<PAGE>
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(MARK ONE)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 1998
--------------------------------------------------
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM ___________________________________ TO
______________________________
COMMISSION FILE NUMBER 333-58223
---------
DIAMOND BRANDS OPERATING CORP.
- --------------------------------------------------------------------------------
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
DELAWARE 41-1905675
- --------------------------------------------------------------------------------
(STATE OR OTHER JURISDICTION OF INCORPORATION OR (I.R.S. EMPLOYEE
ORGANIZATION) IDENTIFICATION NO.)
1800 CLOQUET AVENUE, CLOQUET, MINNESOTA 55720
- --------------------------------------------------------------------------------
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)
218/879-6700
- --------------------------------------------------------------------------------
(REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)
- --------------------------------------------------------------------------------
(FORMER NAME, FORMER ADDRESS AND FORMER FISCAL YEAR, IF CHANGED SINCE LAST
REPORT)
INDICATE BY CHECK MARK WHETHER THE REGISTRANT (1) HAS FILED ALL
REPORTS REQUIRED TO BE FILED BY SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 DURING THE PRECEDING 12 MONTHS (OR FOR SUCH
SHORTER PERIODS THAT THE REGISTRANT WAS REQUIRED TO FILE SUCH
REPORTS), AND (2) HAS BEEN SUBJECT TO SUCH FILING REQUIREMENTS FOR THE
PAST 90 DAYS.
YES NO X
--- ---
<PAGE>
DIAMOND BRANDS OPERATING CORP.
TABLE OF CONTENTS
<TABLE>
<CAPTION>
Page
<S> <C>
PART I - FINANCIAL INFORMATION
ITEM - 1. Financial Statements (Unaudited)
Consolidated Balance Sheets 3
Consolidated Statements of Operations 4
Consolidated Statements of Cash Flow 5
Notes to Consolidated Financial Statements 6
ITEM - 2. Management's Discussion and Analysis of Results
of Operations and Financial Condition 9
PART II - OTHER INFORMATION
Signature 16
</TABLE>
<PAGE>
DIAMOND BRANDS OPERATING CORP.
Consolidated Balance Sheets (Unaudited)
(In Thousands, Except per Share Amounts)
<TABLE>
<CAPTION>
September 30, December 31,
1998 1997
------------- ------------
<S> <C> <C>
ASSETS
CURRENT ASSETS:
Accounts receivable, net of allowances of $773 and $1,195 $ 17,374 $15,526
Inventories 22,285 20,744
Deferred tax asset 2,051 -
Prepaid expenses 2,205 406
------------- ------------
Total current assets 43,915 36,676
------------- ------------
PROPERTY, PLANT AND EQUIPMENT, net of
accumulated depreciation of $17,854 and $16,715 17,152 17,544
GOODWILL 38,192 39,454
DEFERRED FINANCING COSTS 6,965 876
------------- ------------
$106,224 $94,550
------------- ------------
------------- ------------
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
CURRENT LIABILITIES:
Current maturities of long-tem debt $ 2,000 $ 7,892
Accounts payable 6,541 4,500
Accrued expenses 11,851 11,037
------------- ------------
Total current liabilities 20,392 23,429
------------- ------------
DEFERRED INCOME TAXES 735 -
POSTRETIREMENT BENEFIT OBLIGATIONS 1,586 1,586
LONG-TERM DEBT, net of current maturities 179,250 41,605
------------- ------------
Total liabilities 201,963 66,620
------------- ------------
COMMITMENTS AND CONTINGENCIES
STOCKHOLDERS' EQUITY (DEFICIT):
Common stock, $.01 par value; 50,000 shares authorized;
1,000 and 16,112 shares issued and outstanding 1 161
Additional paid in capital - 774
Retained earnings (deficit) (95,740) 26,995
------------- ------------
Total stockholders' equity (deficit) (95,739) 27,930
------------- ------------
$106,224 $94,550
------------- ------------
------------- ------------
</TABLE>
The accompanying notes are an integral part of these consolidated balance
sheets.
3
<PAGE>
DIAMOND BRANDS OPERATING CORP.
Consolidated Statements of Operations (Unaudited)
(In Thousands)
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
-------------------- ---------------------
1998 1997 1998 1997
-------------------- ---------------------
<S> <C> <C> <C> <C>
NET SALES $30,675 $31,498 $89,233 $86,165
COST OF SALES 21,024 20,758 62,372 58,380
------- ------- ------- -------
Gross profit 9,651 10,740 26,861 27,785
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES 3,291 2,940 9,831 8,274
GOODWILL AMORTIZATION 420 420 1,261 1,100
------- ------- ------- -------
Operating income 5,940 7,380 15,769 18,411
INTEREST EXPENSE 4,474 1,185 10,629 3,391
------- ------- ------- -------
Income before provision (benefit) for income taxes 1,466 6,195 5,140 15,020
PROVISION (BENEFIT) FOR INCOME TAXES 658 - (136) 1,376
------- ------- ------- -------
Net income $808 $6,195 $5,276 $13,644
------- ------- ------- -------
------- ------- ------- -------
PRO FORMA NET INCOME:
Income before provision for income taxes $1,466 $6,195 $5,140 $15,020
Pro forma income tax expense (Note 2) 600 2,500 2,100 6,000
------- ------- ------- -------
Pro forma net income $866 $3,695 $3,040 $9,020
------- ------- ------- -------
------- ------- ------- -------
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
4
<PAGE>
DIAMOND BRANDS OPERATING CORP.
Consolidated Statements of Cash Flows (Unaudited)
(In Thousands)
<TABLE>
<CAPTION>
Nine Months Ended
September 30,
---------------------------
1998 1997
---------- ----------
<S> <C> <C>
OPERATING ACTIVITIES
Net income $5,276 $13,644
Adjustments to reconcile net income to net cash provided by operating activities
Depreciation and amortization 4,399 3,740
Deferred income taxes (1,316) 1,376
Change in operating assets and liabilities, net of effects of acquisition
Accounts receivable (1,848) (4,781)
Inventories (1,541) (3,003)
Prepaid expenses (1,799) 367
Accounts payable 2,041 248
Accrued expenses 4,416 1,190
---------- ----------
Net cash provided by operating activities 9,628 12,781
---------- ----------
INVESTING ACTIVITIES
Acquisition of Empire, net of cash received - (24,696)
Purchases of property, plant and equipment (1,523) (2,455)
---------- ----------
Net cash used for investing activities (1,523) (27,151)
---------- ----------
FINANCING ACTIVITIES
Borrowings from bank revolving line of credit 27,200 32,900
Repayments to bank revolving line of credit (30,700) (26,800)
Borrowings on long-term debt 180,000 21,000
Repayments of long-term debt (44,747) (5,509)
S-Corp distributions to shareholders (5,488) (6,851)
Distributions to parent company (127,059) -
Debt issuance costs (7,311) (370)
---------- ----------
Net cash provided by (used for) financing activities (8,105) 14,370
---------- ----------
NET INCREASE IN CASH AND CASH EQUIVALENTS - -
CASH AND CASH EQUIVALENTS, beginning of period - -
---------- ----------
CASH AND CASH EQUIVALENTS, end of period $ - $ -
---------- ----------
---------- ----------
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
5
<PAGE>
DIAMOND BRANDS OPERATING CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
1. BASIS OF PRESENTATION
The accompanying consolidated financial statements include the accounts of
Diamond Brands Operating Corp. ("Operating Corp") and Operating Corp.'s
wholly-owned subsidiaries, Forster Inc. and Empire Candle, Inc. after
elimination of all material intercompany balances and transactions.
Operating Corp. and its subsidiaries are collectively referred to as
"the Company".
The Company is a leading manufacturer and marketer of a broad range of
consumer products, including wooden matches and firestarters, plastic
cutlery and straws, scented, citronella and holiday candles, and
toothpicks, clothespins and wooden crafts. The Company's products are
marketed primarily in the United States and Canada under the nationally
recognized Diamond, Forster and Empire brand names.
The interim consolidated financial statements of the Company are unaudited;
however, in the opinion of management, all adjustments necessary for a fair
presentation of such consolidated financial statements have been reflected
in the interim periods presented. The significant accounting policies and
certain financial information which are normally included in financial
statements prepared in accordance with generally accepted accounting
principles, but which are not required for interim reporting purposes, have
been condensed or omitted. The accompanying consolidated financial
statements of the Company should be read in conjunction with the
consolidated financial statements and related notes included in the
Company's audited financial statements for the year ended December 31,
1997.
2. RECAPITALIZATION
On March 3, 1998, the stockholders of the Company entered into a
recapitalization agreement (the "Recapitalization Agreement") with Seaver
Kent - TPG Partners, L.P. and Seaver Kent I Parallel, L.P. (collectively
"the Sponsors"), which provided for the recapitalization of the Company.
Pursuant to the Recapitalization Agreement, in April 1998, the Operating
Corp.'s parent, Diamond Brands Incorporated (Holdings) purchased from the
existing stockholders 15,129,232 shares of the Company's common stock for
$211.5 million by Operating Corp. (i) issuing $100.0 million of senior
subordinated notes and (ii) entering into a bank credit agreement which
provided for $80.0 million in term loan facilities and a $25.0 million
revolving credit facility. The proceeds of such were used to partially
fund the recapitalization.
3. LONG TERM DEBT
In April 1998, the Company completed offerings of $100.0 million of 10 1/8%
senior subordinated notes due 2008. The net proceeds to the Company for
the offerings,
6
<PAGE>
after discounts, commissions and other offering costs were $95.4 million
and were used to repay existing indebtedness and purchase common stock of
the Company. The senior subordinated notes are fully and unconditionally
guaranteed on a senior subordinated basis, jointly and severally, by all
of Operating Corp.'s direct and indirect subsidiaries (the "Subsidiary
Guarantors"). The Subsidiary Guarantors are Forster, Inc. and Empire
Candle, Inc. Separate financial statements of the Subsidiary Guarantors
are not presented because management has determined that they are not
material to investors. In lieu of the separate guarantor financial
statements, summarized combined financial information of Holdings/Operating
Corp. and the Subsidiary Guarantors are presented below (in Thousands):
<TABLE>
<CAPTION>
DECEMBER 31, 1997
Operating Guarantor Consolidated
Corp. Subsidiaries Eliminations Total
----------------------------------------------------
<S> <C> <C> <C> <C>
Balance Sheet Data:
Current Assets $13,673 $23,003 $ - $36,676
Non Current Assets 97,929 25,423 (65,478) 57,874
Current Liabilities 42,148 6,624 (25,343) 23,429
Noncurrent Liabilities 41,524 1,667 43,191
Stockholders' Equity 27,930 40,135 ( 40,135) 27,930
<CAPTION>
NINE MONTHS ENDED SEPTEMBER 30, 1998
<S> <C> <C> <C> <C>
Statement of Operations Data:
Net Sales $27,823 $61,410 $ - $89,233
Gross Profit 6,943 19,418 26,861
Operating Income 3,337 2,432 15,769
Equity in earnings of 5,253 (5,253)
Subsidiaries
Net Income 5,276 5,253 (5,253) 5,276
<CAPTION>
SEPTEMBER 30, 1998
<S> <C> <C> <C> <C>
Balance Sheet Data:
Current Assets $24,394 $19,521 $ - $43,915
Noncurrent Assets 107,632 24,593 (69,916) 62,309
Current Liabilities 47,316 6,045 (32,969) 20,392
Noncurrent Liabilities 180,449 1,122 181,571
Stockholders' Equity (95,739) 36,947 (36,947) (95,739)
(Deficit)
<CAPTION>
NINE MONTHS ENDED SEPTEMBER 30, 1997
<S> <C> <C> <C> <C>
Statement of Operations Data:
Net Sales $26,193 $59,972 $ - $86,165
Gross Profit 7,268 20,517 27,785
Operating Income 4,213 14,198 18,411
Equity in Earnings of 10,754 (10,754)
Subsidiaries
Net Income 13,644 10,754 (10,754) 13,644
</TABLE>
The Company also entered into a bank credit agreement which provides for
$80.0 million in term facilities with interest rates from LIBOR (5.56250% as
of September 30, 1998) plus 2.0% to LIBOR plus 2.25% due in installments
through March 2006 and a $25.0 million
7
<PAGE>
revolving credit facility at LIBOR plus 2.0%. As of September 30, 1998, the
Company was in compliance with the provisions of its debt covenants.
4. INCOME TAXES
Effective January 1, 1997, the Company converted from a C corporation to an
S corporation due to a change in the tax laws allowing entities with
subsidiaries to elect this status. Deferred tax assets and liabilities as
of December 31, 1996 are reflected as a charge in the consolidated
statement of operations for the nine months ended September 30, 1997.
The taxable income or loss of the Company for the years ended after
December 31, 1996 and prior to the recapitalization is included in the
individual returns of the stockholders for federal tax purposes and, to the
extent allowed and elected, for state tax purposes. Accordingly, there is
no provision for current income taxes for the period from January 1, 1998
to April 20, 1998 and the nine months ended September 30, 1997. Effective
with the recapitalization in April 1998, the Company elected C corporation
status and recognized deferred income taxes for temporary differences
between tax and financial reporting bases.
The unaudited pro forma income tax expense is presented assuming the
Company had been a C corporation since January 1, 1997.
6. NEW ACCOUNTING PRONOUNCEMENTS
Statement of Financial Account Standards (SFAS) No. 131, "Disclosures About
Segments of an Enterprise and Related Information," issued in June 1997 and
effective for fiscal years beginning after December 15, 1997, redefines how
operating segments are determined and requires expanded quantitative and
qualitative disclosure relating to the company's operating segments. The
Company believes that the effect of adopting SFAS No. 131 will not be
significant.
SFAS No. 133, "Accounting for Derivative Instruments and Hedging
Activities", issued in June 1998, establishes accounting and reporting
standards for derivative instruments and for hedging activities. It
requires that an entity recognize all derivatives as either assets or
liabilities and measure those instruments at fair value. The Company
believes that the effect of adopting SFAS No. 133 will not be significant
to the results of operations.
8
<PAGE>
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
GENERAL
Diamond Brands Operating Corp. (the Company), is a leading manufacturer and
marketer of a broad range of consumer products, including wooden matches and
firestarters (Wooden Lights), plastic cutlery and straws (Cutlery), scented,
citronella and holiday candles (Candles), and toothpicks, clothespins and wooden
crafts (Woodenware). The Company's products are marketed primarily under the
nationally recognized Diamond, Forster and Empire brand names, which have been
in existence since 1881, 1887 and 1950, respectively.
The Company derives its revenue primarily from the sale of its products to
substantially all major grocery stores, drug stores, mass merchandisers and
warehouse clubs in the United States. During the nine months ended September
30, 1998, sales to the Company's top 10 customers accounted for approximately
36% of the Company's gross sales, with one customer accounting for
approximately 15% of the Company's gross sales. The Company's ability to
maintain and increase its sales depends on a variety of factors including its
competitive position in such areas as price, quality, brand identity,
distribution and customer service. The Company's products are manufactured
at its four automated manufacturing facilities located in Cloquet, Minnesota,
East Wilton, Maine, Strong, Maine, and Kansas City, Kansas.
Net sales, as calculated by the Company, are determined by subtracting discounts
and allowances from gross sales. Discounts and allowances consist of price
promotions, cash discounts, corporate rebates, slotting fees, consumer coupons,
co-op advertising and unsaleables. The Company's cost of sales and its resulting
gross margin (defined as gross profit as a percentage of net sales) are
principally determined by the cost of raw materials, the cost of the labor to
manufacture its products, the overhead expenses of its manufacturing facilities,
warehouse costs and freight expenses to its customers. In recent years, the
Company has focused on improving its gross margin by seeking to: (i)
consolidate manufacturing operations; (ii) reduce headcount and expenses in
manufacturing; and (iii) increase operating efficiencies through capital
projects with rapid returns on investment.
Polystyrene resin, a commodity whose market price fluctuates with supply and
demand, is a significant component of cost of sales in the Company's Cutlery
products. In order to mitigate the impact of changing polystyrene resin prices,
the Company in January 1997 entered into a three-year supply contract with a
major supplier of polystyrene resin, under which the Company believes it
receives the lowest price available to any customer purchasing similar volume,
and receives short-term price protection during periods of rising prices.
During periods of rising prices, the Company generally has been able to pass
through the majority of the polystyrene resin price increases to its customers
on a delayed basis. During periods of declining polystyrene resin prices, the
Company generally has reduced prices to its customers.
Selling, general and administrative expenses consist primarily of selling
expenses, broker commissions and administrative costs. Broker commissions and
certain selling expenses generally vary with sales volume while administrative
costs are relatively fixed in nature.
9
<PAGE>
RECAPITALIZATION. Diamond Brands Incorporated (Holdings), the Stockholders
and Seaver Kent & Company, LLC (the Sponsors) entered into the
Recapitalization Agreement, the Sponsors and other investors purchased from
Holdings, for an aggregate purchase price of $47.0 million, Holdings
Preferred Stock together with the Warrants to purchase from Holdings Holdings
Common Stock. The Warrants provide the holders with the right to subscribe
and purchase from Holdings Holdings Common Stock at the purchase price at
$0.01 per share at any time prior to their expiration date in April 2008.
The values assigned to the Warrants and Holdings Preferred Stock were $12.3
million and $34.7 million, respectively, based upon the sale prices of
comparable preferred stock instruments in the marketplace. Dividends in
respect of Holdings Preferred Stock accumulate at 12% per annum (representing
a 15% per annum effective yield) to its mandatory redemption value of $47.0
million on the mandatory redemption date of October 15, 2009. Holdings has
the option, at any time, to redeem Holdings Preferred Stock at a price equal
to the Liquidation Preference plus all accumulated and unpaid dividends. The
shares of Holdings Common Stock issuable upon the full exercise of the
Warrants would represent 77.5% of the outstanding shares of Holdings Common
Stock after giving effect to such issuance. In addition, Holdings purchased
for $211.4 million, subject to certain working capital adjustments, from the
Stockholders all outstanding shares of Holdings' capital stock, other than
the Retained Shares. The Retained Shares would represent 22.5% of the
outstanding shares of Holdings Common Stock after giving effect to the full
exercise of the Warrants, having the Implied Value of $15.0 million. The
Equity Repurchase price of $13.98 per share was determined based upon a
competitive process with potential investors managed by Donaldson, Lufkin &
Jenrette Securities Corporation on behalf of the Company. Holdings, the
Sponsors and the holders of the Retained Shares also entered into a
Stockholers Agreement pursuant to which, among other things, the Sponsors
have the ability to direct the voting of outstanding shares of Holdings
Common Stock in proportion to their ownership of such shares as if the
Warrants were exercised in full. Accordingly, the Sponsors have voting
control of Holdings.
In connection with the Recapitalization, Holdings organized Diamond Brands
Operating Corp. and, immediately prior to the consummation of the
Recapitalization, Holdings transferred substantially all of its assets and
liabilities to Operating Corp. Holdings' current operation are, and future
operations are expected to be, limited to owning the stock of Operating Corp.
Operating Corp. repaid substantially all of the Company's funded debt
obligations existing immediately before the consummation of the Recapitalization
in the amount of $51.8 million.
Funding requirements for the Recapitalization (which consummated on April 21,
1998) were $296.5 million (including the Implied Value of the Retained Shares)
and were satisfied through the Retained Shares and the following: (i) the
purchase by the Sponsors and other investors of Holdings Preferred Stock and the
Warrants for $47.0 million ($45.8 million in cash and $1.2 million in officer
notes receivables); (ii) $45.14 million of gross proceeds from the Offering,
(iii) $80.0 million of borrowings under the Term Loan Facilities; (iv) $10.6
million of borrowings under the Revolving Credit Facility; and (v) $100.0
million of gross proceeds from the sale by Operating Corp. of the Senior
Subordinated Notes in a separate offering.
10
<PAGE>
RESULTS OF OPERATIONS
The following table sets forth, for the periods indicated, gross sales and gross
sales as a percentage of the Company's aggregate net sales for the Company's
major product groups, as well as the Company's aggregate net sales, EBITDA and
EBITDA margin.
<TABLE>
<CAPTION>
Three Months Ended September 30, Nine Months Ended September 30,
----------------------------------- -------------------------------------
1998 1997 1998 1997
--------------- --------------- --------------- ----------------
(dollars in millions) (dollars in millions)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Wooden Lights $5.9 19.2% $5.2 16.5% $15.7 17.6% $14.8 17.2%
Cutlery 9.1 29.6 7.6 24.2 29.4 33.0 26.3 30.5
Candles 7.6 24.8 10.4 33.0 18.7 21.0 17.1 19.8
Woodenware 7.3 23.8 6.9 21.9 23.1 25.9 22.5 26.1
Institutional/Other 4.4 14.3 4.0 12.7 12.7 14.2 13.0 15.1
----- ------ ----- ----- ----- ----- ----- -----
Total gross sales 34.3 111.7 34.1 108.3 99.6 111.7 93.7 108.7
Discounts and allowances (3.6) ( 11.7) (2.6) (8.3) (10.4) (11.7) (7.5) 8.7
----- ------ ----- ----- ----- ----- ----- -----
Net sales $30.7 100.0% $31.5 100.0% $89.2 100% $86.2 100.0%
----- ------ ----- ----- ----- ----- ----- -----
----- ------ ----- ----- ----- ----- ----- -----
EBITDA (1) $7.0 22.8% $8.6 27.3% $19.0 21.3% $22.0 25.5%
----- ------ ----- ----- ----- ----- ----- -----
----- ------ ----- ----- ----- ----- ----- -----
</TABLE>
(1) EBITDA represents operating income plus depreciation and amortization
(excluding amortization of deferred financing costs). The Company believes
that EBITDA provides useful information regarding the Company's ability to
service its debt; however, EBITDA does not represent cash flow from
operations as defined by generally accepted accounting principles and
should not be considered as a substitute for net income as an indicator of
the Company's operating performance or cash flow as a measure of liquidity.
11
<PAGE>
THREE MONTHS ENDED SEPTEMBER 30, 1998 COMPARED TO THREE MONTHS ENDED
SEPTEMBER 30, 1997
The following table sets forth, for the periods indicated, certain historical
statement of operations data and such data as a percentage of net sales for the
Company.
<TABLE>
<CAPTION>
Three Months Ended September 30,
-------------------------------------
1998 1997
--------------- -----------------
(dollars in millions)
Actual Actual
------ ------
<S> <C> <C> <C> <C>
Net sales $30.7 100.0% $31.5 100.0%
Cost of sales 21.0 68.4 20.8 66.0
----- ----- ----- -----
Gross profit 9.7 31.6 10.7 34.0
Selling, general and administrative expenses 3.3 10.7 2.9 9.2
Goodwill amortization .4 1.3 .4 1.3
----- ----- ----- -----
Operating income 6.0 19.6 7.4 23.5
Interest expense 4.5 14.7 1.2 3.8
----- ----- ----- -----
Income before provision for
income taxes $1.5 4.9% $6.2 19.7%
----- ----- ----- -----
----- ----- ----- -----
</TABLE>
NET SALES. Net sales for the three months ended September 30, 1998 were $30.7
million, down $.8 million from the comparable three months in 1997. Total
gross sales, however, increased .6% over third quarter 1997 gross sales, to
$34.3 million. Gross sales for Cutlery increased $1.5 million or 19.7% due
to continued strong performance in both branded and private label. Gross
sales of Wooden Lights, Woodenware and Institutional/Other products all
experienced solid increases (13.5%, 5.8% and 10.0% respectively), while
Candle sales declined $2.8 million or 26.9% from the comparable quarter in
1997. The drop in Candle sales can be attributed to a lost customer in 1998,
and production lagging demand. The modest growth in gross sales was offset
by an increase in promotions and slotting allowances of $1.0 million,
primarily for Cutlery and Candles.
GROSS PROFIT. Gross profit from the three months ended September 30, 1998,
decreased $1.1 million or 10.1% to $9.6 million, representing a corresponding
drop in gross margin to 31.5% from 34.1% in 1997. The decline in gross profit
results from production problems relating to the candle line ($.4 million);
additional obsolescence provision associated with candles ($.3 million) and high
freight and distribution costs ($.4 million).
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Selling, general and
administrative expenses increased $.4 million to $3.3 million in the three
months ended September 30, 1998. General spending was up slightly due to
travel and year 2000 remediation matters and the Company had one time
non-recurring cost relating to the severance of the Vice President of Sales
and Marketing ($.2 million).
GOODWILL AMORTIZATION. Goodwill amortization in the three months ended
September 30, 1998, was $.4 million, equal to such amount for the comparable
three months in 1997.
INTEREST EXPENSE. Interest expense in the three months ended September 30, 1998
totaled $4.5 million compared to $1.2 million in 1997. This increase resulted
from the increased debt load and deferred financing costs associated with the
Recapitalization.
12
<PAGE>
EARNINGS BEFORE INTEREST, TAXES, DEPRECIATION AND AMORTIZATION (EBITDA). EBITDA
for the third quarter 1998 was $7.0 million compared to $8.6 million, or 22.8%
of net sales for 1998 compared to 27.3% for 1997.
NINE MONTHS ENDED SEPTEMBER 30, 1998 COMPARED TO NINE MONTHS ENDED SEPTEMBER 30,
1997
The following table sets forth, for the periods indicated, certain historical
statement of operations data and such data as a percentage of net sales for the
Company.
<TABLE>
<CAPTION>
Nine Months Ended September 30,
--------------------------------
1998 1997
--------------------- --------------------
(dollars in millions)
Actual Actual
------ ------
<S> <C> <C> <C> <C>
Net sales $89.2 100.0% $86.2 100.0%
Cost of sales 62.3 69.8 58.4 67.8
----- ----- ----- -----
Gross profit 26.9 30.2 27.8 32.2
Selling, general and administrative expenses 9.8 11.0 8.3 9.6
Goodwill amortization 1.3 1.5 1.1 1.3
----- ----- ----- -----
Operating income 15.8 17.7 18.4 21.3
Interest expense 10.6 11.9 3.4 3.9
----- ----- ----- -----
Income before provision for income taxes $5.2 5.8% $15.0 17.4%
----- ----- ----- -----
----- ----- ----- -----
</TABLE>
NET SALES. Net sales for the nine months ended September 30, 1998, increased
3.5% to $89.2 million from $86.2 million for the comparable period in 1997,
primarily due to the February, 1997 acquisition of Empire which added net
sales of $3.0 million. The Company continued to experience solid growth in
Cutlery as gross sales increased $3.1 million or 11.8%, due to strong
performance in both branded and private label. Gross sales of Wooden Lights
and Woodenware increased 6.1% and 2.7% respectively, while gross sales of
Institutional/Other decreased slightly. Actual gross sales on Candles
decreased $1.4 or 8.2%, when adjusted for the February 1997 acquisition. The
growth in gross sales was offset by increased promotions and slotting
allowances of $2.9 million, primarily for Candles and Cutlery, including $.3
million of unusual Candle allowances.
GROSS PROFIT. Gross profit decreased $.9 million for the nine months ended
September 30, 1998, and correspondingly gross margin declined from 32.2% to
30.2%. The input of the February, 1997 acquisition of Empire ($.8 million)
was offset by inventory and production problems ($1.5 million) associated
with the Candle product line. The Company has made a claim against the
former majority shareholders under the Recapitalization Agreement to recover
certain of these costs. Management believes the inventory problems were one
time and non-recurring in nature. Excluding the effects of these factors,
gross margin would have been 31.8%.
13
<PAGE>
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Selling, general and
administrative expenses increased by $1.5 million to $9.8 million in the nine
months ended September 30, 1998. The Company had non-recurring costs relating to
the severance of the Chief Operating Officer of the Candle division and Vice
President of Sales and Marketing ($.3 million), the write-off of receivables as
a result of the Venture Stores bankruptcy ($.1 million) and expensing of
recruiting and relocation costs ($.2 million) to strengthen the management team.
In addition, the Company incurred higher expenses to support the introduction of
Reflections candles into the grocery trade.
GOODWILL AMORTIZATION. Goodwill amortization in 1998 was $1.3 million, up from
$1.1 million in 1997 as the result of the Empire Acquisition.
INTEREST EXPENSE. Interest expense for the nine months ended September 30,
1998 totaled $10.6 million compared to $3.4 million for the compared nine
months in 1997. This increase is the result of the increased debt load and
deferred financing costs associated with the Recapitalization.
Included are the one time expensing of bridge commitment fees ($1.0 million)
relating to the Recapitalization and write-off of deferred finance costs ($.7
million) related to pre-Recapitalization debt.
EARNINGS BEFORE INTEREST, TAXES, DEPRECIATION AND AMORTIZATION (EBITDA). EBITDA
for the nine months ended September 30, 1998 was $19.0 million or 21.3% compared
to $22.0 million or 25.5% for 1997.
LIQUIDITY AND CAPITAL RESOURCES. Cash provided by operating activity was $9.6
million for nine months ending September 30, 1998 and $12.8 million for 1997.
The Company's primary cash requirements are for working capital and capital
expenditures which generally are funded internally or available under the
current revolving credit facility.
Capital expenditures for the nine months ended September 30, 1998 were $1.5
million compared to $2.5 million for 1997.
RECENTLY ISSUED ACCOUNTING STANDARDS. Financial Accounting Standards Board
Statement (SFAS) NO. 131, "Disclosures About Segments of an Enterprise and
Related Information," issued in June 1997 and effective for fiscal years
beginning after December 15, 1997, redefines how operating segments are
determined and requires expanded quantitative and qualitative disclosures
relating to the company's operating segments. The Company believes that the
effect on it of adopting SFAS No. 131 will not be significant.
INFLATION AND ECONOMIC TRENDS. Although its operations are affected by general
economic trends, the Company does not believe that inflation has had a material
impact on its results of operations.
14
<PAGE>
YEAR 2000
Many computer systems and software applications, including most of those used by
the Company, identify dates using only the last two digits of the year. These
systems are unable to distinguish between dates in the year 2000 and dates in
the year 1900. That inability (referred to as the "Year 2000" issue), if not
addressed, could cause certain systems or applications to fail or provide
incorrect information after December 31, 1999 or when using dates after December
31, 1999. This in turn, could have an adverse effect on Diamond Brands, due to
Diamond Brands' direct dependence on its own system and applications and
indirect dependence on those of other entities with whom Diamond Brands must
interact.
The Company has implemented a process to either replace or modify all of the
Company's current computer systems and software applications which will be Year
2000 compliant. The Company expects to complete the entire project by June 1999.
In connection with this process, the Company has retained two information
technology consulting groups.
The Company currently estimates that its costs incurred in 1997 and through the
year 2000 to enhance its information systems will cost approximately $1.2
million. These costs include estimates for employee compensation on the project
team, consultants, hardware and software. The Company does not anticipate
incurring any additional expenses in connection with the Year 2000 issue.
As a result of the implementation of the new information system, Diamond Brands
is not likely to initiate other major systems projects in connection with the
Year 2000 issue. There can be no assurance that Diamond Brands will not
experience cost overruns or delays in connection with its plan for replacing or
modifying systems.
FORWARD-LOOKING STATEMENTS. Forward-looking statements herein are made pursuant
to the safe harbor provisions of the Private Securities Litigation Reform Act of
1995. There are certain important factors that could cause results to differ
materially from those anticipated by some of the statements made herein.
Investors are cautioned that all forward-looking statements involve risks and
uncertainty. In addition to the factors discussed above, among the factors that
could cause actual results to differ materially are the following: the timing
and strength of new product offerings, pricing strategies of competitors and the
Company's ability to obtain sufficient financing to meet its liquidity needs.
15
<PAGE>
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
DIAMOND BRANDS OPERATING CORP. (Registrant)
By: /s/ Thomas W. Knuesel
------------------------------
Thomas W. Knuesel Vice President of Finance
and Chief Financial Officer (authorized
officer, principal financial and accounting
officer)
Date: November 13, 1998
----------------------
16
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