends or make investments, loans or advances;
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create liens on assets;
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enter into sale and lease-back transactions;
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engage in mergers, acquisitions or consolidations;
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change the business conducted by them; and
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engage in transactions with affiliates.
In addition, under the senior credit facility, we are required to comply with financial covenants, comprised of leverage and interest coverage ratio requirements. Our ability to comply with these covenants will depend on our ongoing financial and operating performance, which in turn will be subject to economic conditions and to financial, market and competitive factors, many of which are beyond our control, and will be substantially dependent on our financial and operating performance which, in turn, is subject to prevailing economic and competitive conditions and to various financial and business factors, including those discussed in the other risk factors disclosed in this Form 10-K, some of which may be beyond our control.
Under our senior credit facility we are required, subject to certain exceptions, to make mandatory prepayments of amounts under the senior credit facility with all or a portion of the net proceeds of certain asset sales and events of loss, certain debt issuances, certain equity issuances and a portion of their excess cash flow. Our circumstances at the time of any such prepayment, particularly our liquidity and ability to access funds, cannot be anticipated at this time. Any such prepayment could, therefore, have a material adverse effect on us. Mandatory prepayments are first applied to the outstanding term loans and, after all of the term loans are paid in full, then applied to reduce the loans
under the revolving credit facility with corresponding reductions in revolving credit facility commitments.
Our Substantial Indebtedness and Future Indebtedness Could Significantly Impair Our Operating and Financial Condition.
The required payments on our substantial indebtedness and future indebtedness, as well as the restrictive covenants contained in the senior credit facility could significantly impair our operating and financial condition. For example, these required payments and restrictive covenants could:
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make it difficult for us to satisfy our debt obligations;
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make us more vulnerable to general adverse economic and industry conditions;
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limit our ability to obtain additional financing for working capital, capital expenditures, acquisitions and other general corporate requirements;
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expose us to interest rate fluctuations because the interest rate on the debt under our revolving credit facility is variable;
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require us to dedicate a substantial portion of our cash flow from operations to payments on our debt, thereby reducing the availability of our cash flow for operations and other purposes;
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limit our flexibility in planning for, or reacting to, changes in our business and the industry in which we operate; and
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place us at a competitive disadvantage compared to competitors that may have proportionately less debt.
We may incur substantial indebtedness in the future. Our incurrence of additional indebtedness would intensify the risks described above.
The Senior Credit Facility Exposes Us to the Variability of Interest Rates.
The revolving credit and term loan portions of our senior credit facility bear interest at variable rates. As of December 23, 2007, we had outstanding a $125.0 million term loan and $122.0 million under the revolving credit facility, which bear interest at variable rates. The interest rates applicable to the senior credit facility vary with the prevailing corporate base rate offered by the administrative agent under the senior credit facility or with LIBOR. If these rates were to increase significantly, our ability to borrow additional funds may be reduced and the risks related to our substantial indebtedness would intensify. Each quarter point change in interest rates would result in a $0.3 million change in annual interest expense on each of the term loan and the revolving credit facility. Accordingly, a significant rise in interest rates would adversely affect our financial results.
If Non-U.S. Citizens Own More Than 19.9% of Our Stock, We May Not Have the Funds or the Ability to Redeem Any Excess Shares and We Could be Forced to Suspend Our Jones Act Operations.
Our certificate of incorporation contains provisions voiding transfers of shares of any class or series of our capital stock that would result in non-U.S. citizens, in the aggregate, owning in excess of 19.9% of the shares of such class or series. In the event that this transfer restriction would be ineffective, our certificate of incorporation provides for the automatic transfer of such excess shares to a trust specified therein. These trust provisions also apply to excess shares that would result from a change in the status of a record or beneficial owner of shares of our capital stock from a U.S. citizen to a non-U.S. citizen. In the event that these trust transfer provisions would also be ineffective, our certificate of incorporation permits us to redeem such excess shares. However, we may not be able to redeem such excess shares because our operations may not have generated sufficient excess cash flow to fund such a redemption. If such a situation occurs, there is no guarantee that we will be able
to obtain the funds necessary to effect such a redemption on terms satisfactory to us or at all. The senior credit facility permits upstream payments from our subsidiaries, subject to exceptions, to the Company to fund redemptions of excess shares.
If, for any of the foregoing reasons or otherwise, we are unable to effect such a redemption when such ownership of shares by non-U.S. citizens is in excess of 25.0% of such class or series, or otherwise prevent non-U.S. citizens in the aggregate from owning shares in excess of 25.0% of any such class or series, or fail to exercise our redemption right because we are unaware that such ownership exceeds such percentage, we will likely be unable to comply with applicable maritime laws. If all of the citizenship-related safeguards in our certificate of incorporation fail at a time when ownership of shares of any class or series of our stock is in excess of 25.0% of such class or series, we will likely be required to suspend our Jones Act operations. Any such actions by governmental authorities would have a severely detrimental impact on our results of operations.
We May Not Have the Necessary Funds to Pay Dividends on Our Common Stock or We May Elect Not to Pay Dividends on Our Common Stock.
We require continuing, significant cash flow in order for us to make payments of regular dividends to our stockholders. However, we have no operations of our own and have derived, and will continue to derive, all of our revenues and cash flow from our subsidiaries. Our subsidiaries are separate and distinct legal entities and have no obligation, contingent or otherwise, to make funds available to us. They may not have sufficient funds or assets to permit payments to us in amounts sufficient to fund future dividend payments. Also, our subsidiaries are subject to contractual restrictions (including with their secured and unsecured creditors) that may limit their ability to upstream cash indirectly or directly to us. Thus, there is a significant risk that we may not have the requisite funds to make regular dividend payments in the future. In addition, we may elect not to pay dividends as a substantial portion of our future earnings will be utilized to make payments of principal and interest on our indebtedness and to fund the development and growth of our business.
Item 1B.
Item 1B.
Unresolved Staff Comments
None
Item 2.
Item 2.
Properties
We lease all of our facilities, including our terminal and office facilities located at each of the ports upon which our vessels call as well as our central sales and administrative offices and regional sales offices. The following table sets forth the locations, descriptions, and square footage of our significant facilities as of December 23, 2007:
(1)
Square footage for marine terminal facilities excludes common use areas used by other terminal customers and us.
(2)
Excludes 1,647,952 square feet of terminal property which we have the option to use and pay for on an as-needed basis.
Item 3.
Item 3.
Legal Proceedings
In the ordinary course of business, from time to time, the Company and its subsidiaries become involved in various legal proceedings which management believes will not have a material adverse effect on the Company’s financial position or results of operations. These relate primarily to claims for loss or damage to cargo, employees’ personal injury claims, and claims for loss or damage to the person or property of third parties. The Company and its subsidiaries generally maintain insurance, subject to customary deductibles or self-retention amounts, and/or reserves to cover these types of claims. The Company and its subsidiaries also, from time to time, become involved in routine employment-related disputes and disputes with parties with which they have contracts.
For several years, there have been two actions pending before the Surface Transportation Board (“STB”) involving HL. The first action, brought by the Government of Guam in 1998 on behalf of itself and its citizens against HL and Matson Navigation Co. (“Matson”), seeks a ruling from the STB that HL’s Guam shipping rates, which are based on published tariff rates, during 1996-1998 were “unreasonable” under the Interstate Commerce Commission Termination Act of 1995 (“ICCTA”), and an order awarding reparations to Guam and its citizens. On September 18, 2007, the Government of Guam filed a motion to dismiss its complaint with the STB citing the STB’s ruling on the methodology for determining the rate reasonableness. The Government of Guam stated it could no longer proceed with its rate challenge. As a result, this case was dismissed by the STB on October 12, 2007.
The second action before the STB involving HL, brought by DHX, Inc. (“DHX”) in 1999 against HL and Matson, challenged the reasonableness of certain rates and practices of HL and Matson. DHX was seeking $11.0 million in damages. On December 13, 2004, the STB (i) dismissed all of the allegations of unlawful activity contained in DHX’s complaint; (ii) found that HL met all of its tariff filing obligations; and (iii) reaffirmed the STB’s earlier holdings that the anti-discrimination provisions of the Interstate Commerce Act, which were repealed by the ICCTA, are no longer applicable to HL’s business. On June 13, 2005, the STB issued a decision that denied DHX’s motion for reconsideration and denied the alternative request by DHX for clarification of the STB’s December 13, 2004 decision. On August 5, 2005, DHX filed a Notice of Appeal with the United States Court of Appeals for the Ninth Circuit challenging the STB’s order dismissing its complaint. DHX filed an appellate brief on November 10, 2005. HL submitted its response to the DHX brief on January 25, 2006, and oral argument was held on June 4, 2007. On August 30, 2007, the court of appeals affirmed, in all material respects, the decision of the STB. The Company has been advised by DHX that it does not intend to pursue this matter further.
Item 4.
Item 4.
Submission of Matters to a Vote of Security Holders
There were no matters submitted to a vote of security holders through the solicitation of proxies or otherwise during the fourth quarter of fiscal 2007.
Part II
Item 5.
Item 5.
Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
The Company’s Common Stock is traded on the New York Stock Exchange under the ticker symbol HRZ. As of January 31, 2008, there were approximately 4,907 holders of record of the Common Stock. The following table sets forth the intraday high and low sales price of the Company’s common stock on the New York Stock Exchange for the fiscal periods presented.
On January 31, 2008, our Board of Directors declared a quarterly cash dividend of $0.11 per share for our common stock, which is payable on March 15, 2008 to holders of record at the close of business on March 1, 2008. We regularly pay quarterly dividends as set forth in the table above. We currently expect that comparable cash dividends will continue to be paid in the future although we have no commitment to do so.
On August 8, 2007, the Company sold $330.0 million aggregate principal amount of its 4.25% Convertible Senior Notes due 2012 (the “Notes”) through offerings to qualified institutional buyers pursuant to Rule 144A under the Securities Act of 1933, as amended. The Company offered and sold the Notes to the initial purchasers in reliance on the exemption from registration provided by Section 4(2) of the Securities Act. The initial purchasers then sold the Notes to qualified institutional buyers pursuant to the exemption from registration provided by Rule 144A under the Securities Act. The Notes and the underlying common stock issuable upon conversion of the Notes have not been registered under the Securities Act and may not be offered or sold in the U.S. absent registration or an applicable exemption from registration requirements. The Company used (i) $28.6 million of the proceeds to purchase 1,000,000 shares of the Company’s common stock in privately negotiated transactions, (ii) $52.5 million of the proceeds to acquire an option to receive the Company’s common stock from the initial purchasers, (iii) $10.6 million of the proceeds to pay the initial purchasers’ discount and offering expenses and (iv) the balance of the proceeds to purchase a portion of the outstanding 9% senior notes and 11% senior discount notes purchased in the Company’s tender offer.
On August 8, 2007, in conjunction with the offering of the Notes, the Company also entered into warrant transactions whereby the Company sold warrants to acquire, subject to customary anti-dilution adjustments, approximately 4.6 million shares of the Company’s common stock at a strike price of approximately $51.41 per share in reliance on the exemption from registration provided by Section 4(2) of the Securities Act. Neither the warrants nor the underlying common stock issuable upon conversion of the warrants have been registered under the Securities Act and may not be offered or sold in the U.S. absent registration or an applicable exemption from registration requirements. The Company received aggregate proceeds of approximately $11.9 million from the sale of the warrants.
Equity Compensation Plan Information
The following table provides information as of December 23, 2007 regarding shares of the Company’s common stock issuable pursuant to its stock option plan:
(1)
For a description of the Company’s equity compensation plans, see Note 17 to the Consolidated Financial Statements in Item 8.
(2)
Each stock option is exercisable for one share of common stock.
The following table provides information about purchases made by the Company of its common stock for each month included in the fourth quarter of 2007:
ISSUER PURCHASES OF EQUITY SECURITIES
(1)
The average price paid per share does not include the cost of commissions.
(2)
On November 19, 2007, the Company’s Board of Directors authorized the Company to commence a stock repurchase program to buy back up to $50.0 million worth of its common stock. The program allowed the Company to purchase shares through open market repurchases and privately negotiated transactions at a price of $26.00 per share or less until the program’s expiration on December 31, 2008. The Company acquired 1,172,700 shares at a total cost of $20.6 million under this program during the fourth quarter of 2007. The Company completed its share repurchase program in the first quarter of 2008, acquiring an additional 1,627,500 shares at a total cost of $29.4 million. Although the Company does not currently intend to repurchase additional shares, the Company will continue to evaluate market conditions and may, subject to approval by the Company’s Board of Directors, repurchase additional shares of its common stock in the future. All share repurchases during the fourth quarter of 2007 and during the first quarter of 2008 were made in accordance with Rule 10b-18 of the Securities Exchange Act of 1934. Repurchased shares have been accounted for as treasury stock.
Total Return Comparison Graph
The below graph compares the cumulative total shareholder return of the public common stock of Horizon Lines, Inc. to the cumulative total returns of the Dow Jones U.S. Industrial Transportation Index and the S&P 500 Index for the period in which the Company’s stock has been publicly traded. Cumulative total returns assume reinvestment of dividends.
Comparison of Cumulative Total Return*
Notwithstanding anything to the contrary set forth in any of our filings under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended, that might incorporate other filings with the Securities and Exchange Commission, including this annual report on Form 10-K, in whole or in part, the Total Return Comparison Graph shall not be deemed incorporated by reference into any such filings.
*
Comparison graph is based upon $100 invested in the given average or index at the close of trading on September 26, 2005 and $100 invested in the Company’s stock by the opening bell on September 27, 2005, as well as the reinvestment of dividends.
Item 6.
Item 6.
Selected Financial Data
The five year selected financial data below should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” beginning on page 35 of this Form 10-K, and our consolidated financial statements and the related notes appearing in Item 15 of this Form 10-K.
All combined and consolidated financial data for the period (or any portion thereof) from December 23, 2002 through February 26, 2003 reflect the combined company CSX Lines, LLC and its wholly owned subsidiaries, CSX Lines of Puerto Rico, Inc., and the domestic liner business of SL Service, Inc. (formerly known as Sea-Land Service, Inc.), all of which were stand-alone wholly owned entities of CSX Corporation (“Predecessor B”). All combined and consolidated financial data for the period (or any portion thereof) from February 27, 2003 through July 6, 2004 reflect Horizon Lines Holding on a consolidated basis (“Predecessor A”). All consolidated financial data for the periods (or any portion thereof) from July 7, 2004 through December 23, 2007 reflect the Company on a consolidated basis.
We have a 52- or 53-week fiscal year (every sixth or seventh year) that ends on the Sunday before the last Friday in December. The twelve months ended December 21, 2003, and the years ended December 25, 2005, December 24, 2006 and December 23, 2007 each consisted of 52 weeks. The twelve months ended December 26, 2004 consisted of 53 weeks.
Selected Financial Data is as follows:
*
For the period ended February 26, 2003, owner’s equity consisted of parent’s net investment, and thus no income (loss) per share has been calculated.
(1)
The Company completed an initial public offering during 2005 and used the proceeds to repurchase certain indebtedness, pay related premiums, redeem its outstanding preferred stock, and pay related transaction expenses. See Note 5 to the Notes to the Consolidated Financial Statements for pro forma information related to these activities.
(2)
On July 7, 2004, as part of the Acquisition-Related Transactions, $250.0 million original principal amount of 9% senior notes were issued, $250.0 million was borrowed under the term loan facility, $6.0 million was borrowed under the revolving credit facility and interest began to accrue thereon. On December 10, 2004, 11% senior discount notes with an initial accreted value of $112.3 million were issued and the accreted value thereof began to increase. During the fourth quarter of 2005, utilizing proceeds from the initial public offering, the Company repurchased $53.0 million and $43.2 million of the 9% senior notes and 11% senior discount notes, respectively. During 2007, the Company completed a private placement of $330.0 million aggregate principal amount of 4.25% convertible senior notes due 2012 and entered into a credit agreement providing for a $250.0 million five year revolving credit facility and a $125.0 million term loan with various financial lenders. The Company utilized a portion of the proceeds from these transactions to (i) repay the borrowings outstanding under the Prior Senior Credit Facility (as defined below) and (ii) purchase
the outstanding principal and pay associated premiums of the 9% senior notes and 11% senior discount notes purchased in the Company’s tender offer.
(3)
During 2006, the Company elected the application of a tonnage tax instead of the federal corporate income tax on income from its qualifying shipping activities. This 2006 election of the tonnage tax was made in connection with the filing of the Company’s 2005 federal corporate income tax return and will also apply to all subsequent federal income tax returns unless the Company revokes this alternative tonnage tax treatment. The Company does not intend to revoke its election of the tonnage tax in the foreseeable future. The Company accounted for this election as a change in the tax status of its qualifying shipping activities. The impact of this tonnage tax election resulted in a decrease in income tax expense of approximately $43.5 million during the year ended December 24, 2006. Approximately $11.0 million, or $0.33 per share, and $18.8 million, or $0.56 per share, relate to the 2005 reduction in income tax expense and revaluation of the deferred taxes related to the application of tonnage tax to qualifying activities, respectively. The Company’s effective tax rate for the year ended December 24, 2006 was (53.9%). Excluding the 2005 income tax impact and revaluation of the deferred taxes related to qualifying activities, the Company’s effective tax rate for the year ended December 24, 2006 was 9.5%. The Company modified its trade routes between the U.S. west coast and Guam and Asia during 2007. As such, the Company’s shipping activities associated with these modified trade routes became qualified shipping activities, and thus the income from these vessels is excluded from gross income in determining federal income tax liability. During 2007, the Company recorded a $7.7 million tax benefit related to the revaluation of deferred taxes related to the qualified shipping income expected to be generated by the new vessels and related to a change in estimate resulting from refinements in the methodology for computing secondary activities and cost allocations for tonnage tax purposes. This benefit was recorded in connection with the filing of the 2006 income tax return in September 2007. Excluding the loss on extinguishment and the related tax benefits, the benefit associated with the revaluation of deferred taxes related to activities qualifying for the application of tonnage tax and the benefits related to the refinements in methodology of applying tonnage tax, the Company’s effective tax rate was 14.1% for the year ended December 23, 2007.
(4)
In connection with the financing of the Acquisition-Related Transactions, we issued and sold 8,391,180 shares of our Series A preferred stock in July 2004. No dividends accrued on these shares. During October 2004, an additional 1,898,730 Series A preferred shares were issued and sold. During December 2004, 5,315,912 Series A preferred shares were redeemed for $53.2 million. In connection with the initial public offering, the Company redeemed all shares of its non-voting $.01 par value Series A Preferred Stock for $62.2 million.
(5)
Concurrent with the issuance of the 4.25% convertible senior notes, the Company entered into note hedge transactions whereby the Company has the option to receive shares of the Company’s common stock when the share price is between certain amounts and the Company sold warrants to financial institutions whereby the financial institutions have the option to receive shares when the share price is above certain levels. The cost of the note hedge transactions to the Company was approximately $33.4 million, net of tax benefits, and the Company received proceeds of $11.9 million related to the sale of the warrants.
(6)
EBITDA is defined as net income plus net interest expense, income taxes, depreciation and amortization. We believe that in addition to GAAP based financial information, EBITDA is a meaningful disclosure for the following reasons: (i) EBITDA is a component of the measure used by our board of directors and management team to evaluate our operating performance, (ii) the senior credit facility contains covenants that requires the Company to maintain certain interest expense coverage and leverage ratios, which contain EBITDA as a component, and restrict certain cash payments if certain ratios are not met, subject to certain exclusions, and our management team uses EBITDA to monitor compliance with such covenants, (iii) EBITDA is a component of the measure used by our management team to make day-to-day operating decisions, (iv) EBITDA is a component of the measure used by our management to facilitate internal comparisons to competitors’ results and the marine container shipping and logistics industry in general and (v) the payment of
discretionary bonuses to certain members of our management is contingent upon, among other things, the satisfaction by Horizon Lines of certain targets, which contain EBITDA as a component. We acknowledge that there are limitations when using EBITDA. EBITDA is not a recognized term under GAAP and does not purport to be an alternative to net income as a measure of operating performance or to cash flows from operating activities as a measure of liquidity. Additionally, EBITDA is not intended to be a measure of free cash flow for management’s discretionary use, as it does not consider certain cash requirements such as tax payments and debt service requirements. Because all companies do not use identical calculations, this presentation of EBITDA may not be comparable to other similarly titled measures of other companies. A reconciliation of net income (loss) to EBITDA is included below (in thousands):
The EBITDA amounts presented above contain certain charges that our management team excludes when evaluating our operating performance, for making day to day operating decisions and that are excluded from EBITDA when determining the payment of discretionary bonuses:
(a)
The adjustment represents non-cash stock-based compensation charges which we incurred during the year ended December 25, 2005 related to the issuance and sale of common stock, including restricted common stock, to non-employee directors and to members of management. All of these shares vested in full upon the consummation of the initial public offering completed during 2005.
(b)
The adjustment represents management fees paid to Castle Harlan and to an entity that was associated with the party that was the primary stockholder of Horizon Lines Holding prior to the Acquisition-Related Transactions. Upon the completion of the Acquisition-Related Transactions, the Company, Horizon Lines and Horizon Lines Holding entered into a new management agreement with Castle Harlan. On September 7, 2005, as a result of an amendment of such agreement and a related payment to Castle Harlan of $7.5 million under such amended agreement, the provisions of such agreement were terminated, except as to expense reimbursement and indemnification and related obligations of the Company, Horizon Lines and Horizon Lines Holding.
(7)
Includes the acquisition of the rights and beneficial interests of the sole owner participant in two separate trusts, the assets of which consist primarily of two vessels, for $25.2 million during the year ended December 25, 2005. Includes vessel purchases of $11.9 million, $7.7 million and $21.9 million for the period from December 22, 2003 through July 6, 2004, the period from July 7, 2004 through December 26, 2004 and the period from February 27, 2003 through December 21, 2003, respectively.
(8)
During 2003, the amounts in cash flows provided by (used in) investing and financing activities primarily represent the accounting for the February 27, 2003 purchase transaction. During 2004, the amounts in cash flows provided by (used in) investing primarily represent the accounting for the Acquisition-Related Transactions and financing activities primarily represent the accounting for the Acquisition-Related Transactions and subsequent financing transactions. Financing activities during 2005 included the proceeds from the initial public offering and the use of proceeds therefrom. The proceeds and cash generated from operations were used to redeem debt and preferred shares, and to pay associated redemption premiums and related transaction expenses. Investing activities during 2007 include the acquisition of HSI and Aero Logistics. Financing activities during 2007 include the Company’s private placement of $330.0 million aggregate principal amount of 4.25% convertible senior notes due 2012 and credit agreement providing for a $250.0 million five year revolving credit facility and a $125.0 million term loan with various financial lenders. The Company utilized a portion of the proceeds from these transactions to (i) repay $192.8 million of borrowings outstanding under the Prior Senior Credit Facility (as defined below), (ii) purchase the outstanding principal and pay associated premiums of the 9% senior notes and 11% senior discount notes purchased in the Company’s tender offer and (iii) purchase 1,000,000 shares of the Company’s common stock. Also during 2007, the Company’s Board of Directors approved a stock repurchase program under which the Company acquired 1,172,000 shares of its common stock at a total cost of $20.6 million.
(9)
For purposes of calculating the ratio of earnings to fixed charges, earnings represent income before income taxes plus fixed charges. Fixed charges consist of interest expense, including amortization of net discount or premium and financing costs, accretion of preferred stock, and the portion of operating rental expense (33%) which management believes is representative of the interest component of rent expense. For the year ended December 2005 and the period from December 23, 2002 through February 26, 2003, earnings were insufficient to cover fixed charges by $17.9 million and $3.0 million, respectively. The calculation of the ratio of earnings to fixed charges is noted below (in thousands):
Item 7.
Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis of our consolidated financial condition and results of operations should be read in conjunction with Selected Consolidated and Combined Financial Data and our annual audited consolidated financial statements and related notes thereto included elsewhere in this Form 10-K. The following discussion includes forward-looking statements that involve certain risks and uncertainties. For additional information regarding forward looking statements, see the Safe Harbor Statement on page (i) of this Form 10-K.
Executive Overview
Operating revenue increased by $49.6 million or 4.3% for the year ended December 23, 2007 from the year ended December 24, 2006. This revenue growth is primarily attributable to unit revenue improvements resulting from favorable changes in cargo mix, general rate increases, revenue related to acquisitions, increased bunker fuel and intermodal fuel surcharges to help offset increases in fuel costs, as well as increased slot charter revenue. This revenue increase is offset partially by lower container volumes shipped.
Operating expenses increased by $50.4 million or 4.8% for the year ended December 23, 2007 from the year ended December 24, 2006. The increase in operating expenses is primarily due to higher vessel operating costs due to the deployment of the new vessels and an increase in the cost of fuel, partially offset by a decrease in variable operating costs due to lower volumes.
Operating revenue increased by $60.7 million or 5.5% for the year ended December 24, 2006 from the year ended December 25, 2005. This revenue growth is primarily attributable to rate improvements resulting from favorable changes in cargo mix, general rate increases, increased bunker fuel and intermodal fuel surcharges to help offset increases in fuel costs, and revenue increases from non-transportation and other revenue services. This revenue increase is offset partially by lower container volumes primarily attributable to soft market conditions in Puerto Rico.
Operating expenses increased by $11.4 million or 1.1% for the year ended December 24, 2006 from the year ended December 25, 2005. The increase in operating expenses is primarily due to increases in vessel fuel expense and rail and truck transportation costs as a result of increases in fuel prices, offset by a decrease in selling, general, and administrative expenses and other variable operating expenses. The decline in selling, general, and administrative expenses is primarily due to lower stock-based compensation charges, the elimination of the Castle Harlan management fee, and a decrease in variable operating costs as a result of lower revenue container volumes shipped.
General
We believe that we are the nation’s leading Jones Act container shipping and integrated logistics company, accounting for approximately 38% of total U.S. marine container shipments from the continental U.S. to Alaska, Puerto Rico and Hawaii, constituting the three non-contiguous Jones Act markets, and to Guam and Micronesia. Under the Jones Act, all vessels transporting cargo between
U.S. ports must, subject to limited exceptions, be built in the U.S., registered under the U.S. flag, manned by predominantly U.S. crews, and owned and operated by U.S.-organized companies that are controlled and 75% owned by U.S. citizens. We own or lease 21 vessels, 16 of which are fully qualified Jones Act vessels, and approximately 22,000 cargo containers. We also provide comprehensive shipping and logistics services in our markets. We have long-term access to terminal facilities in each of our ports, operating our terminals in Alaska, Hawaii, and Puerto Rico and contracting for terminal services in the six ports in the continental U.S. and in the ports in Guam, Hong Kong, Yantian and Taiwan.
History and Transactions
Our long operating history dates back to 1956, when Sea-Land pioneered the marine container shipping industry and established our business. In 1958, we introduced container shipping to the Puerto Rico market and in 1964 we pioneered container shipping in Alaska with the first year-round scheduled vessel service. In 1987, we began providing container shipping services between the U.S. west coast and Hawaii and Guam through our acquisition from an existing carrier of all of its vessels and certain other assets that were already serving that market. Today, as the only Jones Act vessel operator with an integrated organization serving Alaska, Puerto Rico, and Hawaii, we are uniquely positioned to serve our customers that require shipping and logistics services in more than one of these markets.
On February 27, 2003, Horizon Lines Holding (which at the time was indirectly majority-owned by Carlyle-Horizon Partners, L.P.) acquired from CSX Corporation (“CSX”), which was the successor to Sea-Land, 84.5% of CSX Lines, LLC (“Predecessor A”), and 100% of CSX Lines of Puerto Rico, Inc. (“Predecessor Puerto Rico Entity”), which together constitute our business today. This transaction is referred to in this Form 10-K as the February 27, 2003 purchase transaction. CSX Lines, LLC is now known as Horizon Lines, LLC and CSX Lines of Puerto Rico, Inc. is now known as Horizon Lines of Puerto Rico, Inc.
Horizon Lines, Inc. (the “Company”; and together with its subsidiaries, “We”) operates as a holding company for Horizon Lines, LLC (“HL”), a Delaware limited liability company and wholly-owned subsidiary, Horizon Logistics, LLC (“Horizon Logistics”), a Delaware limited liability company and wholly-owned subsidiary, and Horizon Lines of Puerto Rico, Inc. (“HLPR”), a Delaware corporation and wholly-owned subsidiary. The Company was formed as an acquisition vehicle to acquire, on July 7, 2004, the equity interest in Horizon Lines Holding Corp., a Delaware corporation (“HLHC” or “Horizon Lines Holding”). The foregoing acquisition and related financing and other transactions, referred to in this Form 10-K collectively as the “Acquisition-Related Transactions” or “merger,” included a merger whereby Horizon Lines Holding became a direct wholly-owned subsidiary of the Company.
Basis of Presentation
The Company was formed in connection with the Acquisition-Related Transactions, and has no independent operations. Consequently, the accompanying consolidated financial statements include the consolidated accounts of the Company as of December 23, 2007, December 24, 2006 and December 25, 2005 and for the years ended December 23, 2007, December 24, 2006 and December 25, 2005.
Certain prior period balances have been reclassified to conform with the current period presentation.
Fiscal Year
We have a 52- or 53-week (every sixth or seventh year) fiscal year that ends on the Sunday before the last Friday in December. The fiscal years ended December 23, 2007, December 24, 2006 and December 25, 2005 each consisted of 52 weeks.
Critical Accounting Policies
The preparation of our financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and assumptions in the reported amounts of revenues and expenses during the reporting period and in reporting the amounts of assets and liabilities, and disclosures of contingent assets and liabilities at the date of our financial statements. Since many of these estimates and assumptions are based on future events which cannot be determined with certainty, the actual results could differ from these estimates.
We believe that the application of our critical accounting policies, and the estimates and assumptions inherent in those policies, are reasonable. These accounting policies and estimates are constantly re-evaluated and adjustments are made when facts or circumstances dictate a change. Historically, we have found the application of accounting policies to be appropriate and actual results have not differed materially from those determined using necessary estimates.
Revenue Recognition
We account for transportation revenue based upon method two under Emerging Issues Task Force No. 91-9 “Revenue and Expense Recognition for Freight Services in Process.” Under this method we record transportation revenue for the cargo when shipped and an expense accrual for the corresponding costs to complete delivery when the cargo first sails from its point of origin. We believe that this method of revenue recognition does not result in a material difference in reported net income on an annual or quarterly basis as compared to recording transportation revenue between accounting periods based upon the relative transit time within each respective period with expenses recognized as incurred.
We recognize revenue and related costs of sales for our terminal, logistics and other services upon completion of services.
Allowance for Doubtful Accounts and Revenue Adjustments
The Company maintains an allowance for doubtful accounts based upon the expected collectibility of accounts receivable. The Company monitors its collection risk on an ongoing basis through the use of credit reporting agencies. The Company does not require collateral from its trade customers.
In addition, the Company maintains an allowance for revenue adjustments consisting of amounts reserved for billing rate changes that are not captured upon load initiation. These adjustments generally arise: (1) when the sales department contemporaneously grants small rate changes (“spot quotes”) to customers that differ from the standard rates in the system; (2) when freight requires dimensionalization or is reweighed resulting in a different required rate; (3) when billing errors occur; and (4) when data entry errors occur. When appropriate, permanent rate changes are initiated and reflected in the system. These revenue adjustments are recorded as a reduction to revenue.
Casualty Claims
We purchase insurance coverage for a portion of our exposure related to certain employee injuries (workers’ compensation and compensation under the Longshore and Harbor Workers’ Compensation Act), vehicular and vessel collision, accidents and personal injury and cargo claims. Most insurance arrangements include a level of self-insurance (self-retention or deductible) applicable to each claim or vessel voyage, but provide an umbrella policy to limit our exposure to catastrophic claim costs. The amounts of self-insurance coverage change from time to time. Our current insurance coverage specifies that the self-insured limit on claims ranges from $0 to $1,000,000. Our safety and claims personnel work directly with representatives from our insurance companies to continually update the anticipated residual exposure for each claim. In establishing accruals and reserves for claims and insurance expenses, we evaluate and monitor each claim individually, and we use factors such as historical experience, known trends and third-party estimates to determine the appropriate
reserves for potential liability. Changes in the perceived severity of previously reported claims, significant changes in medical costs and legislative changes affecting the administration of our plans could significantly impact the determination of appropriate reserves.
Goodwill, Purchase Costs and Other Identifiable Intangible Assets
Under Statement of Financial Accounting Standards (“SFAS”) No. 142 “Goodwill and Other Intangible Assets,” goodwill and other intangible assets with indefinite lives are not amortized but are subject to annual undiscounted cash flow impairment tests. If there is an apparent impairment, a new fair value of the reporting unit would be determined. If the new fair value is less than the carrying amount, an impairment loss would be recognized.
The majority of the customer contracts and trademarks on the balance sheet as of December 23, 2007 were valued on July 7, 2004, as part of the Acquisition-Related Transactions, using the income appraisal methodology. The income appraisal methodology includes a determination of the present value of future monetary benefits to be derived from the anticipated income, or ownership, of the subject asset. The value of our customer contracts includes the value expected to be realized from existing contracts as well as from expected renewals of such contracts and is calculated using unweighted and weighted total undiscounted cash flows as part of the income appraisal methodology. The value of our trademarks and service marks is based on various factors including the strength of the trade or service name in terms of recognition and generation of pricing premiums and enhanced margins. We amortize customer contracts and trademarks and service marks on a straight-line method over the estimated useful life of four to fifteen years. We evaluate these assets annually for potential impairment in accordance with SFAS No. 142.
Vessel Drydocking
Under U.S. Coast Guard Rules, administered through the American Bureau of Shipping’s alternative compliance program, all vessels must meet specified seaworthiness standards to remain in service carrying cargo between U.S. marine terminals. Vessels must undergo regular inspection, monitoring and maintenance, referred to as drydocking, to maintain the required operating certificates. These drydockings generally occur every two and a half years, or twice every five years. Because drydockings enable the vessel to continue operating in compliance with U.S. Coast Guard requirements, the costs of these scheduled drydockings are customarily deferred and amortized over a 30-month period beginning with the accounting period following the vessel’s release from drydock.
We also take advantage of vessel drydockings to perform normal repair and maintenance procedures on our vessels. These routine vessel maintenance and repair procedures are expensed as incurred. In addition, we will occasionally, during a vessel drydocking, replace vessel machinery or equipment and perform procedures that materially enhance capabilities of a vessel. In these circumstances, the expenditures are capitalized and depreciated over the estimated useful lives.
Deferred Tax Assets and Liabilities
Deferred tax assets represent expenses recognized for financial reporting purposes that may result in tax deductions in the future and deferred tax liabilities represent expense recognized for tax purposes that may result in financial reporting expenses in the future. Certain judgments, assumptions and estimates may affect the carrying value of the valuation allowance and income tax expense in the consolidated financial statements. We record an income tax valuation allowance when the realization of certain deferred tax assets, net operating losses and capital loss carryforwards is not likely. In conjunction with the election of tonnage tax, we revalued our deferred taxes to accurately reflect the rates at which we expect such items to reverse in future periods.
FIN 48
We account for uncertain tax positions in accordance with Financial Accounting Standards Board (the “FASB”) Interpretation No. 48 (“FIN 48”), “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109”. The application of income tax law is inherently complex. As such, we are required to make many assumptions and judgments regarding our income tax positions and the likelihood whether such tax positions would be sustained if challenged. Interpretations and guidance surrounding income tax laws and regulations change over time. As such, changes in our assumptions and judgments can materially affect amounts recognized in the consolidated financial statements.
Stock-Based Compensation
In conjunction with the initial public offering, we early adopted SFAS No. 123R (“SFAS 123R”), “Share-Based Payment”, using the modified prospective approach as of September 30, 2005. SFAS 123R covers a wide range of share-based compensation arrangements including stock options, restricted share plans, and employee stock purchase plans.
In applying SFAS 123R, the value of each equity-based award is estimated on the date of grant using the Black-Scholes option-pricing model. The Black-Scholes model takes into account volatility in the price of our stock, the risk-free interest rate, the estimated life of the equity-based award, the closing market price of our stock and the exercise price. Due to the relatively short period of time since our stock became publicly traded, we base our estimates of stock price volatility on the average of (i) our historical stock price over the period in which it has been publicly traded and (ii) historical volatility of similar entities commensurate with the expected term of the equity-based award; however, this estimate is neither predictive nor indicative of the future performance of our stock. The estimates utilized in the Black-Scholes calculation involve inherent uncertainties and the application of management judgment. In addition, we are required to estimate the expected forfeiture rate and only recognize expense for those options expected to vest.
Property and Equipment
We capitalize property and equipment as permitted or required by applicable accounting standards, including replacements and improvements when costs incurred for those purposes extend the useful life of the asset. We charge maintenance and repairs to expense as incurred. Depreciation on capital assets is computed using the straight-line method and ranges from 3 to 40 years. Our management makes assumptions regarding future conditions in determining estimated useful lives and potential salvage values. These assumptions impact the amount of depreciation expense recognized in the period and any gain or loss once the asset is disposed.
We evaluate each of our long-lived assets for impairment using undiscounted future cash flows relating to those assets whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. When undiscounted future cash flows are not expected to be sufficient to recover the carrying amount of an asset, the asset is written down to its fair value.
Recent Accounting Pronouncements
In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS 157”). SFAS 157 addresses how companies should measure fair value when they are required to use a fair value measure for recognition or disclosure purposes under generally accepted accounting principles. As a result of SFAS 157 there is now a common definition of fair value to be used throughout GAAP. The FASB believes that the new standard will make the measurement of fair value more consistent and comparable and improve disclosures about those measures. The provisions of SFAS 157 were to be effective for fiscal years beginning after November 15, 2007. On December 14, 2007, the FASB issued proposed FSP FAS 157-b which would delay the effective date of SFAS 157 for all nonfinancial assets and nonfinancial liabilities, except those that are recognized or disclosed at fair value in the
financial statements on a recurring basis (at least annually). This proposed FSP partially defers the effective date of Statement 157 to fiscal years beginning after November 15, 2008, and interim periods within those fiscal years for items within the scope of this FSP. Effective for fiscal 2008, the Company will adopt SFAS 157 except as it applies to those nonfinancial assets and nonfinancial liabilities as noted in proposed FSP FAS 157-b. The Company is in the process pf determining the financial impact the partial adoption of SFAS 157 will have on its results of operations and financial position.
The FASB has published for comment a clarification on the accounting for convertible debt instruments that may be settled in cash (including partial cash settlement) upon conversion, such as the convertible notes we issued in August 2007 (“FSP APB 14-a”). The proposed FSP would require the issuer to separately account for the liability and equity components of the instrument in a manner that reflects the issuer’s non-convertible debt borrowing rate. As a result, the liability component would be recorded at a discount reflecting its below market coupon interest rate, and the liability component would subsequently be accreted to its par value over its expected life, with the rate of interest that reflects the market rate at issuance being reflected in the results of operations. The proposed change in methodology will affect the calculations of net income and earnings per share. The proposed effective date of FSP APB 14-a was originally for fiscal years beginning after December 15, 2007 and did not permit early application. In November 2007, the FASB announced it expects to begin its redeliberations of the guidance in the proposed FSP beginning in January 2008. Therefore, it is expected that final guidance will not be issued until at least the first quarter of 2008 and it is unlikely the proposed effective date for fiscal years beginning after December 15, 2007 will be retained. The proposed transition guidance requires retrospective application to all periods presented and does not grandfather existing instruments. The Company is in the process of determining the impact of this proposed FSP.
In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities-including an amendment of FASB Statement No. 115” (“SFAS 159”). SFAS 159 allows an entity the irrevocable option to elect fair value for the initial and subsequent measurement of certain financial assets and liabilities under an instrument-by-instrument election. Subsequent measurements for the financial assets and liabilities an entity elects to fair value will be recognized in the results of operations. SFAS 159 also establishes additional disclosure requirements. This standard is effective for fiscal years beginning after November 15, 2007. The Company is in the process of determining the financial impact the adoption of SFAS 159 will have on its results of operations and financial position.
In December 2007, the FASB issued SFAS No. 141R, “Business Combinations” (“SFAS 141R”). SFAS 141R replaces SFAS 141 and establishes principles and requirements for how an acquirer recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, any non controlling interest in the acquiree and the goodwill acquired. SFAS 141R also establishes disclosure requirements which will enable users to evaluate the nature and financial effects of the business combination. This standard is effective for fiscal years beginning after December 15, 2008.
In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements” (“SFAS 160”). SFAS 160 establishes accounting and reporting standards for ownership interests in subsidiaries held by parties other than the parent, the amount of consolidated net income attributable to the parent and to the noncontrolling interest, changes in a parent’s ownership interest and the valuation of retained noncontrolling equity investments when a subsidiary is deconsolidated. SFAS 160 also establishes reporting requirements that provide sufficient disclosures that clearly identify and distinguish between the interests of the parent and the interests of the noncontrolling owners. This standard is effective for fiscal years beginning after December 15, 2008.
Current Developments
On February 1, 2008, the Company filed a shelf registration on Form S-3. The registration statement, which became effective upon filing with the U.S. Securities and Exchange Commission, registered for resale the $330.0 million aggregate principal amount of 4.25% convertible senior notes due 2012 and the shares issuable upon conversion of the notes that were part of a private placement completed on August 8, 2007. The notes pay interest semiannually at a rate of 4.25% per annum. The notes are convertible under certain circumstances into cash up to the principal amount of the notes, and shares of the Company’s common stock or cash (at the option of the Company) for any conversion value in excess of the principal amount at an initial conversion rate of 26.9339 shares of the Company’s common stock per $1,000 principal amount of notes. This represents an initial conversion price of approximately $37.13 per share. Concurrent with the issuance of the notes, the Company entered into separate note hedge and warrant transactions which were structured to reduce the potential future share dilution associated with the conversion of notes. The cost of the note hedge transactions was approximately $52.5 million, $33.4 million net of tax benefits, and the Company received proceeds of $11.9 million related to the sale of the warrants.
The issuance of the convertible senior notes was part of a series of transactions by which the Company refinanced its capital structure. On August 8, 2007, the Company entered into a credit agreement providing for a $250.0 million five year revolving credit facility and a $125.0 million term loan with various financial lenders (the “Senior Credit Facility”). The Senior Credit Facility obligations are secured by substantially all of the Company’s assets. The terms of the Senior Credit Facility also provide for a $20.0 million swingline subfacility and a $50.0 million letter of credit subfacility.
On July 17, 2007, the Company launched a cash tender offer for any and all of its outstanding 9% senior notes and 11% senior discount notes. On August 13, 2007, the Company completed the cash tender offer with 100% of the outstanding principal amount of the notes validly tendered. The Company used proceeds from the sale of the convertible notes and borrowings under the Senior Credit Facility to fund the cash tender offer for the 9% senior notes and the 11% senior discount notes.
On November 19, 2007, the Company’s Board of Directors authorized the Company to commence a stock repurchase program to buy back up to $50.0 million worth of its common stock. The program allowed the Company to purchase shares through open market repurchases and privately negotiated transactions at a price of $26.00 per share or less until the program’s expiration on December 31, 2008. The Company acquired 1,172,700 shares at a total cost of $20.6 million under this program during the fourth quarter of 2007. The Company completed its share repurchase program in the first quarter of 2008, acquiring an additional 1,627,500 shares at a total cost of $29.4 million. Although the Company does not currently intend to repurchase additional shares, the Company will continue to evaluate market conditions and may, subject to approval by the Company’s Board of Directors, repurchase additional shares of its common stock in the future.
On August 22, 2007, the Company completed the acquisition of Montebello Management, LLC (D/B/A Aero Logistics) (“Aero Logistics”), a full service third party logistics provider, for approximately $27.3 million in cash. As of December 23, 2007, $0.5 million is held in escrow pending achievement of 2008 earnings targets and has been excluded from the purchase price. In addition, subsequent to December 23, 2007, the Company completed its assessment of the working capital received and released $0.4 million originally placed into escrow and paid an additional $0.2 million. The additional $0.2 million increased the total purchase to $27.5 million. Aero Logistics designs and manages custom freight shipping and special handling programs for customers in service-sensitive industries including high-tech, healthcare, energy, mining, retail and apparel. Aero Logistics offers an array of multi-modal transportation services and fully integrated logistics solutions to satisfy the unique needs of its customers. Aero Logistics also operates a fleet of approximately 90 GPS-equipped trailers under the direction of their Aero Transportation division, which provides expedited less-than-truckload (LTL) and full truckload (FTL) service throughout North America.
On June 26, 2007, the Company completed the purchase of Hawaii Stevedores, Inc. (“HSI”) for approximately $4.1 million in cash, net of cash acquired. HSI, which operates as a subsidiary of the Company, is a full service provider of stevedoring and marine terminal services in Hawaii and has operations in all of the commercial ports on Oahu and the Island of Hawaii.
In 2007, a draft of a Technical Corrections Act proposed redefining the Puerto Rico trade such that it would not qualify for application of the tonnage tax. However, the Technical Corrections Act, as passed, did not include any language that will adversely affect our utilization of the tonnage tax regime.
During the first half of 2007, the Company modified its trade route between the U.S. west coast and Asia and Guam commencing with the deployment of newly acquired vessels. This deployment enabled the Company to redeploy Jones Act qualified active vessels to other Jones Act routes and to commence a new U.S. west coast to Hawaii trade route with two of the vessels previously deployed in the Guam trade route.
Shipping Rates
We publish tariffs with fixed rates for all three of our Jones Act trade routes. These rates are subject to regulation by the Surface Transportation Board (“STB”). However, in the case of our Puerto Rico and Alaska trade routes, we primarily ship containers on the basis of confidential negotiated transportation service contracts that are not subject to rate regulation by the STB.
Seasonality
Our container volumes are subject to seasonal trends common in the transportation industry. Financial results in the first quarter are normally lower due to reduced loads during the winter months. Volumes typically build to a peak in the third quarter and early fourth quarter, which generally results in higher revenues and improved margins.
Results of Operations
Operating Revenue Overview
We derive our revenue primarily from providing comprehensive shipping and logistics services to and from the continental U.S. and Alaska, Puerto Rico, Hawaii and Guam. We charge our customers on a per load basis and price our services based on the length of inland and ocean cargo transportation hauls, type of cargo and other requirements, such as shipment timing and type of container. In addition, we assess fuel surcharges on a basis consistent with industry practice and at times may incorporate these surcharges into our basic transportation rates. At times, there is a timing disparity between volatility in our fuel costs and related adjustments to our fuel surcharges (or the incorporation of adjusted fuel surcharges into our base transportation rates) that may result in insufficient recovery of our fuel costs during sharp hikes in the price of fuel and recoveries in excess of our fuel costs when fuel prices level off or decline.
During 2007, over 85% of our revenues were generated from our shipping and logistics services in markets where the marine trade is subject to the Jones Act or other U.S. maritime laws. The balance of our revenue is derived from (i) vessel loading and unloading services that we provide for vessel operators at our terminals, (ii) agency services that we provide for third-party shippers lacking administrative presences in our markets, (iii) vessel space charter income from third-parties in trade lanes not subject to the Jones Act, (iv) management of vessels owned by third-parties, (v) warehousing services for third-parties, and (vi) other non-transportation services.
As used in this Form 10-K, the term “revenue containers” refers to containers that are transported for a charge, as opposed to empty containers.
Operating Expense Overview
Our operating expenses consist primarily of marine operating costs, inland transportation costs, vessel operating costs, land costs and rolling stock rent. Our marine operating costs consist of stevedoring, port charges, wharfage and various other costs to secure vessels at the port and to load and unload containers to and from vessels. Our inland transportation costs consist primarily of the costs to move containers to and from the port via rail, truck or barge. Our vessel operating costs consist primarily of crew payroll costs and benefits, vessel fuel costs, vessel maintenance costs, space charter costs, vessel insurance costs and vessel rent. We view our vessel fuel costs as subject to potential fluctuation as a result of changes in unit prices in the fuel market. Our land costs consist primarily of maintenance, yard and gate operations, warehousing operations and terminal overhead in the terminals in which we operate. Rolling stock rent consists primarily of rent for street tractors, yard equipment, chassis, gensets and various dry and refrigerated containers.
Year Ended December 23, 2007 Compared to Year Ended December 24,
Operating Revenue. Operating revenue increased to $1,206.5 million for the year ended December 23, 2007 from $1,156.9 million for the year ended December 24, 2006, an increase of $49.6 million, or 4.3%. This revenue increase can be attributed to the following factors (in thousands):
The decreased revenue due to revenue container volume declines is primarily due to overall soft market conditions in Puerto Rico and decelerating growth in Hawaii. This revenue container volume
decrease is offset by higher margin cargo mix in addition to general rate increases. Bunker and intermodal fuel surcharges, which are included in our transportation revenue, accounted for approximately 12% of total revenue in both of the years ended December 23, 2007 and December 24, 2006. We increased our bunker and intermodal fuel surcharges several times throughout 2006 and 2007 as a result of fluctuations in the cost of fuel for our vessels, in addition to fuel fluctuations passed on to us by our truck, rail, and barge carriers. Fuel surcharges are evaluated regularly as the price of fuel fluctuates, and we may at times incorporate these surcharges into the base transportation rates that we charge. The increase in non-transportation revenue is primarily due to higher space charter revenue resulting from the extension of the scope of services provided in connection with our expanded service between the U.S. west coast and Guam and Asia, partially offset by lower terminal services revenue.
Operating Expense. Operating expense increased to $954.0 million for the year ended December 23, 2007 from $896.3 million for the year ended December 24, 2006, an increase of $57.7 million or 6.4%. The increase in operating expense is primarily due to higher vessel operating costs related to the deployment of the new vessels and expanded services between the U.S. west coast and Hawaii, which is partially offset by reduced expenses associated with lower container volumes and reduced expenses associated with cost control efforts.
Vessel expense, which is not primarily driven by revenue container volume, increased to $368.7 million for the year ended December 23, 2007 from $319.6 million for the year ended December 24, 2006, an increase of $49.1 million or 15.4%. This increase can be attributed to the following factors (in thousands):
The $7.9 million increase in fuel expense is comprised of an increase of $13.7 million due to a 9.8% increase in fuel prices, offset by a decrease of $5.3 million due to lower fuel consumption and a decrease of $0.5 million due to a loss on fuel hedge in 2006. The increase in vessel operating expenses is primarily due to additional active vessels during 2007 as a result of the expansion of services between the U.S. west coast and Guam and Asia and the U.S. west coast and Hawaii as well as more dry-dockings during 2007 versus 2006. In addition, the Company incurred certain one time, non-recurring expenses associated with the activation of the new vessels of approximately $3.5 million during the year ended December 23, 2007.
Marine expense is comprised of the costs incurred to bring vessels into and out of port, and to load and unload containers. The types of costs included in marine expense are stevedoring and benefits, pilotage fees, tug fees, government fees, wharfage fees, dockage fees, and line handler fees. Marine expense increased to $198.9 million for the year ended December 23, 2007 from $192.2 million for the year ended December 24, 2006, an increase of $6.7 million or 3.5%. This increase in marine expenses can be attributed to additional stevedoring costs related to services provided to third parties as a result of the acquisition of HSI, which is offset by decreased expenses due to lower revenue container volumes.
Inland expense increased to $206.0 million for the year ended December 23, 2007 from $202.0 million for the year ended December 24, 2006, an increase of $4.0 million or 2.0%. The increase in inland expense is due to higher inland expenses as a result of the acquisition of Aero Logistics, offset by lower container volumes.
Land expense is comprised of the costs included within the terminal for the handling, maintenance and storage of containers, including yard operations, gate operations, maintenance, warehouse and terminal overhead.
Non-vessel related maintenance expenses decreased primarily due to a decline in overall volumes and lower maintenance expenses due to newer equipment and process improvement initiatives. Yard and gate expense is comprised of the costs associated with moving cargo into and out of the terminal facility and the costs associated with the storage of equipment and revenue loads in the terminal facility. Yard and gate expenses decreased primarily due to lower revenue container volumes.
Depreciation and Amortization. Depreciation and amortization costs decreased to $47.9 million for the year ended December 23, 2007 from $50.2 million for the year ended December 24, 2006, a decrease of $2.4 million or 4.7%.
The decrease in depreciation - owned vessels is due to certain vessels becoming fully depreciated and no longer subject to depreciation expense. The decrease in depreciation and amortization - other is primarily due to the timing of the purchase and sale of our containers and certain capitalized software assets becoming fully depreciated and no longer subject to depreciation expense. The increase in amortization of intangible assets is due to the amortization of the intangible assets recorded in conjunction with the acquisitions of H.S.I and Aero Logistics.
Amortization of Vessel Drydocking. Amortization of vessel drydocking increased to $17.5 million for the year ended December 23, 2007 compared to $14.7 million for the year ended December 24, 2006, an increase of $2.8 million or 19.4%. The increase is primarily due to the timing of drydockings and drydocking costs.
Selling, General and Administrative. Selling, general and administrative costs decreased to $91.0 million for the year ended December 23, 2007 from $98.3 million for the year ended December 24, 2006, a decrease of $7.3 million or 7.4%. This decrease is comprised of a $10.9 million decrease in the management bonus accrual and $2.0 million decrease of fees incurred in connection with the Company’s 2006 secondary offerings, offset by an increase of approximately $0.7 million of professional fees related to our process re-engineering initiative, $2.0 million increase in salaries and related expenses and $2.8 million of compensation expense related to stock option and restricted stock grants.
Miscellaneous Expense, Net. Miscellaneous expense decreased to $1.0 million for the year ended December 23, 2007 from $1.4 million for the year ended December 24, 2006, a decrease of $0.4 million or 31.2%. This decrease is primarily a result of lower bad debt expense during 2007.
Interest Expense, Net. Interest expense, net decreased to $41.7 million for the year ended December 23, 2007 from $48.6 million for the year ended December 24, 2006, a decrease of $6.9 million or 14.1%. This decrease is a result of the August 2007 refinancing and the related lower interest rates payable on the outstanding debt.
Loss on Early Extinguishment of Debt. Loss on early extinguishment of debt was $38.5 million for the year ended December 23, 2007 compared to $0.6 million during the year ended December 24, 2006. The 2007 loss on extinguishment is due to the write off of net deferred financing costs and premiums paid in connection with the tender offer for the 9% senior notes and the 11% senior discount notes. The 2006 loss on extinguishment is due to the write off of deferred finance fees associated with the $25.0 million voluntary prepayment of our term loan.
Income Tax Benefit. Income tax benefit was $14.0 million in 2007 and $25.3 million in 2006, which represent effective tax rates of (94.0%) and (53.9%), respectively. During 2006, the Company elected the application of tonnage tax. The Company modified its trade routes between the U.S. west coast and Guam and Asia during 2007. As such, the Company’s shipping activities associated with these modified trade routes became qualified shipping activities, and thus the income from these vessels is excluded from gross income in determining federal income tax liability. During 2007, the Company recorded a $7.7 million tax benefit related to the revaluation of deferred taxes related to the qualified shipping income expected to be generated by the new vessels and related to a change in estimate resulting from refinements in the methodology for computing secondary activities and cost allocations for tonnage tax purposes. This benefit was recorded in connection with the filing of the 2006 income tax return in September 2007. Excluding the loss on extinguishment and the related tax benefits, the benefit associated with the revaluation of deferred taxes related to activities qualifying for the application of tonnage tax and the benefits related to the refinements in methodology of applying tonnage tax, the Company’s effective tax rate was 14.1% for the year ended December 23, 2007. The Company’s 2006 election was made in connection with the filing of the Company’s 2005 federal corporate income tax return and the Company accounted for this election as a change in the tax status of its qualifying shipping activities. Excluding the 2005 reduction in income tax expense and revaluation of the deferred taxes related to qualifying activities, the Company’s effective tax rate for the year ended December 24, 2006 was 9.5%. The Company’s effective tax rate is impacted by the Company’s income from shipping activities as well as the income from the Company’s non qualifying shipping activities and will fluctuate based on the ratio of income from qualifying and non-qualifying activities.
Year Ended December 24, 2006 Compared to Year Ended December 25,
Operating Revenue. Operating revenue increased to $1,156.9 million for the year ended December 24, 2006 from $1,096.2 million for the year ended December 25, 2005, an increase of $60.7 million, or 5.5%. This revenue increase can be attributed to the following factors (in thousands):
The decreased revenue due to revenue container volume declines for the year ended December 24, 2006 is primarily due to overall soft market conditions in Puerto Rico as well as a strategic shift away from lower margin automobile cargo to more refrigerated cargo and other higher margin freight. The temporary government shutdown in Puerto Rico and uncertainty surrounding tax reform contributed to the continued soft market conditions. This revenue container volume decrease is offset by higher margin cargo mix in addition to general rate increases. Bunker and intermodal fuel surcharges, which are included in our transportation revenue, accounted for approximately 12% of total revenue in the year ended December 24, 2006 and approximately 8% of total revenue in the year ended December 25, 2005. We increased our bunker and intermodal fuel surcharges several times throughout 2005 and 2006, as a result of significant increases in the cost of fuel for our vessels and as a result of fuel increases passed on to us by our truck, rail, and barge carriers. Fuel surcharges are evaluated regularly as the price of fuel fluctuates, and we may at times incorporate these surcharges into the base transportation rates that we charge. The growth in other non-transportation services is primarily due to increases in terminal services provided to third parties, offset slightly by a decrease in equipment rental income.
Operating Expense. Operating expense increased to $896.3 million for the year ended December 24, 2006 from $867.3 million for the year ended December 25, 2005, an increase of $29.0 million or 3.3%. The increase in operating expense primarily reflects the effect of rising fuel prices, and an increase in rolling stock rent, offset by lower expenses associated with lower container volumes. Vessel expense, which is not primarily driven by revenue container volume, increased to $319.6 million for the year ended December 24, 2006 from $300.3 million for the year ended December 25, 2005, an increase of $19.3 million or 6.4%. This $19.3 million increase can be attributed to the following factors (in thousands):
The $27.1 million increase in fuel expense is comprised of an increase of $32.1 million due to a 27.7% increase in fuel prices, offset by a decrease of $5.0 million due to lower fuel consumption. The decrease in vessel lease expense is due to the purchase of the Horizon Enterprise and the Horizon Pacific in September 2005, offset by lease expense incurred during 2006 for the Horizon Hunter. The decrease in vessel labor and other operating expenses is primarily due to operating one less vessel in Puerto Rico during most of 2006.
Marine expense is comprised of the costs incurred to bring vessels into and out of port, and to load and unload containers. The types of costs included in marine expense are stevedoring and benefits, pilotage fees, tug fees, government fees, wharfage fees, dockage fees, and line handler fees. Marine expense decreased to $192.2 million for the year ended December 24, 2006 from $195.3 million for the year ended December 25, 2005, a decrease of $3.0 million or 1.6%. This decrease in marine expenses can be attributed to a 3.7% decrease in total revenue container volume period over period, offset by contractual labor increases.
Inland expense increased to $202.0 million for the year ended December 24, 2006 from $190.2 million for the year ended December 25, 2005, an increase of $11.8 million or 6.2%. Approximately $7.6 million of this increase is due to higher fuel costs, as rail, truck, and barge carriers have substantially increased their fuel surcharges period over period. The remaining increase is due to rate increases offset by lower volumes.
Land expense is comprised of the costs included within the terminal for the handling, maintenance and storage of containers, including yard operations, gate operations, maintenance, warehouse and terminal overhead. Land expense was flat for the year ended December 24, 2006 compared to the year ended December 25, 2005.
Non-vessel related maintenance expenses decreased primarily due to lower maintenance expenses associated with the new refrigerated container equipment added to our fleet during 2005 and other new container equipment added to our fleet in 2006. This decrease is partially offset by an
increase of $1.6 million in fuel costs. Terminal overhead increased primarily due to higher utility expenses, labor related expenses and higher insurance costs. Yard and gate expense is comprised of the costs associated with moving cargo into and out of the terminal facility and the costs associated with the storage of equipment and revenue loads in the terminal facility. Yard and gate expenses decreased primarily due to decreased revenue container volumes, offset slightly by a $0.3 million increase in fuel costs.
Depreciation and Amortization. Depreciation and amortization costs decreased to $50.2 million for the year ended December 24, 2006 from $51.1 million for the year ended December 25, 2005, a decrease of $0.9 million or 1.8%.
Depreciation of owned vessels increased by $1.6 million due to the acquisition of the rights and beneficial interests of the sole owner participant in two separate trusts, the assets of which consist primarily of the Horizon Enterprise and the Horizon Pacific in the third quarter of fiscal year 2005. The $2.5 million decrease in depreciation and amortization-other is primarily due to a decrease in depreciation of leasehold improvements and containers. The decrease in leasehold improvements is due to the write-off of certain leasehold improvements made prior to the acquisition of the rights and beneficial interests in the aforementioned trusts in September 2005.
Amortization of Vessel Drydocking. Amortization of vessel drydocking decreased to $14.7 million for the year ended December 24, 2006 compared to $15.8 million for the year ended December 25, 2005, a decrease of $1.1 million or 7.1%. The decrease is primarily related to an increased number of drydockings in 2004 and 2005 and to lower overall costs on recent drydockings.
Selling, General and Administrative. Selling, general and administrative costs decreased to $98.3 million for the year ended December 24, 2006 from $114.6 million for the year ended December 25, 2005, a decrease of $16.4 million or 14.3%. This decrease is comprised of an $18.0 million decrease in stock-based compensation expense, and $9.7 million in management fees. The management fee expenses related to the previous management services and related fee provisions of a management agreement with Castle Harlan. Such management agreement was terminated in conjunction with the Company’s initial public offering in September 2005. These decreases are offset by a $4.8 million increase in professional fees, $4.8 million increase in salaries and related expenses, and $1.8 million increase in other expenses. The professional fees increase is primarily due to consulting related professional fees, and an increase in audit and legal fees. In addition, expenses associated with the secondary offerings and shelf registration totaling $2.0 million are relatively flat with other transaction related costs of $2.2 million during 2005.
Miscellaneous Expense, Net. Miscellaneous expense increased to $1.4 million for the year ended December 24, 2006 from $0.6 million for the year ended December 25, 2005, an increase of $0.8 million or 123.3%. This increase is primarily a result of recognized losses on the retirement of equipment during 2006 and an increase in bad debt expense.
Interest Expense, Net. Interest expense, net decreased to $48.6 million for the year ended December 24, 2006 from $51.4 million for the year ended December 25, 2005, a decrease of
$2.8 million or 5.4%. This decrease is comprised of a $7.1 million decrease attributable to the redemption of $53.0 million of the principal amount of the 9% senior notes and $56.0 million principal amount of the 11% senior discount notes utilizing proceeds from the Company’s initial public offering in September 2005 and a $1.1 million increase in interest income related to higher cash balances and higher interest rates earned on the Company’s cash balances during 2006 compared to 2005. The decrease is offset by a $4.4 million increase in interest expense under our senior credit facility due to a 195 basis point increase in interest rates during 2006 as compared to 2005 and a $0.4 million increase in interest expense related to the notes issued by the owner trustees for the purchase of the Horizon Enterprise and the Horizon Pacific.
Loss on Early Extinguishment of Debt. Loss on early extinguishment of debt was $0.6 million for the year ended December 24, 2006 compared to $13.2 million during the year ended December 25, 2005, a decrease of 12.6 million or 95.5%. The 2006 loss on extinguishment is due to the write off of deferred finance fees associated with the $25.0 million voluntary prepayment of our term loan. The 2005 loss on extinguishment is primarily due to redemption premiums and the write-off of deferred financing costs associated with the early retirement of a portion of our 9% senior notes and 11% senior discount notes that occurred during 2005.
Income Tax (Benefit) Expense. Income tax (benefit) expense was ($25.3) million in 2006 and $0.4 million in 2005, which represent effective tax rates of (53.9%) and (2.4%), respectively. During 2006, after evaluating the merits and requirements of the tonnage tax, the Company elected the application of the tonnage tax instead of the federal corporate income tax on income from its qualifying shipping activities. This 2006 election of the tonnage tax was made in connection with the filing of the Company’s 2005 federal corporate income tax return and will also apply to all subsequent federal income tax returns unless the Company revokes this alternative tonnage tax treatment. The Company does not intend to revoke its election of the tonnage tax in the foreseeable future. The Company is accounting for this election as a change in the tax status of its qualifying shipping activities. The impact of this tonnage tax election resulted in a decrease in income tax expense of approximately $43.5 million during the year ended December 24, 2006. Approximately $11.0 million and $18.8 million relate to the 2005 reduction in income tax expense and revaluation of the deferred taxes related to the application of tonnage tax to qualifying activities, respectively. Excluding the 2005 reduction in income tax expense and revaluation of the deferred taxes related to qualifying activities, the Company’s effective tax rate for the year ended December 24, 2006 would be 9.5%. Retroactively applying the tonnage tax to the year ended December 25, 2005 would result in a 2005 effective tax rate of (59.1%). The differences between the federal and state statutory tax rates and the overall effective tax rate for the year ended December 25, 2005 is related primarily to permanent differences resulting from stock-based compensation.
Liquidity and Capital Resources
Our principal sources of funds have been (i) earnings before non-cash charges, (ii) borrowings under debt arrangements and (iii) equity capitalization. Our principal uses of funds have been (i) capital expenditures on our container fleet, our terminal operating equipment, improvements to our owned and leased vessel fleet, and our information technology systems, (ii) vessel drydocking expenditures, (iii) the purchase of vessels upon expiration of operating leases, (iv) working capital consumption, (v) principal and interest payments on our existing indebtedness, (vi) dividend payments to our common stockholders, (vii) acquisitions, (viii) share repurchases, (ix) premiums associated with the tender offer, and (x) purchases of equity instruments in conjunction with the Notes. Cash totaled $6.3 million at December 23, 2007. As of December 23, 2007, $121.7 million was available for borrowing under the $250.0 million revolving credit facility, after taking into account $6.3 million utilized for outstanding letters of credit.
Operating Activities
Net cash provided by operating activities decreased by $60.7 million to $54.8 million for the year ended December 23, 2007 from $115.5 million for the year ended December 24, 2006. Net earnings adjusted for depreciation, amortization, deferred income taxes, accretion and other non-cash operating activities, which includes non-cash stock-based compensation expense, resulted in cash flow generation of $131.6 million for the year ended December 23, 2007 compared to $125.5 million for the year ended December 24, 2006, an increase of $6.1 million. The reduction in cash provided by operating activities is primarily related to a $24.0 million increase in vessel rent payments in excess of accruals, $10.5 million of bonus payments in excess of accruals, a $12.7 million increase in accounts receivable as a result of a slight increase in the number of days sales outstanding, a $7.4 million increase in materials and supplies as a result of increased fuel prices and two additional active vessels during 2007 and a $4.6 million increase in vessel drydocking payments as a result of nine drydockings during 2007 versus five during 2006.
Net cash provided by operating activities increased by $39.1 million to $115.5 million for the year ended December 24, 2006 from $76.4 million for the year ended December 25, 2005. Net earnings adjusted for depreciation, amortization, deferred income taxes, accretion and other non-cash operating activities, which includes non-cash stock-based compensation expense, resulted in cash flow generation of $125.5 million for the year ended December 24, 2006 compared to $94.3 million for the year ended December 25, 2005, an increase of $31.2 million. The 2006 other assets/liabilities working capital use includes $4.2 million of various costs associated with our contractual obligations with Ship Finance Limited. Accounts payable and accrued liabilities working capital changes are primarily due to timing of interest payments and various other operating expenses.
Investing Activities
Net cash used in investing activities was $59.4 million for the year ended December 23, 2007 compared to $19.3 million for the year ended December 24, 2006. The $40.1 million increase is due to the acquisition of HSI and Aero Logistics and a $10.1 million increase in capital expenditures, primarily related to the raising of our Honolulu, Hawaii cranes and other capital expenditures in connection with our fleet enhancement initiative and our San Juan, Puerto Rico terminal redevelopment project, offset by a $1.2 million increase in proceeds from the sale of equipment.
Net cash used in investing activities was $19.3 million for the year ended December 24, 2006 compared to $38.8 million for the year ended December 25, 2005. Approximately $25.2 million of the capital expenditures in the year ended December 25, 2005 is comprised of the acquisition of the rights and beneficial interests of the sole owner participant in two separate trusts, the assets of which consist primarily of the Horizon Enterprise and the Horizon Pacific and the charters related thereto under which HL operates such vessels. Excluding this expenditure, capital expenditures increased approximately $5.3 million in 2006 as compared to 2005. Capital expenditures in 2006 primarily relate to the acquisition of containers, expenditures related to the new fleet enhancement initiative, and capital expenditures relating to the redevelopment of the San Juan, Puerto Rico terminal.
Financing Activities
Net cash used in financing activities during the year ended December 23, 2007 was $83.1 million compared to $43.7 million for the year ended December 24, 2006. The Company used the proceeds provided by the New Credit Facility (as defined below) and the Notes (as defined below) to (i) repay $192.8 million of borrowings outstanding under the Prior Senior Credit Facility (as defined below), (ii) purchase the outstanding principal and pay associated premiums of the 9% senior notes and 11% senior discount notes purchased in the Company’s tender offer, and (iii) purchase 1,000,000 shares of the Company’s common stock. Concurrent with the issuance of the Notes, the Company entered into note hedge transactions whereby the Company has the option to purchase shares of the Company’s common stock and the Company sold warrants to purchase the Company’s
common stock. The cost of the note hedge transactions to the Company was approximately $52.5 million and the Company received proceeds of $11.9 million related to the sale of the warrants. The net cash used in financing activities during the year ended December 23, 2007 also includes a $25.0 million prepayment under the senior credit facility and $4.5 million in long-term debt payments related to the outstanding indebtedness secured by mortgages on the Horizon Enterprise and the Horizon Pacific. The net cash used for financing activities during 2006 includes a $25.0 million prepayment under the senior credit facility, the payment of $1.2 million in financing costs related to fees associated with amendments to HL and HLHC’s senior credit facility, and a $1.3 million open market purchase of HLFHC’s 11% senior discount notes.
Net cash used in financing activities during the year ended December 24, 2006 was $43.7 million compared to $52.9 million for the year ended December 25, 2005. The net cash used for financing activities during 2006 includes a $25.0 million prepayment under the senior credit facility, $14.8 million in dividends to common stockholders, the payment of $1.2 million in financing costs related to fees associated with amendments to HL and HLHC’s senior credit facility, and a $1.3 million open market purchase of HLFHC’s 11% senior discount notes.
Stock Repurchase Program
On November 19, 2007, the Company’s Board of Directors authorized the Company to commence a stock repurchase program to buy back up to $50.0 million worth of its common stock. The program allowed the Company to purchase shares through open market repurchases and privately negotiated transactions at a price of $26.00 per share or less until the program’s expiration on December 31, 2008. The Company acquired 1,172,700 shares at a total cost of $20.6 million under this program during the fourth quarter of 2007. The Company completed its share repurchase program in the first quarter of 2008, acquiring an additional 1,627,500 shares at a total cost of $29.4 million. Although the Company does not currently intend to repurchase additional shares, the Company will continue to evaluate market conditions and may, subject to approval by the Company’s Board of Directors, repurchase additional shares of its common stock in the future. The Company expects to fund future share repurchases with either, or a combination of, existing cash on hand or borrowings under its revolving credit facility.
Outlook
Our outlook for 2008 reflects stable market conditions in Hawaii, flat economic conditions in Puerto Rico, and continued economic growth in Alaska. We expect approximately 1.5% in revenue container volume growth in 2008 and approximately 2.5% revenue growth due to more favorable cargo mix and general rate increases. Our Horizon Logistics division will continue to provide integrated logistics services, including rail, trucking, and distribution services to Horizon Lines and will pursue additional third party logistics business. Since Horizon Logistics is in the infancy stages of its existence, we do not expect the third party business to be significant in 2008. We will continue our process initiatives improvements and cost constraint efforts in both our liner and logistics divisions. Fuel is a significant expense for our operations. The price of fuel is unpredictable and fluctuates based on events outside our control. Continued volatility in fuel prices could impact our profitability because adjustments in our fuel surcharges lag changes in actual fuel cost. As a result of the expected organic growth, continued growth from our 2007 acquisitions, and decreases in interest expense due to our 2007 refinancing, we expect our earnings to increase to $2.01-$2.26 per diluted share in 2008, based upon current economic conditions.
Capital Requirements and Liquidity
Based upon our current level of operations and certain anticipated improvements, we believe that cash flow from operations and available cash, together with borrowings available under the senior credit facility, will be adequate to meet our future liquidity needs throughout 2008. During 2008, we expect to spend approximately $20.6 million and $15.8 million on capital expenditures and drydocking
expenditures, respectively. Such capital expenditures include continued redevelopment of our San Juan Puerto Rico terminal, vessel regulatory and life extension initiatives, and other terminal infrastructure and equipment. We expect to generate cash flows after capital expenditures and drydocking expenses but before debt repayments, share repurchases, and dividends of between $115.0 million and $125.0 million in 2008. We intend to utilize these cash flows to complete our share repurchase program, to pay dividends, and to make debt repayments. However, if attractive acquisition opportunities arise that we believe are consistent with our strategic plans, certain of our cash flows could be utilized to fund acquisitions. Due to the seasonality within our business, we will utilize borrowings under the senior credit facility in the first half of 2008 but plan to repay such borrowings in the second half of the year.
Contractual Obligations and Off-Balance Sheet Arrangements
Contractual obligations as of December 23, 2007 are as follows (in thousands):
(1)
The above contractual obligations table does not include the residual guarantee related to our transaction with Ship Finance Limited. If Horizon Lines does not elect to purchase the vessels at the end of the initial twelve year period and the vessel owners sell the vessels for less than a specified amount, Horizon Lines is responsible for paying the amount of such shortfall which will not exceed $3.8 million per vessel. Such residual guarantee has been recorded at its fair value of approximately $0.2 million as a liability.
(2)
Included in contractual obligations are scheduled interest payments. Interest payments on the senior credit facility are variable and are based as of December 23, 2007 upon the London Inter-Bank Offered Rate (LIBOR) plus 1.50%. The three-month LIBOR / swap curve has been utilized to estimate interest payments on the senior credit facility. Interest on the 4.25% convertible senior notes is fixed and is paid semi-annually on February 15 and August 15 of each year, beginning on February 15, 2008, until maturity on August 15, 2012.
(3)
Other commitments include standby letters of credit and other long term liabilities recorded by the Company
The Company is not a party to any off-balance sheet arrangements that have, or are reasonably likely to have, a current or future effect on the Company’s financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that is material to investors.
Long-Term Debt
Senior Credit Facility
On August 8, 2007, the Company entered into a credit agreement providing for a $250.0 million five year revolving credit facility and a $125.0 million term loan with various financial lenders (the “Senior Credit Facility”). The obligations of the Company are secured by substantially all of the assets of the Company. The terms of the Senior Credit Facility also provide for a $20.0 million swingline subfacility and a $50.0 million letter of credit subfacility. In addition to proceeds from the term loan, the Company borrowed and used $133.5 million under the revolving credit facility to repay borrowings outstanding under the Prior Senior Credit Facility (as defined below) and to purchase a portion of the outstanding 9% senior notes and 11% senior discount notes purchased in the Company’s tender offer. Future borrowings under the Senior Credit Facility are expected to be used for permitted acquisitions, share repurchases and general corporate purposes, including working capital.
Beginning on December 31, 2007, principal payments of approximately $1.6 million are due quarterly on the term loan through September 30, 2009, at which point quarterly payments increase to $4.7 million through September 30, 2011, at which point quarterly payments increase to $18.8 million until final maturity on August 8, 2012. As of December 23, 2007, $247.0 million was outstanding under the Senior Credit Facility, which included a $125.0 million term loan and borrowings of $122.0 million under the revolving credit facility. The interest rate payable under the Senior Credit Facility varies depending on the types of advances or loans the Company selects. Borrowings under the Senior Credit Facility bear interest primarily at LIBOR-based rates plus a spread which ranges from 1.25% to 2.0% (LIBOR plus 1.50% as of the date hereof) depending on the Company’s ratio of total secured debt to EBITDA (as defined in the Senior Credit Facility). The weighted average interest rate at December 23, 2007 was approximately 6.5%. The Company also pays a variable commitment fee on the unused portion of the commitment, ranging from 0.25% to 0.40% (0.30% as of December 23, 2007).
The Senior Credit Facility contains customary affirmative and negative covenants and warranties, including two financial covenants with respect to the Company’s leverage and interest coverage ratio and limits the level of dividends and stock repurchases in addition to other restrictions. It also contains customary events of default, subject to grace periods, as appropriate. The Company was in compliance with all such covenants as of December 23, 2007.
4.25% Convertible Senior Notes
On August 1, 2007, the Company entered into a purchase agreement relating to the sale by the Company of $300.0 million aggregate principal amount of its 4.25% Convertible Senior Notes due 2012 (the “Notes”) for resale to qualified institutional buyers as defined in Rule 144A under the Securities Act of 1933, as amended. Under the terms of the purchase agreement, the Company also granted the initial purchasers an option to purchase up to $30.0 million aggregate principal amount of the Notes to cover over-allotments. The initial purchasers subsequently exercised the over-allotment option in full, and, at closing on August 8, 2007, the initial purchasers acquired $330.0 million aggregate principal amount of the Notes. The net proceeds from the offering, after deducting the initial purchasers’ discount and offering expenses, were approximately $320.5 million. The Company used (i) $28.6 million of the net proceeds to purchase 1,000,000 shares of the Company’s common stock in privately negotiated transactions, (ii) $52.5 million of the net proceeds to acquire an option to receive the Company’s common stock from the initial purchasers, and (iii) the balance of the net proceeds to purchase a portion of the outstanding 9% senior notes and 11% senior discount notes purchased in the Company’s tender offer.
The Notes are general unsecured obligations of the Company and rank equally in right of payment with all of the Company’s other existing and future obligations that are unsecured and unsubordinated. The Notes bear interest at the rate of 4.25%, and the Company will pay interest on the Notes on February 15 and August 15 of each year, beginning on February 15, 2008. The Notes
will mature on August 15, 2012, unless earlier converted, redeemed or repurchased in accordance with their terms prior to August 15, 2012. Holders of the Notes may require the Company to repurchase the Notes for cash at any time before August 15, 2012 if certain fundamental changes occur.
Each $1,000 of principal of the Notes will initially be convertible into 26.9339 shares of the Company’s common stock, which is the equivalent of $37.13 per share, subject to adjustment upon the occurrence of specified events set forth under the terms of the Notes. Upon conversion, the Company would pay the holder the cash value of the applicable number of shares of its common stock, up to the principal amount of the note. Amounts in excess of the principal amount, if any, may be paid in cash or in stock, at the Company’s option. Holders may convert their Notes into the Company’s common stock as follows:
•
Prior to May 15, 2012, if during any calendar quarter, and only during such calendar quarter, if the last reported sale price of the Company’s common stock for at least 20 trading days in a period of 30 consecutive trading days ending on the last trading day of the preceding calendar quarter exceeds 120% of the applicable conversion price in effect on the last trading day of the immediately preceding calendar quarter;
•
Prior to May 15, 2012, if during the five business day period immediately after any five consecutive trading day period (the “measurement period”) in which the trading price per $1,000 principal amount of notes for each day of such measurement period was less than 98% of the product of the last reported sale price of the Company’s common stock on such date and the conversion rate on such date;
•
If, at any time, a change in control occurs or if the Company is a party to a consolidation, merger, binding share exchange or transfer or lease of all or substantially all of its assets, pursuant to which the Company’s common stock would be converted into cash, securities or other assets; or
•
At any time after May 15, 2012 through the fourth scheduled trading day immediately preceding August 15, 2012.
Holders who convert their Notes in connection with a change in control may be entitled to a make-whole premium in the form of an increase in the conversion rate. In addition, upon a change in control, liquidation, dissolution or de-listing, the holders of the Notes may require the Company to repurchase for cash all or any portion of their Notes for 100% of the principal amount plus accrued and unpaid interest. As of December 23, 2007, none of the conditions allowing holders of the Notes to convert or requiring the Company to repurchase the Notes had been met. The Company may not redeem the Notes prior to maturity.
As required by the terms of a registration rights agreement relating to the Notes, the Company filed a shelf registration statement with the SEC with respect to the Notes and the shares issuable upon conversion of the Notes on February 1, 2008.
As discussed in Note 2 to the Notes to the Consolidated Financial Statements, the FASB has published for comment a clarification on the accounting for convertible debt instruments that may be settled in cash (including partial cash settlement) upon conversion, such as the convertible notes we issued in August 2007 (“FSP APB 14-a”). The proposed FSP would require the issuer to separately account for the liability and equity components of the instrument in a manner that reflects the issuer’s non-convertible debt borrowing rate. As a result, the liability component would be recorded at a discount reflecting its below market coupon interest rate, and the liability component would subsequently be accreted to its par value over its expected life, with the rate of interest that reflects the market rate at issuance being reflected on the income statement. The proposed change in methodology will affect the calculations of net income and earnings per share. The proposed effective date of FSP APB 14-a is for fiscal years beginning after December 15, 2007 and does not permit early application. In November 2007, the FASB announced it is expected to begin its redeliberations of the
guidance in the proposed FSP beginning in January 2008. Therefore, it is expected that final guidance will not be issued until at least the first quarter of 2008 and it is unlikely the proposed effective date for fiscal years beginning after December 15, 2007 will be retained. The proposed transition guidance requires retrospective application to all periods presented and does not grandfather existing instruments. The Company is in the process of determining the impact of this proposed FSP.
Concurrent with the issuance of the Notes, the Company entered into note hedge transactions with certain financial institutions whereby if the Company is required to issue shares of its common stock upon conversion of the Notes, the Company has the option to receive up to 8.9 million shares of the Company’s common stock when the price of the Company’s common stock is between $37.13 and $51.41 per share upon conversion, and the Company sold warrants to the same financial institutions whereby the financial institutions have the option to receive up to 4.6 million shares of the Company’s common stock when the price of the Company’s common stock exceeds $51.41 per share upon conversion. The Company will seek approval from its shareholders to increase the number of authorized but unissued shares such that the number of shares available for issuance to the financial institutions increases from 4.6 million to 17.8 million. The separate note hedge and warrant transactions were structured to reduce the potential future share dilution associated with the conversion of Notes. The cost of the note hedge transactions to the Company was approximately $52.5 million, $33.4 million net of tax, and has been accounted for as an equity transaction in accordance with EITF No. 00-19, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock” (EITF No. 00-19).The Company received proceeds of $11.9 million related to the sale of the warrants, which has also been classified as equity because they meet all of the equity classification criteria within EITF No. 00-19.
In accordance with SFAS 128, the Notes will have no impact on diluted earnings per share until the price of the Company’s common stock exceeds the conversion price (initially $37.13 per share) because the principal amount of the Notes will be settled in cash upon conversion. Prior to conversion, the Company will include the effect of the additional shares that may be issued if its common stock price exceeds the conversion price, using the treasury stock method.
Also, in accordance with SFAS 128, the warrants sold in connection with the hedge transactions will have no impact on earnings per share until the Company’s share price exceeds $37.13. Prior to exercise, the Company will include the effect of additional shares that may be issued using the treasury stock method. The call options purchased as part of the note hedge transactions are anti-dilutive and therefore will have no impact on earnings per share.
Long-term Note Payable
In conjunction with the acquisition of HSI, the Company assumed a $2.2 million note payable. The note is secured by the assets of HSI. The note bears interest at 5.26% per year and requires monthly payments of $32 thousand until maturity on February 24, 2014.
Interest Rate Risk
Our primary interest rate exposure relates to the senior credit facility. As of December 23, 2007, the Company had outstanding a $125.0 million term loan and $122.0 million under the revolving credit facility, which bear interest at variable rates. Each quarter point change in interest rates would result in a $0.3 million change in annual interest expense on each of the term loan and the revolving credit facility.
Item 7A.
Item 7A.
Quantitative and Qualitative Disclosures about Market Risk
We maintain a policy for managing risk related to exposure to variability in interest rates, fuel prices and other relevant market rates and prices which includes entering into derivative instruments in order to mitigate our risks.
Our exposure to market risk for changes in interest rates is limited to our senior credit facility and one of our operating leases. The interest rate for our senior credit facility is currently indexed to LIBOR of one, two, three, or six months as selected by us, or the Alternate Base Rate as defined in the senior credit facility. One of our operating leases is currently indexed to LIBOR of one month.
In addition, we utilize derivative instruments tied to various indexes to hedge a portion of our quarterly exposure to bunker fuel price increases. These instruments consist of fixed price swap agreements. We do not use derivative instruments for trading purposes. Credit risk related to the derivative financial instruments is considered minimal and is managed by requiring high credit standards for its counterparties.
Changes in fair value of derivative financial instruments are recorded as adjustments to the assets or liabilities being hedged in the statement of operations or in accumulated other comprehensive income (loss), depending on whether the derivative is designated and qualifies for hedge accounting, the type of hedge transaction represented and the effectiveness of the hedge. As of December 23, 2007, we do not have any hedges in place.
The table below provides information about our debt obligations indexed to LIBOR. The principal cash flows are in thousands.
(1)
We receive the arithmetic average of the reference price calculated using the unweighted method of averaging
Item 8.
Item 8.
Financial Statements and Supplementary Data
See index in Item 15 of this annual report on Form 10-K. Quarterly information (unaudited) is presented in a Note to the consolidated financial statements.
Item 9.
Item 9.
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
Item 9A.
Item 9A.
Controls and Procedures
Disclosure Controls and Procedures
The Company maintains disclosure controls and procedures designed to ensure information required to be disclosed in Company reports filed under the Securities Exchange Act of 1934, as amended (“the Exchange Act”), is recorded, processed, summarized, and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms. Disclosure controls and procedures are designed to provide reasonable assurance that information required to be disclosed in Company reports filed under the Exchange Act is accumulated and communicated to management, including the Company’s Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.
The Company’s management, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company’s disclosure controls and procedures pursuant to Rule 13a-15(b) of the Exchange Act as of December 23, 2007. Based on that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that the Company’s disclosure controls and procedures are effective as of December 23, 2007.
Management’s Report on Internal Control over Financial Reporting
The Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) under the Securities Exchange Act of 1934. Pursuant to the rules and regulations of the Securities and Exchange Commission, internal control over financial reporting is a process designed by, or under the supervision of, the Company’s principal executive and principal financial officers, and effected by the Company’s board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States. Due to inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Further, because of changes in conditions, effectiveness of internal control over financial reporting may vary over time.
The Company’s management, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company’s internal control over financial reporting as of December 23, 2007 based on the control criteria established in a report entitled Internal Control - Integrated Framework, issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on such evaluation management has concluded that our internal control over financial reporting is effective as of December 23, 2007.
Ernst and Young LLP, the Company’s independent registered public accounting firm, has issued an attestation report on the effectiveness of the Company’s internal controls over financial reporting, which is on page of this Annual Report on Form 10-K.
Changes in Internal Control over Financial Reporting
There were no changes in the Company’s internal control over financial reporting during the Company’s fiscal quarter ending December 23, 2007, that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
Item 9B.
Item 9B.
Other Information
None.
Part III
Item 10.
Item 10.
Directors and Executive Officers of the Registrant
The information required by this item as to the Company’s executive officers, directors, director nominees, audit committee financial expert, audit committee, and procedures for stockholders to recommend director nominees will be included in the Company’s proxy statement to be filed for the Annual Meeting of Stockholders to be held on June 3, 2008, and is incorporated by reference herein. The information required by this item as to compliance by the Company’s directors, executive officers and certain beneficial owners of the Company’s Common Stock with Section 16(a) of the Securities Exchange Act of 1934 also will be included in said proxy statement and also is incorporated herein by reference.
The Company has adopted a Code of Business Conduct and Ethics that governs the actions of all Company employees, including officers. The Code of Business Conduct and Ethics is posted within the Investor Relations section of the Company’s internet website at www.horizonlines.com. The Company will provide a copy of the Code of Business Conduct and Ethics to any stockholder upon request. Any amendments to and/or any waiver from a provision of any of the Code of Business Conduct and Ethics granted to any director, executive officer or any senior financial officer, must be approved by the Board of Directors and will be disclosed on the Company’s internet website as soon as reasonably practical following the amendment or waiver. The information contained on or connected to the Company’s internet website is not incorporated by reference into this Form 10-K and should not be considered part of this or any other report that the Company files with or furnishes to the Securities and Exchange Commission.
Item 11.
Item 11.
Executive Compensation
The information required by this item will be included in the Company’s proxy statement to be filed for the Annual Meeting of Stockholders to be held on June 3, 2008, and is incorporated herein by reference.
Item 12.
Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
The information required by this item will be included in the Company’s proxy statement to be filed for the Annual Meeting of Stockholders to be held on June 3, 2008, and is incorporated herein by reference.
Item 13.
Item 13.
Certain Relationships and Related Transactions
The information required by this item will be included in the Company’s proxy statement to be filed for the Annual Meeting of Stockholders to be held on June 3, 2008, and is incorporated herein by reference.
Item 14.
Item 14.
Principal Accountant Fees and Services
The information required by this item will be included in the Company’s proxy statement to be filed for the Annual Meeting of Stockholders to be held on June 3, 2008, and is incorporated herein by reference.
Part IV
Item 15.
Item 15.
Exhibits and Financial Statement Schedules
(a)(1) Financial Statements:
Horizon Lines, Inc.
Index to Consolidated Financial Statements
(a)(2) Exhibits:

Portions of this document were omitted and filed separately pursuant to a request for confidential treatment in accordance with Rule 406 of the Securities Act.

Portions of this document were omitted and filed separately pursuant to a request for confidential treatment in accordance with Rule 24b-2 of the Exchange Act.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrants have duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized, on the 6th day of February 2008.
HORIZON LINES, INC.
By:
/s/ Charles G. Raymond
Charles G. Raymond
Chairman, Chief Executive Officer and President
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 Registrants and in the capacities and on the 6th day of February 2008.
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders
Horizon Lines, Inc.
We have audited the accompanying consolidated balance sheets of Horizon Lines, Inc. as of December 23, 2007 and December 24, 2006, and the related consolidated statements of operations, stockholders’ equity and cash flows for each of the three years in the period ended December 23, 2007. Our audits also included the financial statement schedule listed in the Index at Item 15(a). These financial statements and schedule are the responsibility of the Company’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 the 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. 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 Horizon Lines, Inc. at December 23, 2007 and December 24, 2006, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 23, 2007 in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related 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.
As discussed in Note 18 to the consolidated financial statements, in 2007 the Company adopted Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an interpretation of Financial Accounting Standard No. 109 and changed its method of accounting for uncertainty for income taxes.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Horizon Lines, Inc’s internal control over financial reporting as of December 23, 2007, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 4, 2008 expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP
Charlotte, North Carolina
February 4, 2008
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders
Horizon Lines, Inc.
We have audited Horizon Lines, Inc.’s internal control over financial reporting as of December 23, 2007, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Horizon Lines, Inc.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the 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 effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, Horizon Lines, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 23, 2007, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Horizon Lines, Inc. as of December 23, 2007 and December 24, 2006, and the related consolidated statements of operations, stockholders’ equity and cash flows for each of the three years in the period ended December 23, 2007 and our report dated February 4, 2008 expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP
Charlotte, North Carolina
February 4, 2008
Horizon Lines, Inc.
Consolidated Balance Sheets
The accompanying notes are an integral part of these consolidated financial statements.
Horizon Lines, Inc.
Consolidated Statements of Operations
The accompanying notes are an integral part of these consolidated financial statements.
Horizon Lines, Inc.
Consolidated Statements of Cash Flows
The accompanying notes are an integral part of these consolidated financial statements.
Horizon Lines, Inc.
Consolidated Statements of Changes in Stockholders’ Equity
The accompanying notes are an integral part of these consolidated financial statements.
Horizon Lines, Inc.
Notes to Consolidated Financial Statements
1.
Basis of Presentation and Operations
On July 7, 2004, Horizon Lines, Inc. (the “Company”) was formed as an acquisition vehicle to acquire the equity interest in Horizon Lines Holding Corp. (“HLHC”). The Company was formed at the direction of Castle Harlan Partners IV, L.P. (“CHP IV”), a private equity investment fund managed by Castle Harlan, Inc (“Castle Harlan”). The Company operates as a holding company for Horizon Lines, LLC (“HL”), a Delaware limited liability company and wholly-owned subsidiary, Horizon Logistics Holdings, LLC (“Horizon Logistics”), a Delaware limited liability company and wholly-owned subsidiary, and Horizon Lines of Puerto Rico, Inc. (“HLPR”), a Delaware corporation and wholly-owned subsidiary. HL operates as a Jones Act container shipping company. Horizon Logistics manages the Company’s integrated logistics services, including rail, trucking and distribution operations, in addition to Horizon Services Group, an organization offering transportation management systems and customized software solutions to shippers, carriers, and other supply chain participants.
The accompanying consolidated financial statements include the consolidated accounts of the Company and its majority owned subsidiaries and the related consolidated statements of operations, stockholders’ equity and cash flows. All significant intercompany accounts and transactions have been eliminated.
2.
Significant Accounting Policies
Cash
Cash of the Company consists principally of cash held in banks and temporary investments having a maturity of three months or less at the date of acquisition.
Allowance for Doubtful Accounts and Revenue Adjustments
The Company maintains an allowance for doubtful accounts based upon the expected collectibility of accounts receivable reflective of its historical collection experience. The Company monitors its collection risk on an ongoing basis through the use of credit reporting agencies. The Company does not require collateral from its trade customers.
In addition, the Company maintains an allowance for revenue adjustments consisting of amounts reserved for billing rate changes that are not captured upon load initiation. These adjustments generally arise: (1) when the sales department contemporaneously grants small rate changes (“spot quotes”) to customers that differ from the standard rates in the system; (2) when freight requires dimensionalization or is reweighed resulting in a different required rate; (3) when billing errors occur; and (4) when data entry errors occur. When appropriate, permanent rate changes are initiated and reflected in the system. These revenue adjustments are recorded as a reduction to revenue.
The allowance for doubtful accounts and revenue adjustments approximated $6.2 million at December 23, 2007 and $5.0 million at December 24, 2006, respectively.
Materials and Supplies
Materials and supplies consist primarily of fuel inventory aboard vessels and inventory for maintenance of property and equipment. Fuel is carried at cost on the first in, first out (FIFO) basis, while all other materials and supplies are carried at average cost.
Property and Equipment
Property and equipment are stated at cost. Certain costs incurred in the development of internal-use software are capitalized. Routine maintenance, repairs, and removals other than vessel
Horizon Lines, Inc.
Notes to Consolidated Financial Statements - (Continued)
drydockings are charged to expense. Expenditures that materially increase values, change capacities or extend useful lives of the assets are capitalized. Depreciation and amortization is computed by the straight-line method over the estimated useful lives of the assets or over the terms of capital leases. The estimated useful lives of the Company’s assets are as follows:
The Company evaluates long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. When undiscounted future cash flows will not be sufficient to recover the carrying amount of an asset, the asset is written down to its fair value.
Vessel Drydocking
Vessels must undergo regular inspection, monitoring and maintenance, referred to as drydocking, to maintain the required operating certificates. United States Coast Guard regulations generally require that vessels be drydocked twice every five years. Because drydockings enable the vessel to continue operating in compliance with U.S. Coast Guard requirements, the costs of these scheduled drydockings are customarily capitalized and are then amortized over a 30-month period beginning with the accounting period following the vessel’s release from drydock.
The Company takes advantage of vessel drydockings to also perform normal repair and maintenance procedures on the vessels. These routine vessel maintenance and repair procedures are charged to expense as incurred. In addition, the Company will occasionally during a vessel drydocking, replace vessel machinery or equipment and perform procedures that materially enhance capabilities of a vessel. In these circumstances, the expenditures are capitalized and depreciated over the estimated useful lives.
Intangible Assets
Intangible assets consist of goodwill, customer contracts/relationships, trademarks, non-compete agreements and deferred financing costs. The Company amortizes customer contracts/relationships using the straight line method over the expected useful lives of 4 to 10 years. The Company also amortizes trademarks using the straight line method over the expected life of the related trademarks of 15 years. The Company amortizes debt issue cost using the effective interest method over the term of the related debt.
In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 142 “Goodwill and Other Intangible Assets,” goodwill and other intangible assets with indefinite useful lives are not amortized but are subject to annual undiscounted cash flow impairment tests. At least annually, or sooner if there is an indicator of impairment, the fair value of the reporting unit is calculated. If the calculated fair value is less than the carrying amount, an impairment loss is recognized.
Revenue Recognition
The Company accounts for transportation revenue based upon method two under Emerging Issues Task Force No. 91-9 “Revenue and Expense Recognition for Freight Services in Process”. Under this method the Company records transportation revenue and an accrual for the corresponding
Horizon Lines, Inc.
Notes to Consolidated Financial Statements - (Continued)
costs to complete delivery when the cargo first sails from its point of origin. The Company believes this method of revenue recognition does not result in a material difference in reported net income on an annual or quarterly basis as compared to recording transportation revenue between accounting periods based upon the relative transit time within each respective period with expenses recognized as incurred.
We recognize revenue and related costs of sales for our terminal, logistics and other services upon completion of services.
Casualty and Other Reserves
The Company maintains insurance for casualty, property and health claims. Most of the Company’s insurance arrangements include a level of self-insurance. Reserves are established based on the value of cargo damaged and the use of current trends and historical data for other claims. These estimates are based on historical information along with certain assumptions about future events.
Derivative Instruments
The Company accounts for derivative instruments in accordance with SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended, which requires all derivative instruments be recognized in the financial statements at fair value.
The Company occasionally utilizes derivative instruments tied to various indexes to hedge a portion of its exposure to bunker fuel price increases. These instruments consist of fixed price swap agreements. The Company does not use derivative instruments for trading purposes. Credit risk related to the derivative financial instruments is considered minimal and is managed by requiring high credit standards for its counterparties.
Changes in fair value of derivative financial instruments are recorded as adjustments to the assets or liabilities being hedged in the statement of operations or in accumulated other comprehensive income (loss), depending on whether the derivative is designated and qualifies for hedge accounting, the type of hedge transaction represented and the effectiveness of the hedge.
Income Taxes
The Company accounts for income taxes under the liability method whereby deferred tax assets and liabilities are measured using enacted tax laws and rates expected to apply to taxable income in the years in which the assets and liabilities are expected to be recovered or settled. The effects on deferred tax assets and liabilities of subsequent changes in the tax laws and rates are recognized in income during the year the changes are enacted. Deferred tax assets are reduced by a valuation allowance when, in the judgment of management, it is more likely than not that some portion or all of the deferred tax assets will not be realizable.
The American Jobs Creation Act of 2004 (“the Act”) instituted an elective alternative tax on qualifying shipping activities (“tonnage tax”) for corporations operating U.S.-flag vessels in U.S. foreign trade, as defined in the Act. During 2006, after evaluating the merits and requirements of the tonnage tax, the Company elected the application of the tonnage tax instead of the federal corporate income tax on income from its qualifying shipping activities. As the Company expects to continue to qualify for application of the tonnage tax, deferred tax assets and liabilities relating to the qualifying shipping activities are measured using an effective tax rate of zero.
Horizon Lines, Inc.
Notes to Consolidated Financial Statements - (Continued)
Stock-based Compensation
On September 16, 2005, the Board of Directors of Horizon Lines, Inc. authorized the issuance of up to an aggregate of 3,088,668 shares of common stock for various stock-based compensation arrangements. The Company early adopted SFAS No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123R”) in the fourth quarter of fiscal year 2005. SFAS 123R covers a wide range of share-based compensation arrangements including stock options, restricted share plans, and employee stock purchase plans.
In applying SFAS 123R, the value of each equity-based award is estimated on the date of grant using the Black-Scholes option-pricing model. The Black-Scholes model takes into account volatility in the price of our stock, the risk-free interest rate, the estimated life of the equity-based award, the closing market price of our stock and the exercise price. Due to the lack of trading activity since our stock became publicly traded, we base our estimates of stock price volatility on the average of (i) our historical stock price over the period in which it has been publicly traded and (ii) historical volatility of similar entities commensurate with the expected term of the equity-based award; however, this estimate is neither predictive nor indicative of the future performance of our stock. The estimates utilized in the Black-Scholes calculation involve inherent uncertainties and the application of management judgment. In addition, we are required to estimate the expected forfeiture rate and only recognize expense for those options expected to vest.
Pension and Post-retirement Benefits
The Company has noncontributory pension plans and post-retirement benefit plans covering certain union employees. Costs of these plans are charged to current operations and consist of several components that are based on various actuarial assumptions regarding future experience of the plans. In addition, certain other union employees are covered by plans provided by their respective union organizations. The Company expenses amounts as paid in accordance with union agreements.
Amounts recorded for the pension plan and the post-retirement benefit plan reflect estimates related to future interest rates, investment returns, and employee turnover. The Company reviews all assumptions and estimates on an ongoing basis.
As of December 24, 2006, we adopted Statement No. 158 (“SFAS 158”), “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of Statements No. 87, 88, 106, and 132(R),” (“SFAS 158”), which requires the recognition of the overfunded or underfunded status of its defined benefit and post-retirement benefit plans as an asset or liability, with changes in the funded status recognized as an adjustment to the ending balance of other accumulated comprehensive income in the year they occur. The pension plan and the post-retirement benefit plan are in an underfunded status and upon adoption in December 2006, we recorded a decrease to accumulated other comprehensive income of $1.0 million, net of tax.
Computation of Net Income (Loss) per Share
Basic net income (loss) per share is computed by dividing net income (loss) by the weighted daily average number of shares of common stock outstanding during the period. Diluted net income (loss) per share is computed using the weighted daily average number of shares of common stock outstanding for the period plus dilutive potential common shares, including stock options and warrants using the treasury-stock method and from convertible preferred stock using the “if converted” method.
Horizon Lines, Inc.
Notes to Consolidated Financial Statements - (Continued)
Fiscal Period
The fiscal period of the Company typically ends on the Sunday before the last Friday in December. For fiscal year 2007, the fiscal period began on December 25, 2006 and ended on December 23, 2007. For fiscal year 2006, the fiscal period began on December 26, 2005 and ended on December 24, 2006. For fiscal year 2005, the fiscal period began on December 27, 2004 and ended on December 25, 2005.
Use of Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates, assumptions and to use judgments that affect the amounts reported in the financial statements and accompanying notes. Actual results may differ from those estimates.
Recent Accounting Pronouncements
In September 2006, the Financial Accounting Standards Board (the “FASB”) issued SFAS No. 157, “Fair Value Measurements” (“SFAS 157”). SFAS 157 addresses how companies should measure fair value when they are required to use a fair value measure for recognition or disclosure purposes under generally accepted accounting principles. As a result of SFAS 157 there is now a common definition of fair value to be used throughout GAAP. The FASB believes that the new standard will make the measurement of fair value more consistent and comparable and improve disclosures about those measures. The provisions of SFAS 157 were to be effective for fiscal years beginning after November 15, 2007. On December 14, 2007, the FASB issued proposed FSP FAS 157-b which would delay the effective date of SFAS 157 for all nonfinancial assets and nonfinancial liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). This proposed FSP partially defers the effective date of Statement 157 to fiscal years beginning after November 15, 2008, and interim periods within those fiscal years for items within the scope of this FSP. Effective for fiscal 2008, the Company will adopt SFAS 157 except as it applies to those nonfinancial assets and nonfinancial liabilities as noted in proposed FSP FAS 157-b. The Company is in the process pf determining the financial impact the partial adoption of SFAS 157 will have on its results of operations and financial position.
The FASB has published for comment a clarification on the accounting for convertible debt instruments that may be settled in cash (including partial cash settlement) upon conversion, such as the convertible notes we issued in August 2007 (“FSP APB 14-a”). The proposed FSP would require the issuer to separately account for the liability and equity components of the instrument in a manner that reflects the issuer’s non-convertible debt borrowing rate. As a result, the liability component would be recorded at a discount reflecting its below market coupon interest rate, and the liability component would subsequently be accreted to its par value over its expected life, with the rate of interest that reflects the market rate at issuance being reflected in the results of operations. The proposed change in methodology will affect the calculations of net income and earnings per share. The proposed effective date of FSP APB 14-a was originally for fiscal years beginning after December 15, 2007 and did not permit early application. In November 2007, the FASB announced it expects to begin its redeliberations of the guidance in the proposed FSP beginning in January 2008. Therefore, it is expected that final guidance will not be issued until at least the first quarter of 2008 and it is unlikely the proposed effective date for fiscal years beginning after December 15, 2007 will be retained. The proposed transition guidance requires retrospective application to all periods presented and does not grandfather existing instruments. The Company is in the process of determining the impact of this proposed FSP.
Horizon Lines, Inc.
Notes to Consolidated Financial Statements - (Continued)
In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities-including an amendment of FASB Statement No. 115” (“SFAS 159”). SFAS 159 allows an entity the irrevocable option to elect fair value for the initial and subsequent measurement of certain financial assets and liabilities under an instrument-by-instrument election. Subsequent measurements for the financial assets and liabilities an entity elects to fair value will be recognized in the results of operations. SFAS 159 also establishes additional disclosure requirements. This standard is effective for fiscal years beginning after November 15, 2007. The Company is in the process of determining the financial impact the adoption of SFAS 159 will have on its results of operations and financial position.
In December 2007, the FASB issued SFAS No. 141R, “Business Combinations” (“SFAS 141R”). SFAS 141R replaces SFAS 141 and establishes principles and requirements for how an acquirer recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, any non controlling interest in the acquiree and the goodwill acquired. SFAS 141R also establishes disclosure requirements which will enable users to evaluate the nature and financial effects of the business combination. This standard is effective for fiscal years beginning after December 15, 2008.
In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements” (“SFAS 160”). SFAS 160 establishes accounting and reporting standards for ownership interests in subsidiaries held by parties other than the parent, the amount of consolidated net income attributable to the parent and to the noncontrolling interest, changes in a parent’s ownership interest and the valuation of retained noncontrolling equity investments when a subsidiary is deconsolidated. SFAS 160 also establishes reporting requirements that provide sufficient disclosures that clearly identify and distinguish between the interests of the parent and the interests of the noncontrolling owners. This standard is effective for fiscal years beginning after December 15, 2008.
Supplemental Cash Flow Information
During 2005, the Company assumed outstanding indebtedness of approximately $4.5 million in connection with the acquisition of the rights and beneficial interests of the sole owner participant in two separate owner trusts, the assets of which consist primarily of two vessels.
On December 25, 2006, the Company adopted the provisions of FIN 48 and recorded a $3.5 million increase in the liability for unrecognized tax benefit, which was accounted for as a reduction to retained earnings. During 2007, in conjunction with the acquisition of HSI, the Company assumed a $2.2 million note payable. The note is secured by the assets of HSI. Also during 2007, the Company recorded a $19.2 million income tax benefit related to the note hedge transactions entered into in conjunction with the issuance of the convertible senior notes due 2012. See Note 10 for additional information related to the convertible senior notes and the note hedge transactions. The Company’s employee stock purchase plan contains a dividend reinvestment provision. As such, during 2007, the Company retained a total of $29 thousand related to quarterly dividends paid on outstanding shares purchased through the employee stock purchase plan and issued 1,117 shares of its common stock.
Cash payments (receipts) for interest and income taxes were as follows (in thousands):
Horizon Lines, Inc.
Notes to Consolidated Financial Statements - (Continued)
3.
Acquisitions
On August 22, 2007, the Company completed the acquisition of Montebello Management, LLC (D/B/A Aero Logistics) (“Aero Logistics”), a full service third party logistics provider, for approximately $27.3 million in cash. As of December 23, 2007, $0.5 million is held in escrow pending achievement of 2008 earnings targets and has been excluded from the purchase price. In addition, subsequent to December 23, 2007, the Company completed its assessment of the working capital received and released $0.4 million originally placed into escrow and paid an additional $0.2 million. The additional $0.2 million increased the total purchase to $27.5 million. Aero Logistics designs and manages custom freight shipping and special handling programs for customers in service-sensitive industries including high-tech, healthcare, energy, mining, retail and apparel. Aero Logistics offers an array of multi-modal transportation services and fully integrated logistics solutions to satisfy the unique needs of its customers. Aero Logistics also operates a fleet of approximately 90 GPS-equipped trailers under the direction of their Aero Transportation division, which provides expedited less-than-truckload (“LTL”) and full truckload (“FTL”) service throughout North America. Aero Logistics is a wholly owned subsidiary of Horizon Logistics. As an existing 3-PL, Aero Logistics brings air, LTL brokerage, warehousing and international expedited transport services that significantly broaden the offerings Horizon Logistics can present to current and potential customers.
On June 26, 2007, the Company completed the purchase of Hawaii Stevedores, Inc. (“HSI”) for approximately $4.1 million in cash, net of cash acquired. HSI, which operates as a subsidiary of the Company, is a full service provider of stevedoring and marine terminal services in Hawaii and has operations in all of the commercial ports on Oahu and the Island of Hawaii. This acquisition enables the Company and HSI to work together to find efficiencies in the way stevedoring is handled today and grow third party business.
The following summarizes the fair values of the assets acquired and the liabilities assumed as part of the acquisitions (in thousands):
Of the $7.4 million of identifiable intangible assets acquired, $7.1 million is attributable to customer contracts/relationships and $0.3 million was assigned to non-competition agreements.
Of the $27.9 million of goodwill acquired, $22.4 million is expected to be deductible for tax purposes.
Horizon Lines, Inc.
Notes to Consolidated Financial Statements - (Continued)
The following table presents pro-forma financial information as though the acquisitions had occurred on December 27, 2004 (in thousands, except per share amounts):
4.
SFL Agreements
In April 2006, the Company completed a series of agreements with Ship Finance International Limited and certain of its subsidiaries (“SFL”) to charter five new non-Jones Act qualified container vessels, each with a capacity of 2,824 twenty-foot equivalent units (“TEUs”) and capable of a service speed of up to 23 knots (the “new vessels”). All five of the new vessels were built in a South Korean shipyard pursuant to contracts between the shipyard and various third parties (the “sellers”). All of the new vessels were deployed in the Company’s modified trade routes between the U.S. west coast and Asia and Guam during the second quarter of 2007. This deployment enabled the Company to redeploy Jones Act qualified active vessels to other Jones Act routes. Upon deployment of the new vessels in the modified trade route between the U.S. west coast and Asia and Guam, the Company commenced a new U.S. west coast to Hawaii trade route with two of the vessels previously deployed in the Guam trade route.
Upon the delivery of each vessel to SFL Holdings by the applicable seller, SFL Holdings transferred the vessel to one of its wholly-owned subsidiaries (the “Shipowner”). In connection with each such transfer, the transferred vessel was reflagged as a U.S. vessel and bareboat chartered by the applicable Shipowner to the Company. The bareboat charter for each new vessel is a “hell or high water” charter, and the obligation of the Company to pay charter hire thereunder for the vessel is absolute and unconditional. The aggregate annual charter hire for all of the five new vessels is approximately $32.0 million. Under the charters, the Company is responsible for crewing, insuring, maintaining, and repairing each vessel and for all other operating costs with respect to each vessel. The term of each of the bareboat charters is twelve years from the date of delivery of the related vessel, with a three year renewal option exercisable by the Company. In addition, the Company has the option to purchase all of the new vessels following the five, eight, twelve, and, if applicable, fifteen year anniversaries of the date of delivery at pre-agreed purchase prices. If the Company elects to purchase all of the vessels after the five or eight year anniversary date, it will have the right to assume the outstanding debt under the Fortis Capital Corp. (“Fortis”) credit facility, and the amount of the debt so assumed will be credited against the purchase price paid by it for the vessels. If the Company elects not to purchase the new vessels at the end of the initial twelve-year period and the Shipowners sell the new vessels for less than a specified amount, the Company is responsible for paying the amount of such shortfall, which shall not exceed $3.8 million per new vessel. If the new vessels are to be sold by the Shipowners to an affiliated party for less than a different specified amount, the Company has the right to purchase the new vessels for that different specified amount.
Although the Company is not the primary beneficiary of the variable interest entities created in conjunction with the SFL transactions, the Company has an interest in the variable interest entities. Based on the Company’s analysis of the expected cash flows related to the variable interest entity, the Company believes only a remote likelihood exists that it would become the primary beneficiary of the variable interest entity and would be required to consolidate the variable interest entity. Certain
Horizon Lines, Inc.
Notes to Consolidated Financial Statements - (Continued)
contractual obligations and off-balance sheet obligations arising from this transaction include the annual operating lease obligations and the residual guarantee. The Company is accounting for the leases as operating leases. The residual guarantee was recorded at its fair value of approximately $0.2 million as a liability on the Company’s balance sheet.
5.
Initial Public Offering and Related Transactions
Initial Public Offering
On September 30, 2005, the Company issued and sold 12,500,000 shares (the “Initial Shares”) of its common stock, in an initial public offering (referred to herein as the “initial public offering”), at a price of $10.00 per share, less the underwriters’ discount of 7% per share. On October 14, 2005, the Company issued and sold an additional 1,875,000 shares (the “Additional Shares”) of its common stock to the underwriters of its initial public offering at a price of $10.00 per share, representing the initial public offering price to the public, less the underwriters’ discount of 7% per share. These shares were issued and sold pursuant to the exercise in full by the underwriters of their option to purchase additional shares from the Company granted to them with respect to the initial public offering.
The following unaudited pro forma combined financial statements are based on our historical consolidated financial statements, and are adjusted to give effect to the consummation of the issuance and sale by the Company of the Initial Shares and the Additional Shares pursuant to the initial public offering, the use of proceeds therefrom, and other related transactions, as if, in each case, such transactions occurred as of December 27, 2004 (in thousands, except per share amounts).
6.
Shelf Registration and Secondary Offerings
During 2006, the Company filed an automatic shelf registration and completed two secondary offerings. The shelf registration statement, which became effective upon filing with the SEC, registered for resale (and other dispositions) 2,678,894 outstanding shares of the Company’s common stock. All of these shares were held by Castle Harlan Partners IV, L.P. and its co-investor Stockwell Fund, L.P. and their respective affiliates and associates. In conjunction with the secondary offerings, 12,707,500 shares of the Company’s common stock were sold by stockholders of the Company. The Company did not receive any proceeds from any resales or other dispositions under the shelf registration statement or from the sale of stock under the secondary offerings. The Company incurred approximately $2.0 million in fees associated with the shelf registration and secondary offerings during 2006. Such fees are included within selling, general, and administrative expenses in the consolidated statement of operations for the year ended December 24, 2006.
Horizon Lines, Inc.
Notes to Consolidated Financial Statements - (Continued)
7.
Property and Equipment
Property and equipment consist of the following (in thousands):
The majority of our depreciation expense is related to our vessels and capitalized software. Depreciation expense related to our vessels was $11.7 million, $10.9 million and $9.3 million for the years ended December 23, 2007, December 24, 2006 and December 25, 2005, respectively. Depreciation expense related to capitalized software was $5.3 million, $9.6 million, and $9.7 million for the years ended December 23, 2007, December 24, 2006 and December 25, 2005, respectively.
8.
Intangible Assets
Intangible assets consist of the following (in thousands):
In conjunction with the acquisitions of HSI and Aero Logistics, the Company recorded intangible assets related to customer contracts/relationships of $7.1 million, non-compete agreements of $0.3 million and goodwill of $27.9 million.
During the third quarter of 2007, in conjunction with the redemption of the 9% senior notes and the 11% senior discount notes and the extinguishment of the prior senior credit facility, the Company wrote off approximately $12.4 million of net deferred financing costs. In addition, during the second quarter of 2007, the Company wrote off approximately $0.6 million of net deferred financing costs in
Horizon Lines, Inc.
Notes to Consolidated Financial Statements - (Continued)
conjunction with a $25.0 million voluntary prepayment on the term loan component of its prior senior credit facility. The Company recorded deferred financing costs of $12.9 million in connection with the issuance of the convertible notes (as defined in Note 10) and entering into the senior credit facility (as defined in Note 10).
Estimated aggregate amortization expense for each of the succeeding five fiscal years is as follows (in thousands):
9.
Other Accrued Liabilities
Other accrued liabilities consist of the following (in thousands):
10.
Long-Term Debt
Long-term debt consists of the following (in thousands):
Horizon Lines, Inc.
Notes to Consolidated Financial Statements - (Continued)
Senior Credit Facility
On August 8, 2007, the Company entered into a credit agreement providing for a $250.0 million five year revolving credit facility and a $125.0 million term loan with various financial lenders (the “Senior Credit Facility”). The obligations of the Company are secured by substantially all of the assets of the Company. The terms of the Senior Credit Facility also provide for a $20.0 million swingline subfacility and a $50.0 million letter of credit subfacility. In addition to proceeds from the term loan, the Company borrowed and used $133.5 million under the revolving credit facility to repay borrowings outstanding under the Prior Senior Credit Facility (as defined below) and to purchase a portion of the outstanding 9% senior notes and 11% senior discount notes purchased in the Company’s tender offer. Future borrowings under the Senior Credit Facility are expected to be used for permitted acquisitions and general corporate purposes, including working capital.
Beginning on December 31, 2007, principal payments of approximately $1.6 million are due quarterly on the term loan through September 30, 2009, at which point quarterly payments increase to $4.7 million through September 30, 2011, at which point quarterly payments increase to $18.8 million until final maturity on August 8, 2012. As of December 23, 2007, $247.0 million was outstanding under the Senior Credit Facility, which included a $125.0 million term loan and borrowings of $122.0 million under the revolving credit facility. The interest rate payable under the Senior Credit Facility varies depending on the types of advances or loans the Company selects. Borrowings under the Senior Credit Facility bear interest primarily at LIBOR-based rates plus a spread which ranges from 1.25% to 2.0% (LIBOR plus 1.50% as of the date hereof) depending on the Company’s ratio of total secured debt to EBITDA (as defined in the Senior Credit Facility). The weighted average interest rate at December 23, 2007 was approximately 6.5%. The Company also pays a variable commitment fee on the unused portion of the commitment, ranging from 0.25% to 0.40% (0.30% as of December 23, 2007).
The Senior Credit Facility contains customary affirmative and negative covenants and warranties, including two financial covenants with respect to the Company’s leverage and interest coverage ratio and limits the level of dividends and stock repurchases in addition to other restrictions. It also contains customary events of default, subject to grace periods. The Company was in compliance with all such covenants as of December 23, 2007.
4.25% Convertible Senior Notes
On August 1, 2007, the Company entered into a purchase agreement relating to the sale by the Company of $300.0 million aggregate principal amount of its 4.25% Convertible Senior Notes due 2012 (the “Notes”) for resale to qualified institutional buyers as defined in Rule 144A under the Securities Act of 1933, as amended. Under the terms of the purchase agreement, the Company also granted the initial purchasers an option to purchase up to $30.0 million aggregate principal amount of the Notes to cover over-allotments. The initial purchasers subsequently exercised the over-allotment option in full, and, at closing on August 8, 2007, the initial purchasers acquired $330.0 million aggregate principal amount of the Notes. The net proceeds from the offering, after deducting the initial purchasers’ discount and offering expenses, were approximately $320.5 million. The Company used (i) $28.6 million of the net proceeds to purchase 1,000,000 shares of the Company’s common stock in privately negotiated transactions, (ii) $52.5 million of the net proceeds to acquire an option to receive the Company’s stock from the initial purchasers, and (iii) the balance of the net proceeds to purchase a portion of the outstanding 9% senior notes and 11% senior discount notes purchased in the Company’s tender offer.
The Notes are general unsecured obligations of the Company and rank equally in right of payment with all of the Company’s other existing and future obligations that are unsecured and
Horizon Lines, Inc.
Notes to Consolidated Financial Statements - (Continued)
unsubordinated. The Notes bear interest at the rate of 4.25%, and the Company will pay interest on the Notes on February 15 and August 15 of each year, beginning on February 15, 2008. The Notes will mature on August 15, 2012, unless earlier converted, redeemed or repurchased in accordance with their terms prior to August 15, 2012. Holders of the Notes may require the Company to repurchase the Notes for cash at any time before August 15, 2012 if certain fundamental changes occur.
Each $1,000 of principal of the Notes will initially be convertible into 26.9339 shares of the Company’s common stock, which is the equivalent of $37.13 per share, subject to adjustment upon the occurrence of specified events set forth under the terms of the Notes. Upon conversion, the Company would pay the holder the cash value of the applicable number of shares of its common stock, up to the principal amount of the note. Amounts in excess of the principal amount, if any, may be paid in cash or in stock, at the Company’s option. Holders may convert their Notes into the Company’s common stock as follows:
•
Prior to May 15, 2012, if during any calendar quarter, and only during such calendar quarter, if the last reported sale price of the Company’s common stock for at least 20 trading days in a period of 30 consecutive trading days ending on the last trading day of the preceding calendar quarter exceeds 120% of the applicable conversion price in effect on the last trading day of the immediately preceding calendar quarter;
•
Prior to May 15, 2012, if during the five business day period immediately after any five consecutive trading day period (the “measurement period”) in which the trading price per $1,000 principal amount of notes for each day of such measurement period was less than 98% of the product of the last reported sale price of the Company’s common stock on such date and the conversion rate on such date;
•
If, at any time, a change in control occurs or if the Company is a party to a consolidation, merger, binding share exchange or transfer or lease of all or substantially all of its assets, pursuant to which the Company’s common stock would be converted into cash, securities or other assets; or
•
At any time after May 15, 2012 through the fourth scheduled trading day immediately preceding August 15, 2012.
Holders who convert their Notes in connection with a change in control may be entitled to a make-whole premium in the form of an increase in the conversion rate. In addition, upon a change in control, liquidation, dissolution or de-listing, the holders of the Notes may require the Company to repurchase for cash all or any portion of their Notes for 100% of the principal amount plus accrued and unpaid interest. As of December 23, 2007, none of the conditions allowing holders of the Notes to convert or requiring the Company to repurchase the Notes had been met. The Company may not redeem the Notes prior to maturity.
As required by the terms of a registration rights agreement relating to the Notes, the Company filed a shelf registration statement with the SEC with respect to the Notes and the shares issuable upon conversion of the Notes on February 1, 2008.
Concurrent with the issuance of the Notes, the Company entered into note hedge transactions with certain financial institutions whereby if the Company is required to issue shares of its common stock upon conversion of the Notes, the Company has the option to receive up to 8.9 million shares of its common stock when the price of the Company’s common stock is between $37.13 and $51.41 per share upon conversion, and the Company sold warrants to the same financial institutions whereby the financial institutions have the option to receive up to 4.6 million shares of the Company’s common
Horizon Lines, Inc.
Notes to Consolidated Financial Statements - (Continued)
stock when the price of the Company’s common stock exceeds $51.41 per share upon conversion. The Company will seek approval from its shareholders to increase the number of authorized but unissued shares such that the number of shares available for issuance to the financial institutions increases from 4.6 million to 17.8 million. The separate note hedge and warrant transactions were structured to reduce the potential future share dilution associated with the conversion of Notes. The cost of the note hedge transactions to the Company was approximately $52.5 million, $33.4 million net of tax, and has been accounted for as an equity transaction in accordance with EITF No. 00-19, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock” (EITF No. 00-19).The Company received proceeds of $11.9 million related to the sale of the warrants, which has also been classified as equity because they meet all of the equity classification criteria within EITF No. 00-19.
In accordance with SFAS 128, the Notes will have no impact on diluted earnings per share until the price of the Company’s common stock exceeds the conversion price (initially $37.13 per share) because the principal amount of the Notes will be settled in cash upon conversion. Prior to conversion, the Company will include the effect of the additional shares that may be issued if its common stock price exceeds the conversion price, using the treasury stock method.
Also, in accordance with SFAS 128, the warrants sold in connection with the hedge transactions will have no impact on earnings per share until the Company’s share price exceeds $37.13. Prior to exercise, the Company will include the effect of additional shares that may be issued using the treasury stock method. The call options purchased as part of the note hedge transactions are anti-dilutive and therefore will have no impact on earnings per share.
Prior Senior Credit Facility
During 2004, the Company entered into a senior credit facility with various financial lenders, which was amended and restated on April 7, 2005 (the “Prior Senior Credit Facility”). On August 8, 2007, in connection with entering into the Senior Credit Facility, the Company’s Prior Senior Credit Facility was terminated. Borrowings under the Senior Credit Facility were used to pay $192.8 million on the term loan component of the Prior Senior Credit Facility. The Company incurred no penalties in connection with the termination of the Prior Senior Credit Facility.
Other Debt
In conjunction with the acquisition of HSI, the Company assumed a $2.2 million note payable. The note is secured by the assets of HSI. The note bears interest at 5.26% per year and requires monthly payments of $32 thousand until maturity on February 24, 2014.
During 2005, the Company assumed outstanding indebtedness of approximately $4.5 million in connection with the acquisition of the rights and beneficial interests of the sole owner participant in two separate owner trusts, the assets of which consist primarily of two vessels. Horizon Lines repaid the $4.5 million indebtedness assumed in connection with this acquisition in January 2007.
Fair Value of Financial Instruments
The estimated fair values of the Company’s debt as of December 23, 2007 and December 24, 2006 were $545.8 million and $528.5 million, respectively. The fair value of the Notes are based on quoted market prices. The fair value of the other long-term debt approximates carrying value.
Horizon Lines, Inc.
Notes to Consolidated Financial Statements - (Continued)
Annual maturities of long-term debt obligations are as follows (in thousands):
11.
Net Income (Loss) Per Common Share
In accordance with SFAS 128, “Earnings Per Share,” basic net income (loss) per share is computed by dividing net income (loss) by the weighted daily average number of shares of common stock outstanding during the period. Diluted net income (loss) per share is based upon the weighted daily average number of shares of common stock outstanding for the period plus dilutive potential common shares, including stock options using the treasury-stock method and from convertible stock using the “if converted” method (in thousands, except per share amounts):
On November 19, 2007, the Company’s Board of Directors authorized the Company to commence a stock repurchase program to buy back up to $50.0 million worth of its common stock. The program allowed the Company to purchase shares through open market repurchases and privately negotiated transactions at a price of $26.00 per share or less until the program’s expiration on December 31, 2008. The Company acquired 1,172,700 shares at a total cost of $20.6 million under this program during the fourth quarter of 2007. Subsequent to December 23, 2007, the Company completed its share repurchase program, acquiring an additional 1,627,500 shares at a total cost of $29.4 million.
Horizon Lines, Inc.
Notes to Consolidated Financial Statements - (Continued)
12.
Preferred Stock
During 2005, in conjunction with the initial public offering, the Company redeemed all shares of its non-voting $.01 par value Series-A Preferred Stock. The Series-A Preferred stock was issued in conjunction with the Acquisition-Related Transactions . The Company recorded these shares at their fair value in accordance with FAS No. 141 “Business Combinations”. As the preferred shares had no coupon rate and no stated redemption period, management determined that a 10% discount rate and a one year redemption period was appropriate. The 10% discount rate was based upon a comparison to other similar offerings in the marketplace considering terms such as coupon rates, convertibility, and voting rights. As management’s intention at the time of issuance of the preferred shares was to redeem the preferred shares within a year after issuance, a one year period was utilized to accrete the shares to their redemption value. During 2005, the Company recorded $5.1 million of accretion of its Series A Preferred stock. The Company classified the value of these shares between liabilities and equity.
13.
Derivative Financial Instruments
During 2006 and 2005, the Company entered into fuel swap contracts to fix the price of fuel. The contracts were accounted for as cash flow hedges. Accordingly, the Company recorded the fair value of the hedge contracts in other current assets and accumulated other comprehensive income. There were no hedges outstanding as of December 23, 2007 or as of December 24, 2006.
14.
Leases
The Company leases certain equipment and facilities under operating lease agreements. Non-cancelable, long-term leases generally include provisions for maintenance, options to purchase at fair value and to extend the terms. Rent expense under operating lease agreements totaled $96.4 million, $71.6 million and $74.3 million for the years ended December 23, 2007, December 24, 2006 and December 25, 2005, respectively.
The Company leases certain equipment under a capital lease agreement. The net book value of this equipment totaled $0.1 million and $0.3 million at December 23, 2007 and December 24, 2006, respectively. Depreciation expense for equipment under the capital lease totaled $0.2 million for each of the years ended December 23, 2007, December 24, 2006 and December 25, 2005.
Future minimum lease obligations at December 23, 2007 are as follows (in thousands):
Horizon Lines, Inc.
Notes to Consolidated Financial Statements - (Continued)
15.
Related Parties
In February 2005, the Company sold promissory notes from certain members of management, having an aggregate original principal balance of $0.3 million, together with the right to receive the accrued but unpaid interest thereon, to its principal stockholder, CHP IV, for an aggregate purchase price equal to the aggregate outstanding principal amount of these notes, plus all accrued but unpaid interest thereon. The promissory notes were issued in conjunction with the issuance of restricted shares to certain members of management.
During 2005, the Company recorded $2.2 million in selling, general, and administrative expenses related to a management agreement with Castle Harlan. In addition, in connection with the initial public offering in 2005, the Company recorded a charge of $7.5 million related to the termination of the ongoing management services and fee related provisions of the management agreement.
16.
Employee Benefit Plans
Savings Plans
The Company provides a 401(k) Savings Plan for substantially all of its employees who are not part of collective bargaining agreements. Under provisions of the savings plan, an employee is immediately vested with respect to Company contributions. The Company matches employee contributions up to 6% of qualified compensation. The cost for this benefit totaled $2.3 million, $2.1 million and $1.9 million for the years ended December 23, 2007, December 24, 2006 and December 25, 2005, respectively. The Company also administers a 401(k) plan for certain union employees with no Company match.
Pension Plans
The Company sponsors a defined benefit plan covering approximately 30 union employees as of December 23, 2007. The plan provides for retirement benefits based only upon years of service. Employees whose terms and conditions of employment are subject to or covered by the collective bargaining agreement between Horizon Lines and the International Longshore & Warehouse Union Local 142 are eligible to participate once they have completed one year of service. Contributions to the plan are based on the projected unit credit actuarial method and are limited to the amounts that are currently deductible for income tax purposes. The Company recorded net periodic benefit costs of $0.4 million during each of the years ended December 23, 2007, December 24, 2006 and December 25, 2005. The plan was underfunded by $1.2 million and $1.4 million at December 23, 2007 and December 24, 2006, respectively.
As part of the acquisition of HSI, the Company assumed net liabilities of approximately $2.4 million related to a pension plan covering approximately 50 salaried employees. Of the $2.4 million, $0.3 million was recorded within other accrued liabilities and $2.1 million was recorded as other long-term liabilities. The pension plan was frozen to new entrants as of December 31, 2005. Contributions to the plan are based on the projected unit credit actuarial method and are limited to the amounts that are currently deductible for income tax purposes. The Company recorded net periodic benefit costs of $37 thousand during the year ended December 23, 2007. The plan was underfunded by $2.2 million at December 23, 2007.
Post-retirement Benefit Plans
In addition to providing pension benefits, the Company provides certain healthcare (both medical and dental) and life insurance benefits for eligible retired members (“post-retirement benefits”). For eligible employees hired on or before July 1, 1996, the healthcare plan provides for post-retirement health coverage for an employee who, immediately preceding his/her retirement date, was an active participant in the retirement plan and has attained age 55 as of his/her retirement date. For eligible
Horizon Lines, Inc.
Notes to Consolidated Financial Statements - (Continued)
employees hired after July 1, 1996, the plan provides post-retirement health coverage for an employee who, immediately preceding his/her retirement date, was an active participant in the retirement plan and has attained a combination of age and service totaling 75 years or more as of his/her retirement date. The net periodic benefit costs related to the post-retirement benefits were $0.6 million during each of the years ended December 23, 2007, December 24, 2006 and December 25, 2005. The post-retirement benefit plan was underfunded by $2.5 million and $2.2 million at December 23, 2007 and December 24, 2006, respectively.
As part of the acquisition of HSI, the Company assumed liabilities of approximately $5.4 million related to post-retirement medical, dental and life insurance benefits for eligible active and retired employees. Of the $5.4 million, $0.2 million was recorded within other accrued liabilities and $5.2 million was recorded within other long-term liabilities. Effective June 25, 2007, the plan provides for post-retirement medical, dental and life insurance benefits for salaried employees who had attained age 55 and completed 20 years of service as of December 31, 2005. Any salaried employee already receiving post-retirement medical coverage as of June 25, 2007 will continue to be covered by the plan. For eligible union employees hired on or before July 1, 1996, the healthcare plan provides for post-retirement medical coverage for an employee who, immediately preceding his/her retirement date, was an active participant in the retirement plan and has attained age 55 as of his/her retirement date. For eligible union employees hired after July 1, 1996, the plan provides post-retirement health coverage for an employee who, immediately preceding his/her retirement date, was an active participant in the retirement plan and has attained age 55 and has a combination of age and service totaling 75 years or more as of his/her retirement date. The Company recorded net periodic benefit costs of $0.2 million during the year ended December 23, 2007. The plan was underfunded by $4.9 million at December 23, 2007.
Obligations and Funded Status
Horizon Lines, Inc.
Notes to Consolidated Financial Statements - (Continued)
Net Periodic Benefit Cost
Rate Assumptions
(1)
The defined benefit plan benefit payments are not based on compensation, but rather on years of service.
For every 1% increase in the assumed health care cost trend rate, service and interest cost will increase $0.2 million and the Company’s benefit obligation will increase $1.1 million. For every 1% decrease in the assumed health care cost trend rate, service and interest cost will decrease $0.1 million and the Company’s benefit obligation will decrease $0.8 million. Expected Company contributions during 2008 total $0.8 million, all of which is related to the pension plan. The following benefit payments, which reflect expected future service, as appropriate, are expected to be paid (in thousands):
Horizon Lines, Inc.
Notes to Consolidated Financial Statements - (Continued)
The Company’s pension plans investment policy and weighted average asset allocations at December 23, 2007 by asset category, are as follows:
The objective of the pension plan investment policy is to grow assets in relation to liabilities, while prudently managing the risk of a decrease in the pension plan’s assets. The pension plan management committee has established a target investment mix with upper and lower limits for investments in equities, fixed-income and other appropriate investments. Assets will be re-allocated among asset classes from time-to-time to maintain the target investment mix. The committee has established a target investment mix of 65% equities and 35% fixed-income for the plans.
The expected return on plan assets is based on our asset allocation mix and our historical return, taking into account current and expected market conditions.
Other Plans
Under collective bargaining agreements, the Company participates in a number of union-sponsored, multi-employer benefit plans. Payments to these plans are made as part of aggregate assessments generally based on hours worked, tonnage moved, or a combination thereof. Expense for these plans is recognized as contributions are funded. The Company made contributions of $9.9 million, $9.7 million and $10.0 million during the years ended December 23, 2007, December 24, 2006 and December 25, 2005, respectively. A decline in the value of assets held by these plans, caused by performance of the investments in the financial markets in recent years, may result in higher contributions to these plans. Moreover, if the Company exits these markets, it may be required to pay a potential withdrawal liability if the plans are underfunded at the time of the withdrawal. However, the Company is unable to determine the potential amount of liability, if any, at this time. Any adjustments would be recorded when it is probable that a liability exists and it is determined that markets will be exited.
17.
Stock-Based Compensation
On December 23, 2007, the Company has two share-based compensation plans, which are described in more detail below. The Company recorded expense of $3.8 million in the year ended December 23, 2007, related to all stock-based compensation. The total income tax benefit recognized in the income statement for stock-based compensation arrangements was $1.3 million.
Stock Options
The Company maintains a stock plan for the grants of stock options and restricted stock awards to officers and employees of the Company. On September 16, 2005, the Board of Directors of Horizon Lines Inc. authorized the issuance of up to an aggregate of 3,088,668 shares of common stock. As of December 23, 2007, there were 1,091,434 shares of common stock reserved for issuance under the stock plan. Stock options granted under these plans have been granted at an option price equal to the closing market value of the stock on the date of the grant. Options granted under this plan have 10-year contractual terms and typically become exercisable after one or three years after the grant
Horizon Lines, Inc.
Notes to Consolidated Financial Statements - (Continued)
date, subject to continuous service with the Company. The Compensation Committee of the Board of Directors of the Company (the “Board of Directors”) approves the grants of nonqualified stock options by the Company, pursuant to the Company’s Amended and Restated Equity Incentive Plan. These options are granted on such approval date.
On March 26, 2007, the Board of Directors approved the grant by the Company of non qualified options to certain employees of the Company to purchase an aggregate of 329,000 shares of its common stock at a price of $33.51 per share. Each option is scheduled to cliff vest and become fully exercisable on March 26, 2010, provided the employee who was granted such option is continuously employed by the Company through such date. Recipients who retire from the Company after attaining age 591/2 are entitled to proportionate vesting. The grant date fair value of the options granted was $10.58 per share.
On July 27, 2006, the Board of Directors approved the grant by the Company of nonqualified stock options to certain employees of the Company to purchase an aggregate of 38,075 shares of its common stock at a price of $15.97 per share. The Company recorded $49 thousand and $22 thousand of compensation expense during the years ended December 23, 2007 and December 24, 2006, respectively, related to the options.
On April 7, 2006, the Board of Directors approved the grant by the Company of nonqualified stock options to certain employees of the Company to purchase an aggregate of 617,500 shares of its common stock at a price of $12.54 per share. The Company recorded $0.5 million and $0.4 million of compensation expense during the years ended December 23, 2007 and December 24, 2006, respectively, related to the options. None of these options were exercised and none and 19,256 of these options were forfeited during the years ended December 23, 2007 and December 24, 2006, respectively.
The weighted average grant date fair values of options granted during 2007 and 2006 were $10.58 and $2.87, respectively. No shares vested during 2007. In connection with the adoption of SFAS 123R, the Company estimates the fair value of each stock option on the date of grant using a Black-Scholes option-pricing model, applying the following assumptions, and amortizes the expense over the option’s vesting period using the straight-line attribution approach:
Significant assumptions used to estimate the fair value of the share-based compensation awards are as follows:
Expected Life: The Company determined the expected life of the options utilizing the short-cut method due to the lack of historical evidence regarding employees’ expected exercise behavior. Under this approach, the expected term is presumed to be the mid-point between the vesting date and the end of the contractual term.
Expected Volatility: Due to the relatively short period of time since our stock became publicly traded, the Company bases its estimates of stock price volatility on the average of (i) our historical stock price over the period in which it has been publicly traded and (ii) historical volatility of similar entities commensurate with the expected term of the stock options.
Horizon Lines, Inc.
Notes to Consolidated Financial Statements - (Continued)
The Company recognized approximately $1.7 million, or $0.05 per share, in compensation costs related to stock options within selling, general, and administrative expenses on the consolidated statement of operations and a deferred tax asset of approximately $1.3 million during fiscal 2007. The Company recognized approximately $0.7 million, or $0.02 per share, in compensation costs within selling, general, and administrative expenses on the consolidated statement of operations and a deferred tax asset of approximately $0.1 million during fiscal 2006. The Company will recognize an additional $3.4 million in compensation costs using the straight line method over a weighted average period of 1.2 years.
A summary of option activity under the Company’s stock plan is presented below:
(a)
The aggregate intrinsic value of stock options exercised during the years ended December 23, 2007 and December 24, 2006 was $0.3 million and $0.5 million, respectively.
Cash received from the exercise of stock options under the Company’s stock plan for the years ended December 23, 2007 and December 24, 2006 was $0.2 million and $0.1 million, respectively.
Restricted Stock
On August 28, 2007, in conjunction with the acquisition of Aero Logistics, the Company granted 50,001 shares of restricted stock to certain employees of Aero Logistics. The shares of restricted stock will vest on March 31, 2010 if certain performance targets are achieved, provided the employee who was granted such restricted stock is continuously employed by the Company through such date. The grant date fair market value of the restricted shares was $27.50 per share.
On June 28, 2007, the Company granted 75,965 shares of restricted stock to the Company’s Chief Executive Officer (the “CEO”). The restricted stock will cliff vest on December 31, 2009, provided the CEO has been in continuous employment with the Company. The grant date fair value of the restricted shares was $32.91 per shares.
Horizon Lines, Inc.
Notes to Consolidated Financial Statements - (Continued)
On June 5, 2007, the Company granted 3,487 restricted shares each to three new members of the Board of Directors. The grant date fair market value of the restricted shares was $34.42 per share and the shares will cliff vest on June 5, 2010.
On June 5, 2007, the Company granted 1,744 restricted shares each to all non-employee members of the Board of Directors. The grant date fair market value of the restricted shares was $34.42 per share and the shares will vest in full on June 5, 2008.
On March 26, 2007, the Company granted 71,500 shares of restricted stock to certain employees of the Company and its subsidiaries. The shares of restricted stock will vest on March 26, 2010 if certain performance targets are achieved, provided the employee who was granted such restricted stock is continuously employed by the Company and its subsidiaries through such date. The grant date fair market value of the restricted shares was $33.51 per share.
On January 30, 2007, the Company granted 4,064 restricted shares each to three new members of the Board of Directors. The grant date fair market value of the restricted shares was $29.53 per share and the shares will vest in full on January 30, 2010.
On February 1, 2006, the Company entered into a restricted stock agreement for 70,000 shares with a member of management that cliff vest in full on February 1, 2011.
A summary of the status of the Company’s restricted stock awards is presented below:
The Company recorded $1.9 million and $0.1 million of compensation expense related to restricted stock during the years ended December 23, 2007 and December 24, 2006, respectively. As of December 23, 2007, there was $6.2 million of total unrecognized compensation expense related to restricted stock awards. That cost is expected to be recognized over a weighted-average period of 2.4 years. No restricted stock awards vested during 2007.
Employee Stock Purchase Plan
On April 19, 2006, the Board of Directors voted to implement an employee stock purchase plan (as amended, the “ESPP”) effective July 1, 2006. The Company has reserved 308,866 shares of its common stock for issuance under the ESPP. Employees generally are eligible to participate in the ESPP if they are employed before the beginning of the applicable purchase period, are customarily employed more than five months in a calendar year and more than twenty hours per week, and are not, and would not become as a result of being granted an option under the ESPP, 5% stockholders
Horizon Lines, Inc.
Notes to Consolidated Financial Statements - (Continued)
of the Company or any of its designated subsidiaries. Participation in the ESPP will end automatically upon termination of employment. Eligible employees are permitted to acquire shares of common stock through payroll deductions within a percentage range of their salary as determined by the Company’s Compensation Committee. Such employee purchases are subject to maximum purchase limitations.
The ESPP is intended to qualify as an “employee stock purchase plan” under Section 423 of the Internal Revenue Code of 1986, as amended. The ESPP will terminate on July 1, 2016 unless it terminates earlier under the terms of the ESPP. The Board of Directors and the Compensation Committee have the authority to amend, terminate or extend the term of the ESPP, except that no action may adversely affect any outstanding options previously granted under the plan and stockholder approval is required to increase the number of shares issued or to change the terms of eligibility. The Board of Directors and the Compensation Committee are able to make amendments to the ESPP as it determines to be advisable if the financial accounting treatment for the ESPP changes from the financial accounting treatment in effect on the date the ESPP was adopted by the Board of Directors.
In connection with the adoption of SFAS 123R, the Company estimates the fair value of each share of stock using a Black-Scholes option-pricing model, applying the following assumptions, and amortizes the expense over the plan purchase period using the straight-line attribution approach:
The Company recorded $0.2 million and $0.1 million of compensation expense during the years ended December 23, 2007 and December 24, 2006, respectively, related to participation in the ESPP. As of December 23, 2007, there was no unrecognized compensation expense related to the ESPP.
18.
Income Taxes
During the third quarter of 2006, the Company elected the application of the tonnage tax instead of the federal corporate income tax on income from our qualifying shipping activities. The Company modified its trade routes between the U.S. west coast and Guam and Asia during 2007. As such, the Company’s shipping activities associated with these modified trade routes became qualified shipping activities, and thus the income from these vessels is excluded from gross income in determining federal income tax liability. During 2007, the Company recorded a $7.7 million tax benefit related to the revaluation of deferred taxes related to the qualified shipping income expected to be generated by the new vessels and related to a change in estimate resulting from refinements in the methodology for computing secondary activities and cost allocations for tonnage tax purposes. The Company’s effective tax rate for the year ended December 23, 2007 and December 24, 2006 was (94.0%) and (53.9)%, respectively.
Horizon Lines, Inc.
Notes to Consolidated Financial Statements - (Continued)
Income tax (benefit) expense are as follows (in thousands):
The difference between the income tax (benefit) expense and the amounts computed by applying the statutory federal income tax rates to earnings before income taxes are as follows (in thousands):
In accordance with the provisions of SFAS 109 and APB No. 25, the Company recorded a tax benefit attributable to the recognition of certain tax benefits derived from the exercise of non-qualified stock options in the amount of $0.1 million as an increase and $1.3 million as a decrease directly to additional paid-in capital for the years ended December 23, 2007 and December 24, 2006, respectively.
Horizon Lines, Inc.
Notes to Consolidated Financial Statements - (Continued)
The components of deferred tax assets and liabilities are as follows (in thousands):
The Company has net operating loss carryforwards for federal income tax purposes in the amount of $84.7 million and $39.4 million as of December 23, 2007 and December 24, 2006, respectively. In addition, the Company has net operating loss carryforwards for state income tax purposes in the amount of $48.0 million and $47.0 million as of December 23, 2007 and December 24, 2006, respectively. The Federal and state net operating loss carryforwards begin to expire in 2024 and 2019, respectively. Furthermore, the Company has an alternative minimum tax credit carryover with no expiration period in the amount of $1.6 million as of December 23, 2007 and December 24, 2006.
In July 2006, the Financial Accounting Standards Board (the “FASB”) issued Interpretation No. 48 (“FIN 48”), “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109.” FIN 48 clarifies the accounting for income taxes by prescribing the minimum recognition threshold a tax position is required to meet before being recognized in the financial statements. FIN 48 also provides guidance on derecognition, measurement, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 applies to all tax positions related to income taxes. On December 25, 2006, the Company adopted the provisions of FIN 48. The adoption and implementation of FIN 48 resulted in a $3.5 million increase in the liability for unrecognized tax benefits, which was accounted for as a reduction to the December 25, 2006 balance of retained earnings. A reconciliation of the beginning and ending amount of unrecognized tax benefits is as follows (in thousands):
Horizon Lines, Inc.
Notes to Consolidated Financial Statements - (Continued)
The total amount of unrecognized tax benefits, if recognized, that would affect the effective tax rate is $7.6 million.
Included in the FIN 48 balance at December 23, 2007, is $0.5 million of tax positions for which the ultimate deductibility is highly certain but for which there is uncertainty about the timing of such deductibility. Because of the impact of the deferred tax accounting, the disallowance of the shorter deductibility period would not affect the annual effective tax rate nor would it accelerate the payment of cash to the taxing authority to an earlier position because the Company would have net operating losses to offset such disallowance. In addition, the FIN 48 balance includes $0.4 million associated with the federal tax benefit for state tax liabilities currently recorded as a deferred tax asset.
The Company recognizes interest accrued and penalties related to unrecognized tax benefits in its income tax expense. During its fiscal years for 2005 through 2007, the Company has not recognized any interest and penalties in its statement of operations and statement of financial position. Furthermore, there were no accruals for the payment of interest and penalties at either December 23, 2007 or December 24, 2006.
The Company or one of its subsidiaries files income tax returns in the U.S. federal jurisdiction, various U.S. state jurisdictions and foreign jurisdictions. With few exceptions, the Company is no longer subject to U.S. federal, state and local, or non-U.S. income tax examinations by tax authorities for years before 2004. The tax years which remain subject to examination by major tax jurisdictions as of December 23, 2007 include 2004-2007.
Net operating loss credits generated from tax losses in Guam begin to expire in 2023. In 2004, the Company recorded a valuation allowance against the deferred tax asset attributable to the net operating loss generated in Guam in the amount of $1.3 million. To the extent the Company reverses a portion of the valuation allowance, such adjustment would be recorded as a reduction to goodwill.
19.
Commitments and Contingencies
Legal Proceedings
In the ordinary course of business, from time to time, the Company and its subsidiaries become involved in various legal proceedings which management believes will not have a material adverse effect on the Company’s financial position or results of operations. These relate primarily to claims for loss or damage to cargo, employees’ personal injury claims, and claims for loss or damage to the person or property of third parties. The Company and its subsidiaries generally maintain insurance, subject to customary deductibles or self-retention amounts, and/or reserves to cover these types of claims. The Company and its subsidiaries also, from time to time, become involved in routine employment-related disputes and disputes with parties with which they have contracts.
For several years, there have been two actions pending before the Surface Transportation Board (“STB”) involving HL. The first action, brought by the Government of Guam in 1998 on behalf of itself and its citizens against HL and Matson Navigation Co. (“Matson”), seeks a ruling from the STB that HL’s Guam shipping rates, which are based on published tariff rates, during 1996-1998 were “unreasonable” under the Interstate Commerce Commission Termination Act of 1995 (“ICCTA”), and an order awarding reparations to Guam and its citizens. On September 18, 2007, the Government of Guam filed a motion to dismiss its complaint with the STB citing the STB’s ruling on the methodology for determining the rate reasonableness. The Government of Guam stated it could no longer proceed with its rate challenge. As a result, this case was dismissed by the STB on October 12, 2007.
The second action before the STB involving HL, brought by DHX, Inc. (“DHX”) in 1999 against HL and Matson, challenged the reasonableness of certain rates and practices of HL and Matson. DHX was
Horizon Lines, Inc.
Notes to Consolidated Financial Statements - (Continued)
seeking $11.0 million in damages. On December 13, 2004, the STB (i) dismissed all of the allegations of unlawful activity contained in DHX’s complaint; (ii) found that HL met all of its tariff filing obligations; and (iii) reaffirmed the STB’s earlier holdings that the anti-discrimination provisions of the Interstate Commerce Act, which were repealed by the ICCTA, are no longer applicable to HL’s business. On June 13, 2005, the STB issued a decision that denied DHX’s motion for reconsideration and denied the alternative request by DHX for clarification of the STB’s December 13, 2004 decision. On August 5, 2005, DHX filed a Notice of Appeal with the United States Court of Appeals for the Ninth Circuit challenging the STB’s order dismissing its complaint. DHX filed an appellate brief on November 10, 2005. HL submitted its response to the DHX brief on January 25, 2006, and oral argument was held on June 4, 2007. On August 30, 2007, the court of appeals affirmed, in all material respects, the decision of the STB. The Company has been advised by DHX that it does not intend to pursue this matter further.
Standby Letters of Credit
The Company has standby letters of credit, primarily related to its property and casualty insurance programs. On December 23, 2007 and December 24, 2006, these letters of credit totaled $6.3 million and $26.6 million, respectively. Of the $26.6 million outstanding on the letters of credit as of December 24, 2006, $20.1 million related to the Company’s agreements with SFL and have since been returned as a result of the fulfillment of the underlying obligations.
Labor Relations
Approximately 67.5% of the Company’s total work force is covered by collective bargaining agreements. One collective bargaining agreement, covering approximately 4.6% of the workforce has expired. Our employees who are covered under this agreement are continuing to work under an old agreement while we negotiate a new agreement. Two collective bargaining agreements, covering approximately 22.0% of the workforce will be under renegotiation during 2008.
Horizon Lines, Inc.
Notes to Consolidated Financial Statements - (Continued)
20.
Quarterly Financial Data (Unaudited)
Set forth below are unaudited quarterly financial data (in thousands, except per share amounts):
(1)
The first quarter of 2007 includes a $2.5 million tax benefit related to the revaluation of deferred taxes associated with the qualified shipping income expected to be generated by the vessels in the Company’s modified trade routes between the U.S. west cost and Guam and Asia.
(2)
The third quarter of 2007 includes a $23.9 million loss, net of tax benefits, on extinguishment related to the refinancing of the Company’s long term debt.
(3)
During the third quarter of 2006, the Company elected the application of a tonnage tax.
(4)
The fourth quarter of 2006 results include a $1.8 million adjustment, or $0.05 per share, reflecting the cumulative effect of the periodic costs related to the Company’s post-retirement benefit plan. This amount was not material to any affected prior quarter or annual reporting period and as such, was recorded in the fourth quarter of 2006.
Schedule II
Horizon Lines, Inc.
Valuation and Qualifying Accounts
Years Ended December 2007, 2006 and 2005
(1)
As a result of the removal of certain deferred tax assets and the related valuation allowances.