10-Q 1 a10-q.txt FORM 10-Q UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q /X/ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 2000 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: 0-15638 MICHAEL FOODS, INC. -------------------------------------------------------------------------------- (Exact name of registrant as specified in its charter) Minnesota 41-0498850 -------------------------------------------------------------------------------- (State or other jurisdiction of (I.R.S. Employer Identification No.) incorporation or organization) Suite 324, Park National Bank Building 5353 Wayzata Boulevard Minneapolis, MN, 55416 -------------------------------------------------------------------------------- (Address of principal executive offices) (Zip code) (952) 546-1500 -------------------------------------------------------------------------------- (Registrant's telephone number, including area code) 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 period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. [ X ]Yes [ ]No The number of shares outstanding of the registrant's Common Stock, $.01 par value, as of August 4, 2000 was 18,280,457 shares. 1 PART I - FINANCIAL INFORMATION MICHAEL FOODS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS (Unaudited)

See accompanying notes to condensed consolidated financial statements. 2 MICHAEL FOODS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF EARNINGS Three Months Ended June 30, (Unaudited)

See accompanying notes to condensed consolidated financial statements. 3 MICHAEL FOODS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF EARNINGS Six Months Ended June 30, (Unaudited)

See accompanying notes to condensed consolidated financial statements. 4 MICHAEL FOODS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS Six Months Ended June 30, (Unaudited)

See accompanying notes to condensed consolidated financial statements. 5 MICHAEL FOODS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) NOTE A - BASIS OF PRESENTATION The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with Regulation S-X pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to such rules and regulations, although management believes that the disclosures are adequate to make the information presented not misleading. Michael Foods, Inc. (the "Company") utilizes a fiscal year consisting of either 52 or 53 weeks, ending on the Saturday nearest to December 31 each year. The quarters ended June 30, 2000 and 1999 each included thirteen weeks of operations. For clarity of presentation, the Company has described both periods presented as if the quarters ended on June 30. In the opinion of management, the unaudited condensed consolidated financial statements contain all adjustments (consisting of only normal recurring adjustments) necessary to present fairly the financial position as of June 30, 2000 and the results of operations for the three and six month periods ended June 30, 2000 and 1999 and cash flows for the six months ended June 30, 2000 and 1999. The results of operations for the six months ended June 30, 2000 are not necessarily indicative of the results for the full year. The Company's basic net earnings per share is computed by dividing net earnings by the weighted average number of outstanding common shares. The Company's diluted net earnings per share is computed by dividing net earnings by the weighted average number of outstanding common shares and common share equivalents relating to stock options, when dilutive. Options to purchase 823,182 and 828,626 shares of Common Stock, with a weighted average exercise price of $24.70, which were outstanding during the three and six month periods ended June 30, 2000, were excluded from the computation of common share equivalents for those periods because they were anti-dilutive. Options to purchase 852,767 and 826,724 shares of common stock, with a weighted average exercise price of $24.78, were outstanding during the three and six month periods ended June 30, 1999, but were excluded from the computation of common share equivalents for those periods because they were anti-dilutive. NOTE B - INVENTORIES Inventories, other than flocks, are stated at the lower of cost (determined on a first-in, first-out basis) or market. Flock inventory represents the cost of purchasing and raising flocks to laying maturity, at which time their cost is amortized to operations over their expected useful life of generally one to two years, assuming no salvage value. Inventories consist of the following:

6 MICHAEL FOODS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) NOTE C - COMMITMENTS AND CONTINGENCIES USE OF ESTIMATES Preparation of the Company's consolidated financial statements requires management to make estimates and assumptions that affect reported amounts of assets and liabilities and related revenues and expenses. Actual results could differ from the estimates used by management. LICENSE AGREEMENT The Company has an exclusive license agreement for a patented process for the production and sale of extended shelf-life egg products. Under the license agreement, the Company has the right to defend and prosecute infringement of the licensed patents. The U.S. Federal Court of Appeals has upheld the validity of the four patents subject to the license agreement. However, subsequently a patent examiner at the U.S. Patent and Trademark Office ("PTO") rejected the patents. In August 1999, the examiner's rejections were largely overturned by the Board of Appeals and Interferences of the PTO. Counsel advises that reexamination certificates have now been issued confirming the validity of three of the four patents. It is expected that the fourth patent will be reissued in the near future. These patents are scheduled to expire in 2006. In the second quarter of 2000 the Company and the patent holder completed a new royalty arrangement whereby the Company pays a reduced amount of royalties and, in turn, is responsible for one-half of any litigation expense incurred to defend the patents. LITIGATION The Company is engaged in routine litigation incidental to its business. Management believes it will not have a material effect upon its consolidated financial position, liquidity or results of operations. NOTE D - SHAREHOLDERS' EQUITY During the second quarters of 2000 and 1999 the Company repurchased 1,500,000 and 414,800 shares of Common Stock under a share repurchase program which began in July 1998 and which was expanded in February and May 2000. Such repurchases for the first six months of 2000 and 1999 were 2,109,400 and 920,100 shares of Common Stock. NOTE E - COMPREHENSIVE INCOME Comprehensive income consists of net earnings and foreign currency translation adjustments. Total comprehensive income was $12,243,000 and $11,746,000 for the three months ended June 30, 2000 and 1999. The total comprehensive income was $21,486,000 and $20,163,000 for the six months ended June 30, 2000 and 1999. 7 MICHAEL FOODS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) NOTE F - BUSINESS SEGMENTS The Company operates in four reportable segments - Egg Products, Refrigerated Distribution, Dairy Products and Potato Products. Certain financial information on the Company's operating segments is as follows (unaudited, in thousands):

ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS THREE MONTHS ENDED JUNE 30, 2000 VS THREE MONTHS ENDED JUNE 30, 1999 RESULTS OF OPERATIONS Readers are directed to Note F - Business Segments for data on the unaudited financial results of the Company's four business segments for the three months ended June 30, 2000 and 1999. Egg Products Division net sales for the 2000 period reflected unit sales increases, particularly for value-added products, which more than offset significant deflationary pricing impacts on industrial products. Significant unit sales increases were recorded for extended shelf-life liquid eggs and dried egg products. Egg prices increased approximately 6% compared to second quarter 1999 levels, as 8 THREE MONTHS ENDED JUNE 30, 2000 VS THREE MONTHS ENDED JUNE 30, 1999, CONT. RESULTS OF OPERATIONS, CONT. reported by Urner Barry Publications - a widely quoted industry pricing service. This increase raised the cost of purchased eggs during a period where prices for industrial egg products were generally declining. Approximately two-thirds of the Division's annual egg needs are purchased under contracts, or in the spot market. While a portion of these eggs are secured under fixed price contracts, a majority are priced according to the cost of grain inputs or to egg market prices as reported by Urner Barry. Approximately one-third of annual egg needs are sourced from internal flocks, where feed costs typically represent roughly two-thirds of the cost of producing such eggs. Feed costs were slightly higher in the 2000 period, compared to the 1999 period, due to higher prices for soybean meal. Increased egg costs, for both internally and externally procured eggs, in the 2000 period, compared to the 1999 period, were generally not met with comparable price changes in egg products prices, creating margin pressure for certain industrial egg products. Divisional operating profit in the 2000 period also reflected the benefit of reduced royalty expense, a portion of which was a retroactive adjustment to January 1, 1999. Under an agreement reached during the 2000 period, royalties related to products produced and sold by the Company under a license with North Carolina State University ("NCSU") are limited to a fixed portion of the annual production. In consideration of the reduced royalty arrangement, the Company is responsible for one-half of any future litigation expense incurred to defend the patented egg ultra-pasteurization processing technology. Refrigerated Distribution Division net sales for the 2000 period reflected strong unit sales increases, with cheese and butter showing particular strength. Sales growth resulted from a brand repositioning over the past two years and a broadening consumer advertising campaign in selected markets, along with notable new account activity and new product introductions. The volume growth, along with more normal product costs for items related to the national butterfat market, resulted in margin expansion in the 2000 period. The Dairy Products Division net sales decline for the 2000 period reflected lower unit sales volumes for the core dairy mix business, in part due to the loss of a major industrial (tanker) customer in late 1999, which offset increased volumes for cartoned specialty products and creamer products. Divisional operating profit declined in the 2000 period as a result of the reduced sales volumes, high overhead expenses and above average operating expenses. Potato Products Division net sales for the 2000 period reflected a strong unit sales increase, particularly for retail grocery items. New account activity, same-account sales growth and new product introductions all contributed to the sales gain. The operating profit increase in the 2000 period resulted from the volume growth, an improved sales mix, and efficient plant operations at the main potato processing facility. The decrease in gross profit margin of the Company for the period ended June 30, 2000, as compared to the results of the same period in 1999, reflected the factors discussed above, particularly the Dairy Products weakness and margin pressures within the industrial egg products category. It is management's strategy to increase value-added product sales as a percent of total sales over time, while decreasing commodity-sensitive products' contribution to consolidated sales. These efforts historically have been beneficial to gross profit margins in most periods. Selling, general and administrative expenses decreased as a percent of sales in the period ended June 30, 2000, as compared to the results of the same period in 1999. Favorable impacts, including the reduced egg products royalty arrangement and a related one-time retroactive benefit, more than offset 9 THREE MONTHS ENDED JUNE 30, 2000 VS THREE MONTHS ENDED JUNE 30, 1999, CONT. RESULTS OF OPERATIONS, CONT. increased expenses related to amortization of the costs associated with the Company's information systems upgrade project, increases in bad debt expense resulting from a foodservice distributor's bankruptcy filing, and additional sales and marketing efforts. SIX MONTHS ENDED JUNE 30, 2000 VS SIX MONTHS ENDED JUNE 30, 1999 RESULTS OF OPERATIONS Readers are directed to Note F - Business Segments for data on the unaudited financial results of the Company's four business segments for the six months ended June 30, 2000 and 1999. Egg Products Division net sales for the 2000 period reflected unit sales increases, particularly for value-added products, which more than offset significant deflationary pricing impacts on certain products. Sales were particularly strong for extended shelf-life liquid eggs, dried egg products and precooked frozen omelets, patties and curds. Egg prices decreased approximately 5% compared to first half 1999 levels, as reported by Urner Barry Publications. This decrease helped reduce the cost of purchased eggs, while also reducing selling prices for certain egg products and shell eggs. Approximately two-thirds of the Division's annual egg needs are purchased under contracts, or in the spot market. While a portion of these eggs are secured under fixed price contracts, a majority are priced according to the cost of grain inputs or to egg market prices as reported by Urner Barry. Approximately one-third of annual egg needs are sourced from internal flocks, where feed costs typically represent roughly two-thirds of the cost of producing such eggs. Feed costs were lower in the 2000 period, compared to the 1999 period, due to lower prices for the primary feed ingredient - corn. Decreased egg costs, for both internally and externally procured eggs, in the 2000 period, compared to the 1999 period, were more than offset by pricing weakness for certain egg products, creating margin pressure for industrial egg products. Divisional operating profit for the 2000 period also reflected the benefit of reduced royalty expense, a portion of which was a retroactive adjustment to January 1, 1999. Under an agreement reached during the 2000 period, royalties related to products produced and sold by the Company under a license with NCSU are limited to a fixed portion of the annual production. In consideration of the reduced royalty arrangement, the Company is responsible for one-half of any future litigation expense incurred to defend the patented egg ultra-pasteurization processing technology. Included in the 1999 period Egg Products results were two non-recurring items. First, a gain was recorded on the sale of a shell egg production facility. Second, a Belgium animal feed contamination scare resulted in losses at the Company's two European egg products joint ventures. The net effect of these items was a modest addition to earnings. Refrigerated Distribution Division net sales for the 2000 period reflected strong unit sales increases, with cheese and butter showing particular strength. Sales growth resulted from a brand repositioning over the past two years and a broadening consumer advertising campaign in selected markets, along with notable new account activity and new product introductions. The volume growth, along with more normal product costs for items related to the national butterfat market, resulted in margin expansion in the 2000 period. The Dairy Products Division net sales decline for the 2000 period reflected lower unit sales volumes for the core dairy mix business, in part due to the loss of a major industrial (tanker) customer in late 1999, which offset increased volumes for cartoned specialty products and creamer products. Divisional operating profit declined in the 2000 period as a result of the reduced sales volumes, high overhead expenses and above average operating expenses. 10 SIX MONTHS ENDED JUNE 30, 2000 VS SIX MONTHS ENDED JUNE 30, 1999, CONT. RESULTS OF OPERATIONS, CONT. Potato Products Division net sales for the 2000 period reflected a strong unit sales increase, particularly for mashed items and retail shredded products. New account activity, same-account sales growth and new product introductions all contributed to the sales gain. The strong operating profit increase in the 2000 period resulted primarily from the volume growth, as plant operations at the main potato processing facility benefited from the increased production throughput. The increase in gross profit margin of the Company for the period ended June 30, 2000, as compared to the results of the same period in 1999, reflected the factors discussed above, particularly the strength in the Refrigerated Distribution and Potato Products segments. It is management's strategy to increase value-added product sales as a percent of total sales over time, while decreasing commodity-sensitive products' contribution to consolidated sales. These efforts historically have been beneficial to gross profit margins in most periods. Selling, general and administrative expenses increased as a percent of sales in the period ended June 30, 2000, as compared to the results of the same period in 1999. Expenses increased due to amortization of the costs associated with the Company's information systems upgrade project, amortization of a non-compete agreement related to a May 1999 Dairy Products acquisition, increases in bad debt expense resulting from a foodservice distributor's bankruptcy filing, and additional sales and marketing efforts. However, the increased expenses were partially offset by the favorable impact of the reduced egg products royalty arrangement, including a one-time retroactive benefit. GENERAL Certain of the Company's products are sensitive to changes in commodity prices. The Company's Egg Products Division derived less than 3% of the Division's net sales for the first six months of 2000 from shell eggs, which are sensitive to commodity price swings. Value-added extended shelf-life liquid egg products lines and precooked egg products accounted for approximately 50% of the Egg Products Division's net sales. The remainder of Egg Products Division sales is derived from the sale of other egg products, which vary from being commodity-sensitive to value-added. Gross profit from shell eggs is primarily dependent upon the relationship between shell egg prices and the cost of feed, both of which can fluctuate significantly. Shell egg pricing in the 2000 period was approximately 5% below 1999 levels as measured by Urner Barry Publications. Gross profit margins for extended shelf-life liquid eggs, egg substitutes, and precooked egg products are less sensitive to commodity price fluctuations than are other egg products or shell eggs. The Company's Refrigerated Distribution Division derives approximately 70% of its net sales from refrigerated products produced by others, thereby reducing the effects of commodity price swings. The balance of refrigerated distribution sales are from shell eggs, some of which are produced by the Egg Products Division and are sold on a distribution, or non-commodity, basis by the Refrigerated Distribution Division. The Dairy Products Division sells its products primarily on a cost-plus basis and, therefore, the Division's earnings are not typically affected greatly by raw ingredient price fluctuations, except over short time periods. The Potato Products Division typically purchases 70%-90% of its raw potatoes from contract producers under annual contracts. The remainder is purchased at market prices to satisfy short-term production requirements or to take advantage of market prices when they are lower than contracted 11 CAPITAL RESOURCES AND LIQUIDITY prices. Moderate variations in the purchase price of raw materials or the selling price per pound of finished products can have a significant effect on Potato Products Division operating results. Inflation is not expected to have a significant impact on the Company's business. The Company generally has been able to offset the impact of inflation through a combination of productivity gains and price increases. Acquisitions and capital expenditures have been, and will likely continue to be, a significant capital requirement. The Company plans to continue to invest in state-of-the-art production facilities to enhance its competitive position. Historically, the Company has financed its growth principally from internally generated funds, bank borrowings, issuance of senior debt and the sale of Common Stock. The Company believes that these financing alternatives will continue to meet its anticipated needs. The Company invested $15,182,000 in capital expenditures during the six months ended June 30, 2000. The Company plans to spend approximately $55,000,000 in total capital expenditures in 2000, the majority of which is to expand production capacity for value-added products. The Company has two unsecured lines of credit for $80,000,000 and $20,000,000 with its principal banks. As of June 30, 2000, $77,600,000 was outstanding under these lines of credit. In July 1998, the Company's Board of Directors authorized the purchase of up to 2,000,000 shares of Common Stock on the open market or in privately negotiated transactions. In February 2000, the Board authorized an additional purchase of up to 2,000,000 shares of Common Stock on the open market or in privately negotiated transactions, with an additional 500,000 share authorization made in May 2000. Through June 30, 2000, the Company had repurchased 4,012,200 shares of Common Stock for $89,121,000. During the second quarter of 2000 the Company repurchased 1,500,000 shares of Common Stock. SEASONALITY Consolidated quarterly operating results are affected by the seasonality of the Company's net sales and operating profits. Specifically, shell egg prices typically rise seasonally in the first and fourth quarters of the year due to increased demand during holiday periods. Generally, refrigerated distribution operations experience higher net sales and operating profits in the fourth quarter, coinciding with incremental consumer demand during the holiday season. Net sales and operating profits from dairy operations typically are significantly higher in the second and third quarters due to increased consumption of ice milk and ice cream products during the summer months. Operating profits from potato products are less seasonal, but tend to be higher in the second half of the year coinciding with the potato harvest. FORWARD-LOOKING STATEMENTS Certain items in this Form 10-Q may be forward-looking statements, which are made in reliance upon the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements are subject to numerous risks and uncertainties, including variances in the demand for the Company's products due to consumer developments and industry developments, as well as variances in the costs to produce such products, including normal volatility in egg and feed costs. The Company's actual financial results could differ materially from the results estimated by, forecasted by, or implied by the Company in such forward-looking statements. 12 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK There were no material changes in the Company's market risk during the six month period ended June 30, 2000. PART II - OTHER INFORMATION ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS The 2000 Annual Meeting of Shareholders of Michael Foods, Inc. was held on April 27, 2000. The items voted upon and the results of the vote follow: 1. The election of ten persons to serve as directors until the next annual election and until their successors are duly elected and qualified:

2. Proposal to ratify the appointment of Grant Thornton LLP as independent auditors for 2000:

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits ~~10.78 Shareholder Agreement By and Between Michael Foods, Inc. and the Shareholders of Michael Foods, Inc. as listed, dated as of May 22, 2000 27.1 Financial Data Schedule~~

(b) Reports on Form 8-K The Company filed a Form 8-K on May 22, 2000 announcing that it had completed stock repurchases of 1.5 million shares, exhausting repurchase authorizations, and that its Board of Directors authorized the purchase of up to an additional 0.5 million shares of the Company's Common Stock in the open market or in privately negotiated transactions. 13 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. MICHAEL FOODS, INC. ---------------------------------------- (Registrant) Date: August 14, 2000 By: /s/ Gregg A. Ostrander ------------------------------ Gregg A. Ostrander (Chairman, President and Chief Executive Officer) Date: August 14, 2000 By: /s/ John D. Reedy ------------------------------ John D. Reedy (Executive Vice President, Treasurer, Chief Financial Officer and Principal Accounting Officer) 14

MICHAEL FOODS INC 10-Q