| MONTEREY GOURMET FOODS 1 |
| Business "e , "e Item 1A Risk Factors "e , and "e Item 7, Managementapstas Discussion and Analysis of Financial Condition and Results of Operations "e |
| Many important factors could cause actual results to differ materially from managementapstas expectations, including: o Weather could impact the price of raw materials the Company purchases |
| o The extent to which the Company can reduce costs according to its cost reduction initiatives |
| o Unpredictable difficulties or delays in the development of new products or the Companyapstas ability to forecast consumer trends |
| o Changes in US economic conditions such as inflation, or interest rate fluctuations |
| o Pricing changes of raw materials, freight, or impacts for competitive pricing |
| o Inherent risks of food production |
| o Integration of acquired businesses |
| o Difficulties in obtaining or retaining the management and other human resource competencies that the Company needs to achieve its business objectives |
| o The impact on the Company from the loss of a significant customer or a few customers |
| o Changes in the regulatory environment |
| o Capital spend requirements |
| o Ability to pay current debt obligations |
| o Adoption of new accounting pronouncements promulgated by the Financial Accounting Standards Board or other accounting standard setting agencies |
| ( "e the Company "e ) began its business in 1989 as a producer and distributor of refrigerated gourmet pasta and sauces to restaurants and grocery stores in the Monterey, California area |
| The Company has since expanded its operations to include a more diversified range of gourmet refrigerated food products, which it provides to grocery and club stores throughout the United States, as well as selected regions in Canada, the Caribbean, Latin America, and Asia Pacific |
| The Companyapstas overall strategy is to enhance the value of the Monterey Gourmet Foods brands by distributing its gourmet food products through multiple channels of distribution, while selectively participating in private label partnerships |
| The Company currently produces and/or markets premium quality refrigerated gourmet pastas, gnocchi, pasta sauces, prepared entrees, salsas, dips, hummus, polenta, soups, cheeses, spreadable cheeses, and gourmet sausages, emphasizing superior flavors and innovative products |
| The Company seeks to build brand recognition and customer loyalty by employing a marketing program that focuses on developing multiple points of sale for the Companyapstas products, and increasing consumer awareness of the Companyapstas offerings primarily through in-store sampling and advertising and cooperative advertising with its customers |
| The Company markets and sells its products primarily through grocery and club stores |
| The Company offers over 250 varieties of contemporary gourmet food products that are produced using the Companyapstas proprietary recipes |
| In 2005, the Company expanded its line and distribution of whole wheat pasta |
| The Company entered the frozen category with its "e OneStep Gourmet "e product which offers consumers a complete meal in less than 10 minutes |
| It also introduced several Hispanic Products including two flavors of premium tamales |
| Also in 2005, the 2 Company acquired Sonoma Cheese Company which markets its original Sonoma Jack Cheese in many flavor varieties, and Casual Gourmet Foods which markets a line of gourmet soups and sausages |
| In 2004, the Company introduced new prepared food items such as the grilled wrapped sandwiches, expanded its line of "e quick preparation "e gourmet entrees, expanded its distribution of reduced-carbohydrate pastas and sauces and began the introduction of a line of whole wheat pastas |
| In 2003, the Company introduced new prepared food items such as lasagna and stuffed manicotti along with a line of reduced-carbohydrate pasta products under the CARB-SMART(TM) Brand, and several extensions of existing lines |
| On January 12, 2006, as a subsequent event, Monterey Gourmet Foods, Inc |
| ( "e Monterey "e ), Suekat LLC ( "e Suekat "e ) and CIBO Naturals, LLC ( "e CIBO "e ), amended their previous agreement for the purchase and sale of limited liability company units, as a result of which Monterey acquired the remaining 15dtta5prca of CIBO from Suekat in exchange for 300cmam000 unregistered shares of Monterey common stock with an estimated market value of dlra1dtta2 million |
| passed a resolution to amend its bylaws changing its fiscal year from a 52/53 week year ending on the Sunday closest to December 31 to that of a calendar year, effective as of the end of and for the quarter ending June 30, 2005 |
| On April 7, 2005, Monterey Gourmet Foods, Inc |
| ( "e Sonoma "e ), and the shareholders of Sonoma ( "e Shareholders "e ) entered into a definitive agreement for the purchase by Monterey of 80prca of Sonomaapstas outstanding shares ( "e Stock Purchase Agreement "e ) |
| Sonoma markets a variety of refrigerated branded specialty cheese items, including their flagship products, Sonoma Jack Cheeses in a variety of flavors |
| Sonomaapstas products are sold in retail supermarkets, club stores, and specialty food stores across the US with the greatest penetration in the Western US markets |
| Some of the most popular cheese flavors include Hot Pepper Jack Cheese, Garlic Jack Cheese, Mediterranean Jack Cheese and Pesto Jack Cheese |
| Sonoma maintains its headquarters in Sonoma, CA On January 11, 2005, the Company entered into a definitive agreement with Casual Gourmet Foods, Inc |
| ( "e Casual "e ), and the shareholders of Casual ( "e Shareholders "e ) for the purchase by the Company of 60prca of Casualapstas outstanding shares with the balance of Casualapstas shares to be acquired by the Company in three annual installments at predetermined contractual prices |
| Casual, which produces branded gourmet sausages, prepared soups and other food products, is a Florida corporation with headquarters in Clearwater, Florida |
| In 2004, the Company acquired an 80prca interest in CIBO Naturals LLC ( "e CIBO "e ), a leading manufacturer of premium sauces and spreads located in Seattle, Washington |
| CIBO produces a variety of refrigerated gourmet sauces and spreads including fresh pesto sauces, flavored cheeses, bruschetta toppings and tapenade spreads |
| Their products are sold nationally through club stores, supermarket delis and specialty food stores |
| The CIBO acquisition met the Companyapstas strategy for growth in the premium refrigerated foods category |
| CIBO, through its "e CIBO Naturals "e brand, sells unique, high quality products and has developed a strong position in its markets which has great growth potential in both expanded distribution and in new products |
| The Company sells its products through leading grocery store chains including Albertsonapstas, King Soopers, Safeway, Fred Meyer, Kroger, Raleyapstas, Trader Joeapstas, Wegmans, Dominickapstas, Hannaford Brothers, Shop Rite, Jewel, Publix and QFC; and warehouse club stores including Costco Wholesale, Samapstas Club, a division of Wal-Mart, and BJapstas |
| As of December 31, 2005, approximately 10cmam100 grocery and club stores offered Monterey Gourmet Foods &apos products |
| The Company also has a web site, www |
| com, to further support its brand by providing both consumer and investor information |
| The site provides insight into the Companyapstas profile, product offerings, financial strength, as well as consumer tips for those interested in gourmet food and links its recently acquired brands |
| The success of the Companyapstas sales efforts will depend in large part on four key factors: (1) whether grocery and club store chains will continue to increase the number of their stores offering the Companyapstas products, (2) whether the Company can continue to increase the number of grocery and club store chains offering its products, 3) whether the Company continues to introduce new products that meet consumer acceptance and 4) whether the Company can continue to diversify into other complementary businesses and leverage its strengths to continue to grow revenues and profits at levels attractive to its investors |
| Grocery and club store chains continually re-evaluate the products carried in their stores, and no assurances can be given that the chains currently offering the Companyapstas products will continue to do so in the future |
| Monterey Gourmet Foods was originally incorporated in California in June 1989 and was reincorporated in Delaware in August 1996 |
| The Companyapstas executive offices and principal facilities are located at 1528 Moffett Street, Salinas, California 93905 |
| Investors can obtain copies of the Companyapstas periodic reports and proxy material from the Companyapstas website free of charge, as well as from the SECapstas website at www |
| 3 Industry Overview The Company believes that the US retail market for refrigerated specialty foods is fragmented and growing with a number of national, regional and local competitors |
| The Company believes that it can be successful in this market by offering higher quality, upscale products with superior flavor profiles |
| The Company also believes that it can leverage its existing presence in club stores and retail grocery chain stores to gain distribution of its other gourmet food products |
| The organic food business has been growing at a double-digit rate since the 1960s and has now reached over dlra10 billion in retail sales, according to Organic Trade Associations 2004 Manufacturing Survey |
| New Federal standards, under the auspices of the United States Department of Agriculture ( "e USDA "e ), were adopted for the industry in October 2002 |
| The purpose of the new standards was to provide a framework for organic content of product with the use of the USDA seal for those products meeting the "e organic "e definition (95prca organic content), and set standards for product quality and food safety so as to improve the overall strength of the organic foods industry and protect the consumer |
| Emerald Valley and other credible producers who meet the standards to be labeled USDA organic will be in an excellent position to participate in the future growth of the industry |
| Currently all Emerald Valley products qualify for the USDA designation |
| The Companyapstas future organic offerings will be produced and formulated with the objective of qualifying for the USDA designation |
| The California Milk Advisory Board stated that Americans consumed 8dtta8 billion pounds of cheese in 2003 |
| Cheese consumption has increased from 11dtta1 pounds per person in 1987 to 30dtta6 pounds in 2003 |
| The specialty cheeses category in which the Company competes has grown from 420 million pounds consumed in 1994 to 815 million pounds in 2003 |
| Specialty cheeses represents almost 10prca of all cheese consumed in the United States |
| The Company believes this is a growing category and that Sonoma Cheese is well positioned to grow with this category and also expand market share |
| The refrigerated pasta category, along with all pastas has seen reductions in sales starting in 2003 as the low-carbohydrate diets became more popular due to the publicized relationship between reduced carbohydrate consumption and weight loss |
| Starting in 2005, this trend has reversed and the consumption of carbohydrates has been on the rise |
| The smaller refrigerated pasta category has grown faster than the overall pasta category because of the gourmet products it includes |
| Monterey Gourmet Foods believes its products are well positioned to take advantage of the growing trend to more gourmet food products |
| No assurance can be given that the market for refrigerated gourmet food products will expand further and that space will be made available at the store level to house refrigerated products |
| Nor can there be any assurance that current trends in healthy gourmet eating or consumer demand for quick meal solutions, or consumer spending levels in the specialty food category will continue in the future |
| Additionally, as the Company expands into different geographic regions and new product categories, it may encounter different consumer perceptions, diet trends, attitudes, behavior and competition |
| This may adversely impact the Companyapstas expansion strategy and cause it to incur greater expenses than anticipated in the promotion of its products |
| Strategy Monterey Gourmet Foods &apos overall objective is to become a leading national marketer of refrigerated gourmet food products through distribution of its products to grocery and club stores and through key acquisitions |
| The principal elements of the Companyapstas strategy include the following: o Expand market share through same-store revenue growth, addition of new grocery and club stores, geographic and product line diversification, including creation of additional meal solutions using Monterey Gourmet Foods products |
| o Introduce new products on a timely basis to maintain customer interest and to respond to changing consumer tastes |
| In order to maximize its margins, the Company will focus most of its efforts on those new products that can be manufactured and distributed out of its Salinas, California, Eugene, Oregon or Seattle, Washington facilities, and may supplement this effort by selected co-packing arrangements that compliment its existing product lines |
| o Reduce operating costs as a percentage of sales through continual evaluation of administrative and production staffing and procedures |
| The Company will consider additional capital improvements at its manufacturing facilities in order to increase production efficiencies and capacities, and to reduce the Companyapstas cost of goods on a per unit basis |
| The Company continues to rationalize its production capabilities and may consolidate facilities as management deems necessary |
| o Create brand awareness by communicating to the consumer that Monterey Gourmet Foods and its sister brands provide a healthy and nutritious line of products, and therefore, promote repeat business by reinforcing positive experiences with the Companyapstas products |
| 4 o Utilize the current national sales force of the Company to expand distribution and sales of the newly acquired brands without adding additional sales overhead |
| o Consider the acquisition of other compatible companies or product lines to expand distribution, or the range of product offerings, or to accomplish other synergies where the acquisition is expected to create long-term stockholder value, and be accretive to earnings in the first year |
| The Company will continue to direct its advertising and promotional activities to specific programs customized to suit its grocery and club store accounts as well as to reach target consumers |
| These will include in-store demonstrations, coupon programs, temporary price reduction promotions, cross promoting of products, and other related activities |
| There can be no assurance that the Company will be able to increase its net revenues from grocery and club stores |
| Because the Company will continue to make expenditures associated with the expansion of its business, the Companyapstas results of operations may be affected |
| The success of the Companyapstas acquisition strategy is dependent upon its ability to generate cash from current operations, attract new capital, find suitable acquisition candidates, and successfully integrate new businesses and operations |
| There is no assurance that acquisitions can be financed from current cash flow, and, if not, that outside sources of capital will be available to supplement internally-generated funds |
| There is no assurance that management can successfully select suitable acquisition candidates and that these new businesses can be successfully integrated to create long term stockholder value |
| Products The Company produces and markets a variety of gourmet refrigerated pastas; including borsellini, ravioli, tortelloni, tortellini; pasta sauces; salsas; dips; hummus; Sonoma Jack(TM) cheeses, chicken sausages, soups, and polenta under the Monterey Gourmet Foods, Monterey Pasta, Arthurapstas, CIBO Naturals, La Frescala, Emerald Valley Kitchen, Sonoma Cheese, and Casual Gourmet brands, as well as private labels |
| The Emerald Valley Kitchen brand was acquired as part of the Emerald Valley acquisition in August 2002 |
| The CIBO Naturals brand was acquired as part of the CIBO Naturals LLC acquisition in 2004 |
| The Sonoma Cheese brand was acquired as part of the Sonoma Foods acquisition in 2005 |
| The Casual Gourmet brand was acquired as part of the Casual Gourmet Foods acquisition in 2005 |
| The Company is committed to diversifying its offerings with innovative new product line extensions, complementary products, and other gourmet food products |
| The Companyapstas product development chefs and product development consultants focus on creating new products that innovatively blend complementary tastes, food textures and ingredients while strictly adhering to the Companyapstas emphasis on freshness, healthfulness and quality |
| As new products are introduced, selected items will be discontinued to help ensure that the product line is focused on consumer demand, to maximize the Companyapstas return on its shelf space in grocery and club stores, and to respond to changing trends and consumer preferences |
| The Companyapstas refrigerated products are packaged predominantly in clear lightweight containers, which reveal the fresh appearance of its products |
| Monterey Gourmet Foods presents its products with a colorful logo, distinctive graphics, ingredient information and cooking instructions to communicate the gourmet, fresh and healthful qualities of its products |
| All of the Companyapstas products feature innovative packaging graphics to maximize shelf impact and generate increased consumer interest in the products, with increased emphasis on quickly informing the consumer about the products |
| The Company will continue to emphasize innovative packaging techniques to maximize appeal on the shelf as an important sales tool |
| The goal of the Company is to introduce new products on a timely and regular basis to increase customer interest and to respond to changing consumer tastes |
| There can be no assurance that the Companyapstas efforts to achieve such goals will result in successful new products or product lines or that new products can be developed and introduced on a timely and regular basis |
| If the Companyapstas new products are not successful, the Companyapstas grocery and club store sales may be adversely affected as customers seek new products |
| Production The Company currently produces pasta, pasta sauce and wrapped sandwiches in a 43cmam700 square foot Monterey County, California facility |
| The Company also leases 89cmam200 square feet of space three miles from the main production facility |
| Within this 89cmam200 square foot facility, the Company has its refrigerated distribution center, a prepared foods manufacturing line and ambient storage |
| In addition, the Company produces organic salsas, dips, and hummus at its 19cmam000 square foot organically certified facility in Eugene, Oregon, which was integrated into the business as part of the Emerald Valley acquisition |
| CIBO Naturals LLC which operates out of a 27cmam000 square foot facility in Seattle, WA was acquired in 2004 |
| The California facilities are strategically located in one of the largest produce-growing regions in the United States and are near several major vendors and food distributors |
| Both 5 California facilities are certified by the USDA and utilize state of the art thermal processing, chilling and packaging processes |
| The Company employs a total of approximately 297 persons at all locations, including 44 administrative personnel, 17 sales personnel, 3 drivers, and 233 distribution and production personnel |
| For additional information, see "e Employees "e on page 8 |
| Refrigerated pasta is manufactured at the California facilities using high quality ingredients such as Extra Fancy Durham Wheat Flour, whole eggs, fresh and dry herbs and Individually Quick Frozen ( "e IQF "e ) vegetables and spices, chicken and other proteins, various fresh cheeses, and milk products |
| The ingredients are mixed in accordance with the Companyapstas proprietary recipes |
| After filling with fresh and unusual ingredients such as snow crab, spinach, feta cheese, lobster, chicken, and other types of specialty cheeses, the pasta products receive a prescribed thermal process, or pasteurization to insure product safety and to preserve flavor, quality and shelf life |
| The products are then chilled immediately and packaged in controlled atmosphere trays |
| Pasta sauces, salsas, dips, spreadable cheeses are mixed and processed in individual batches in accordance with the Companyapstas proprietary processes and recipes and then directly packed and sealed in plastic containers |
| The new "e quick preparation "e baked entrees are baked in new rotary tray ovens |
| After preparation, processing, chilling and packaging, all pasta, baked entrees, and sauces are kept in cold storage to preserve quality and shelf life |
| The new grilled wrapped sandwiches and burritos are produced with proprietary recipes, hand rolled in a special tortilla, grilled and quickly packaged to preserve flavor, quality and shelf life |
| Cheeses and sausages are produced and packaged by outside companies under agreements to protect recipes and provide the quality that the Company requires |
| The Company regularly reviews a variety of potential capital projects for the production department and in the past three years has spent approximately dlra4dtta7 million on capital improvements |
| These included significant upgrades and improvements to the pasta production lines, two packaging lines, capacity for chunky ravioli, clean rooms, increased sauce capacity and efficiency, and boiler and utility upgrades to accommodate capacity increases |
| Capital resources were used to improve sauce labeling, borsellini pasta production capability, and upgrade the ingredients blending area |
| The new production facility, established during 2003, added approximately 30 percent of additional pasta manufacturing capacity at a cost, including leasehold improvements, of approximately dlra2dtta1 million |
| Also in 2003, the Company added the ability to produce items in the rapidly growing prepared foods category, and corresponding plant improvement to accommodate these new products |
| Also added was automated filling equipment that reduced operating costs |
| 8 million was spent on capital spending |
| 25 million was spent at the newly acquired CIBO facility to upgrade its filling and packaging equipment |
| Projects completed in 2004 consisted of improved packaging equipment for the new "e quick preparation "e baked line to improve product quality and consistency, product pouching equipment which allows the company to sell its products in a pouch and other smaller projects to ensure product safety |
| In 2005, the Company completed projects which upgraded its wrap line, upgraded the cooking and ventilation equipment at its Emerald Valley Organics facility, added capacity to produce tamales, and added refrigeration storage and additional packaging equipment at the CIBO Naturals facility |
| Future additions of assets will be evaluated for increased efficiency, flexibility and capacity needs |
| Raw Materials The Company purchases its raw materials from vendors throughout the United States and the world, although the majority of its raw materials come from domestic sources, and the many of the domestic ingredients come from California |
| Vendor selection is based on ability to meet specifications and pricing, in that order |
| Because the ingredients are agricultural products, the Company uses a combination of contracts which are one year or less in duration, as well as open market purchases to minimize the pricing risks and uncertainty of supply |
| The Company does have one long-term contract with its liquid nitrogen provider which expires November 30, 2007 |
| The most significant ingredients used are dairy-based ingredients, eggs, flour, cooked seafood, cooked chicken and other meats, spinach, basil, tomatoes, and spices |
| Management is unaware of any current restrictions or other factors that would have a material adverse effect on the availability of these raw materials |
| The Companyapstas purchasing policies are designed to provide more than one credible source for all ingredients |
| In 2004, the Company experienced higher than normal raw material costs in protein and dairy based ingredients and some ingredients have continued at historically high prices into 2005 |
| Distribution The Companyapstas success depends upon an effective system of distribution for its products |
| The Company delivers products directly to warehouses for several Northern California chains |
| Sonoma Cheese delivers certain cheese products to local wineries on Company trucks |
| The Company distributes its products to other customers and other parts of the country, which is over 90prca of its business using common carriers |
| The dependence on other companies for delivery of its products poses a risk to the Company |
| While the common carrier method of delivery has been reliable and available at acceptable rates thus far, there can be no assurance that the Company will continue to be able to negotiate acceptable freight rates in the future and that delivery will not be disrupted for reasons including, but not limited to, adverse weather, natural disasters or labor disputes in the trucking industry |
| During 2004 and 2005, fuel costs increased compared to previous years, which impacted the Companyapstas operating margin in 2004 and 2005 |
| 6 Grocery Chain and Club Store Sales Monterey Gourmet Foods sells its products to supermarket chains and club stores with the approximate number of stores at each year-end listed below: Years Ended ----------------------------------- 2003 2004 2005 ----------------------------------- Retail grocery stores 7cmam940 8cmam500 9cmam100 Club stores 1cmam060 1cmam100 1cmam100 ----------------------------------- Total 9cmam000 9cmam600 10cmam200 =================================== The Company has two customers that represent more than ten percent of net revenues |
| Combined these two customers represent over 60prca of the Companyapstas revenues for the past three years |
| Net revenues are detailed as follows: Years Ended ----------------------------------- 2003 2004 2005 ----------------------------------- Costco 34prca 36prca 45prca Samapstas Club Stores 32prca 24prca 17prca All other customers 34prca 40prca 38prca ---------------------------------- Total 100prca 100prca 100prca ================================== The increase in the percent of sales to Costco comes from additional sales to Costco from the recently acquired companies and the increase in the number of items being sold to Costco |
| The Company currently sells its products to eight separate US Costco regions, Mexico, and Canada which make purchasing decisions independently of one another |
| These regions re-evaluate, on a regular basis, the products carried in their stores |
| During 2003, Costco made a decision to reduce the number of items that it offers to its members, which caused a reduction in the number of items that the Company sold to Costco during 2003 and 2004 |
| Sales to Costco stabilized and actually increased in 2005 |
| There can be no assurance that these Costco regions will continue to offer Monterey Gourmet Foods products in the future or continue to allocate Monterey Gourmet the same amount of shelf space |
| The Company currently supplies its products to Samapstas Club stores where the purchasing decisions are made at the company headquarters with input from the store level |
| During the 4th quarter of 2004 Samapstas Club implemented an item reduction program which reduced the number of items that the Company sells to Samapstas Club and correspondingly has reduced the amount of shelf space for the Companyapstas products |
| During 2005, the Company spent significant resources increasing sales to Samapstas Club |
| While the Company is in the eighth year of its relationship with Samapstas Club, there can be no assurance that Samapstas Club stores will continue to carry its products |
| On February 2, 2004 the Company announced that approximately 1cmam100 Wal-Mart Supercenters discontinued its private label pasta and sauce program which the Company had been making since 2002 |
| Wal-Mart Supercenterapstas private label business represented dlra3cmam490cmam000, dlra147cmam000, and dlra0 of Net Sales in 2003, 2004 and 2005, respectively |
| The loss of either Costco or Samapstas Club as customers could materially and adversely affect the Companyapstas business operations |
| During 2003, 2004 and 2005 net revenues to foreign customers represented 3dtta4prca, 3dtta4prca and 2dtta2prca of total net revenues, with Canada and Mexico accounting for over 90prca of those sales, and the remainder going to Asia Pacific |
| 7 Marketing The Companyapstas marketing strategy is to create and sell innovative premium quality products in the categories in which it competes and to communicate to consumers that Monterey Gourmet Foods provides a gourmet quality nutritious line of products and to promote repeat business by reinforcing positive experiences with the Companyapstas products |
| The Companyapstas approach includes the introduction of new products on a timely basis to increase customer interest and to respond to changing consumer tastes |
| Additionally, the Company will continue to expand its sales into those geographic regions that will best support the purchase of the Companyapstas upscale premium grade products |
| Competition The Companyapstas business is subject to significant competition |
| The refrigerated food industry is highly competitive and is dominated by large multinational companies including among others Nestle and Kraft |
| There are also a number of regional competitors |
| Multinational competitors have significantly more brand name recognition, marketing personnel, and cash resources than the Company |
| Moreover, competition for shelf space in club and grocery stores is intense and poses great difficulty for smaller food companies |
| The Company has developed several products for which there is limited competition currently in the refrigerated sector including whole wheat pasta, wrapped sandwiches, burritos, tamales, spreadable cheeses, flavored jack cheese, gourmet sausages and quick preparation gourmet entrees |
| Management will continue to try to produce distinctive products, which fill specific niches where there is little or no national competition |
| Competitive factors in the refrigerated food market include brand awareness, product quality and taste, perceived healthfulness, price and availability of grocery and club store shelf space |
| The Companyapstas prices are slightly higher than most of its competitors &apos prices on most items due to higher quality ingredients and the overall premium quality of its product line |
| The Company believes the excellent quality, taste and perceived healthfulness of its products are superior to that of most of its competitors |
| The Company also believes that the quality of its products and the variety of its product lines provide a competitive advantage over many companies which market more traditional products |
| Management Information relating to directors and executive officers of the Company is set forth in Part III of this report |
| Government Regulation The Company is subject to the regulations of the US Food and Drug Administration ( "e FDA "e ), USDA, state, local, and organic industry regulations relating to cleanliness, maintenance of food production equipment, food storage, cooking and cooling temperatures, food handling, and organic ingredient content of products, and is subject to unannounced on-site inspections of production facilities |
| Regulations in new markets, new regulations in existing markets, and future changes in existing regulations may adversely impact the Company by raising the cost of production and delivery of its products and/or by affecting the perceived healthfulness of the Companyapstas products |
| Effective January 2006, all food products were required to declare the content of "e trans fatty acids "e on individual labels |
| The Company has complied with this requirement and has declared that its products contain no trans fatty acids |
| A failure to comply with one or more regulatory requirements could result in a variety of sanctions, including fines and the withdrawal of the Companyapstas products from store shelves |
| The Company is not aware of any currently existing facts or circumstances that it is not addressing which would cause it to fail to comply with any of the regulations to which it is currently subject |
| Employees As of December 31, 2005, the Company employed a total of 297 persons at all locations, including 44 administrative personnel, 17 sales personnel, 3 drivers, and 233 distribution and production personnel |
| None of the Companyapstas employees are represented by a labor union and the Company believes its relations with its employees are good |
| Trademarks and Service Marks The Company or its subsidiaries has registered the "e Monterey Pasta Company "e , "e CIBO Naturals "e , "e Sonoma "e , "e Sonoma Jack "e , "e Casual Gourmet "e , "e Borsellini "e , and "e Homestyle Fresh Soups "e names and, in the case of Monterey Pasta Company, corresponding logo design with the United States Patent and Trademark Office |
| The Company is currently in the process of registering "e Maria Sabellas "e , One Step gourmet "e and "e Chefapstas Finest "e |
| There can be no assurance that competitors will not adopt similar names or logo designs outside the protection of the Companyapstas trademark registration |
| In March of 1999, the Company acquired the right to use the "e Arthurapstas "e label with its acquisition of the Frescala Foods, Inc |
| In December 2000, it acquired the right to use the "e Nateapstas "e label through its acquisition of the Nateapstas polenta business Also the Company acquired the rights to two unregistered trademarks, "e La Frescala "e , and "e Emerald Valley Organics "e , as part of acquisitions of businesses |
| 8 ITEM 1A RISK FACTORS Any of the following factors could materially adversely affect the Companyapstas future operating results |
| Certain characteristics and dynamics of the Companyapstas business and of financial markets generally create risks to the Companyapstas long-term success and to predictable quarterly results |
| Other factors are included in "e Managementapstas Discussion and Analysis of Financial Condition and Results of Operations |
| These risks include: o Effect on Profitability |
| The Company reported a loss for the years 2004 and 2005 and at December 31, 2005, the Company had an accumulated deficit of dlra6cmam438cmam000 |
| There can be no assurance that the Company will generate profits in the short or long term |
| o Liquidity; Access to Capital |
| Management believes that its current cash balances, operations, and newly negotiated bank lines of credit will provide adequate liquidity to meet the Companyapstas planned capital and operating requirements for normal operations and capital expenditures through the 2006 calendar year |
| See Note 7 to the consolidated financial statements (Item 15) for a description of the credit facility |
| The Company is required to pay dlra2dtta5 million in principal on its outstanding loans in 2006 which is greater than the cash generated from operations in 2005 |
| If the Companyapstas operations do not provide cash sufficient to fund its operations and make required debt payments; the Company may be required to seek outside financing and there can be no assurance that the Company will be able to obtain such financing when needed, on acceptable terms, or at all |
| In addition, any future equity financing or convertible debt financing could cause the Companyapstas stockholders to incur dilution in net tangible book value per share of the Companyapstas Common Stock |
| o Acquisitions; Potential Goodwill Impairment |
| The Company has acquired four companies since 2003, and is in the process of integrating these acquisitions onto one financial platform |
| Certain other synergies have been identified such as selling and distribution opportunities which should increase sales and reduce costs |
| There are no guarantees that any of these synergies will be properly completed or improve the profitability of the Company |
| In addition, the Company has recorded net intangible assets of dlra11dtta1 million and goodwill of dlra12dtta0 million as part of the acquisitions |
| If these assets become impaired, the assets will be expensed in the periods they become impaired which will impact profitability |
| In the fourth quarter 2005, Casual Gourmet saw a significant reduction in its sales to its two largest customers |
| If revenues to these two customers do not return to historical levels, the Company may need to make a charge against earnings in order to record the impairment of the goodwill and or intangible assets that have previously been recorded |
| o Hiring and Retention of Key Personnel |
| The success of the Company depends on its ability to retain key executives, and to motivate and retain other key employees and officers |
| CEO James Williams joined the Company in October 2002 and CFO Scott Wheeler joined the Company in April 2003 |
| The Company currently has a key man insurance policy with a face amount of dlra500cmam000 for Mr |
| Part of the Companyapstas acquisition strategy is to maintain the current management of each acquired company and motivate them appropriately to help garner synergies and grow their respective companies |
| The management of CIBO, Casual Gourmet, and Sonoma Foods have employment contracts to help insure the growth of these acquisitions |
| There can be no assurance that key management will remain stable; significant management turnover could disrupt the Companyapstas operations with consequent adverse effect on the business |
| o Material Weakness in Internal Controls: The Companyapstas management has evaluated the effectiveness of the Companyapstas disclosure controls and procedures pursuant to Rule 13a-15(b) of the Exchange Act as of December 31, 2005 |
| Based on that evaluation, the Company has concluded that, because of a material weakness in internal control, the Companyapstas disclosure controls and procedures were not fully effective as of December 31, 2005 |
| If this weakness cannot be rectified, financial statement accuracy may be at risk |
| See Item 9A, which is incorporated here by reference |
| o Impact of Inflation |
| The increased cost of dairy ingredients had a material inflationary impact on the Companyapstas operations during 2005 |
| Freight rate increases related to fuel surcharges have impacted the Companyapstas financial performance as it ships and sources raw ingredients from across the country |
| Medical benefits continued to increase at rates higher than the consumer price index |
| Energy costs such as electricity and natural gas have increased significantly and the Company is projecting additional increases over the next several months |
| Increases in labor, employee benefits, freight, ingredients and packaging, rents and other operating expenses have adversely affected the Companyapstas profitability and may continue to impact the Company in future periods |
| The Company cannot predict whether such increases will occur in the future or their magnitude if they do occur |
| Also, the Company cannot predict if it can pass these higher costs along to its customers |
| o Risks Inherent in Food Production |
| The Company faces all of the risks inherent in the production and distribution of refrigerated food products, including contamination, adulteration, spoilage, and the associated risks of product liability litigation, which may occur even with an isolated event |
| Although the Company has modern production facilities, and has 9 obtained USDA approval for them, and employs what it believes are the necessary processes and equipment in order to insure food safety, there can be no assurance that the Companyapstas procedures will be adequate to prevent the occurrence of such events |
| o Dependence on Major Customers |
| During 2005, two of the Companyapstas customers, Costco and Wal-Mart (including its subsidiary, Samapstas Club), accounted for 45prca and 17prca, respectively, of the Companyapstas total revenues |
| The Company currently sells its products to eight separate US Costco regions and its international regions which currently make purchasing decisions independently of one another |
| These regions re-evaluate, on a regular basis, the products carried in their stores |
| There can be no assurance that these Costco regions will continue to offer the Companyapstas products in the future or continue to allocate Monterey Pasta the same amount of shelf space |
| There can be no assurance that Samapstas Club will continue to carry the Companyapstas products |
| Loss of either of these customers, Costco or Samapstas Club, or a significant reduction in sales to either, would have a material adverse effect on the Company |
| Additionally, liberalized pricing or allowance terms would create downward pressure on gross margins |
| o Diversification of Product Line |
| Over the last three years, the Company has acquired four new subsidiaries |
| A major reason for the acquisitions is the diversification of the Companyapstas gourmet food product line |
| Each acquisition brings new product lines, management talents and skills, and customers |
| There can be assurances that the acquisition strategy will be profitable in the near or long term |
| o Changing Consumer Preferences |
| Consumer preferences change, sometimes quickly, and the success of the Companyapstas food products depends on the Companyapstas ability to identify the tastes and dietary habits of consumers and offer products that appeal to their preferences |
| The Company introduces new products and improved products, and incurs development and marketing costs associated with new products |
| If the Companyapstas products fail to meet consumer preferences, then the Companyapstas strategy to grow sales and profits with new products will be less successful |
| Recent attention to low carbohydrate diets by certain segments of the US population has affected the consumption of pasta, and pasta sales have decline as a percentage of grocery sales in the US As American consumers seek new ways to reduce their intake of carbohydrates, Monterey Gourmet Foods has developed products to address these changing preferences |
| Towards the end of 2004, the low-carbohydrate diet trend decreased and the trend has been towards whole grains and less refined products |
| The Company has spent resources to develop whole wheat pasta products that meet this new trend |
| However, there can be no assurance that these new products will meet the changing demands of the consumer |
| o Seasonality and Quarterly Results |
| The Companyapstas grocery and club store accounts are expected to experience seasonal fluctuations to some extent with the corresponding impact upon quarterly results |
| The Companyapstas business is dominated by several very large competitors, who have significantly greater resources than the Company; such competitors can outspend the Company and negatively affect the Companyapstas market share and results of operations |
| o Dependence on Common Carriers |
| The Company also is dependent on common carriers to distribute its products |
| Any disruption in its distribution system or increase in the costs thereof could have a material adverse impact on the Companyapstas business |
| o California Energy Supply and Pricing |
| Because the majority of the Companyapstas operations are in California, its operating costs are affected by regional increases in electricity and natural gas prices |
| As a result, the Companyapstas operating results have been affected by the increased cost of energy and in addition, natural disasters, such as hurricane Katrina, can impact the availability and pricing of energy |
| The two plants in Salinas, California are currently operating below planned capacity, which increases costs of producing products in these plants |
| If sales of products produced at these plants do not increase or additional costs cannot be reduced, these products will remain unprofitable which will impact future earnings of the Company |
| In response to this lower than required sales volume out of these plants the Company announced a plan to close the smaller of these two operating plants |
| The Company will incur costs to close the plant and move equipment to other locations |
| o Volatility of Stock Price |
| The market price of the Companyapstas common stock has fluctuated substantially since the initial public offering of the Companyapstas common stock in December 1993 |
| Such volatility may, in part, be attributable to the Companyapstas operating results or to changes in the direction of the Companyapstas expansion efforts |
| In addition, changes in general conditions in the economy, the financial markets or the food industry, natural disasters or other developments affecting the Company or its competitors could cause the market price of the Companyapstas common stock to fluctuate substantially |
| In addition, in recent years, the stock market has experienced extreme price and volume fluctuations |
| This volatility has had a significant effect on the market prices of securities issued by many companies, including the Company, for reasons sometimes unrelated to the operating performance of these companies |
| Moreover, any announced shortfall in the Companyapstas net sales or earnings from levels expected by securities analysts or the market could have an immediate and significant adverse effect on the trading price of the Companyapstas common stock in any given 10 period |
| Additionally, the Company may not learn of such shortfalls until late in the fiscal quarter, shortly before operating results are due to be announced |
| The announcement, together or in succession, of such a shortfall and of lower than expected quarterly operating results, could result in an even more immediate and significant adverse impact on the trading price of the Companyapstas common stock upon announcement of the shortfall or quarterly operating results |
| o Marketing and Sales Risks |
| The future success of the Company will depend on a number of factors, including whether grocery and club store chains will continue to expand the number of their individual stores offering the Companyapstas products and whether allowances and other incentives will expand retail distribution |
| Expansion into new markets increases the risk of significant product returns resulting from the Companyapstas supply of slower selling items to its customers |
| In addition, grocery and club store chains continually re-evaluate the products carried in their stores and no assurances can be given that the chains currently offering the Companyapstas products will continue to do so in the future, either in the same measure or at all |
| Should these channels choose to reduce or eliminate products, the Company could experience a significant reduction in its product sales |
| The Company remains dependent on the use of slotting allowances and other incentives to expand retail distribution |
| o Compliance with laws applicable to its business |
| The companyapstas facilities and products are subject to many laws and regulations administered by the United States Department of Agriculture, the Federal Food and Drug Administration, and other federal, state, local, and foreign governmental agencies relating to the processing, packaging, storage, distribution, advertising, labeling, quality, and safety of food products |
| The companyapstas failure to comply with applicable laws and regulations could subject it to administrative penalties and injunctive relief, civil remedies, including fines, injunctions and recalls of its products, and negative publicity |
| o Sarbanes Oxley Act: The Company is also subject to the rules and regulations of the Securities and Exchange Commission and recently passed laws regarding publicly traded companies including the Sarbanes Oxley Act of 2002 |
| The Company is not an accelerated filer and therefore is not required to comply with certain sections of this Act |
| However, the Company has spent some resources complying with Section 404 of this Act and the Company believes that it will need to spend additional significant resources to become compliant with this Act |
| The Companyapstas California and Oregon locations entered into a partially self-insured workerapstas compensation program for fiscal year 2003 and have continued the program into 2005 |
| This program features a fixed annual payment, with a deductible on a per occurrence basis |
| The annual expense consists of a base fee paid to an insurance company to administer the program, direct cash expenses to pay for injuries, an estimate for potential injuries that may have occurred but have not been reported, an estimate by the insurance company of costs to close out each injury, and an estimate for injury development |
| The Company has been on this partially self-insured program for three years and therefore has limited history of claim resolution available to support the Companyapstas specific actuarial projections |
| Therefore the Company is using published industry actuarial data from an insurance carrier and reviewing each claim individually to determine the amount of reserves that should be established |
| Management believes that its current safety program and its safety record will provide the foundation to enable the Company to realize the premium savings partially self-insured programs are designed to achieve; however, estimated reserves may vary from future cash outlays |