10-Q/A 1 hines_10qa1-093006.htm HINES HORTICULTURE, INC. Hines Horticulture, Inc.

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q/A

Amendment No. 1
 
(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, 2006
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
000-24439

HINES HORTICULTURE, INC.
(Exact name of registrant as specified in its charter)

Delaware
 
33-0803204
(State or other jurisdiction of
 
(I.R.S. Employer
incorporation or organization)
 
Identification Number)

12621 Jeffrey Road
Irvine, California 92620
(Address of principal executive offices) (Zip Code)

(949) 559-4444
(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.
Yes(  )   No(X )

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer (  )
 
Accelerated filer (  )
 
Non-accelerated filer (X)

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes(  )     No(X)

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

As of November 10, 2006, there were 22,072,549 shares of Common Stock, par value $0.01 per share, outstanding.



HINES HORTICULTURE, INC.
AMENDMENT NO. 1 TO FORM 10-Q

TABLE OF CONTENTS
 
Part I. Financial Information

Item 1.
Financial Statements (Unaudited)
Page No.
 
 
 
 
Condensed Consolidated Balance Sheets as of September 30, 2006 (as restated) and December 31, 2005 (as restated)
4
 
 
 
 
Condensed Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2006 (as restated) and 2005 (as restated)
5
 
 
 
 
Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2006 (as restated) and 2005 (as restated)
6
 
 
 
 
Notes to the Condensed Consolidated Financial Statements
7
 
 
 
Item 2.
Management's Discussion and Analysis of Financial Condition and Results of Operations
21
 
 
 
Item 4.
Controls and Procedures
32
 
 
 
Part II. Other Information
 
 
 
Item 1. Legal Proceedings
33
     
Item 6.
Exhibits
33
 
 
 
 
Signature
34
 
 
 
 
Index to Exhibits
35


1


Explanatory Note
(Dollars in thousands)

This amended quarterly report on Form 10-Q/A (Amendment No. 1) is being filed by us to amend our quarterly report on Form 10-Q for the quarterly period ended September 30, 2006 originally filed with the Securities and Exchange Commission on November 14, 2006.

In connection with the preparation of our consolidated financial statements for the year ended December 31, 2006, we identified errors which affected the full year and each of the fiscal quarters of 2004 and 2005, and the first, second and third fiscal quarters of 2006

This amendment on Form 10-Q/A includes changes to Item 1, Item 2 and Item 4 of Part I and Item 1 and Item 6 of Part II. Except as identified in the prior sentence, no other item included in the original Form 10-Q has been amended. Except as required to reflect the effects of the restatement described below, this Form 10-Q/A does not reflect events occurring after the filing of our original Form 10-Q or modify or update those disclosures affected by subsequent events. Information not affected by the restatement is unchanged and reflects the disclosures made at the time of the original filing of the Form 10-Q on November 14, 2006.

As a result of the foregoing, we are restating herein the following financial statements:
 
our condensed consolidated balance sheets as of September 30, 2006 and December 31, 2005;
 
our condensed consolidated statements of operations for the three months and nine months ended September 30, 2006 and 2005; and
 
our condensed consolidated statements of cash flows for the nine months ended September 30, 2006 and 2005.

Summaries of the errors and how they impact our condensed consolidated financial statements follow. A summary of the impact of the errors on the financial statements for fiscal years 2005 and 2004 is presented in our 2006 Annual Report on Form 10-K for the year ended December 31, 2006 filed on July 10, 2007.

Inventory Costs  
We determined that certain materials and supplies were incorrectly capitalized as a component of nursery stock after the related inventory was sold, thereby misstating inventory and costs of goods sold for the full year and each of the quarters of 2004 and 2005 and the first, second and third quarters of 2006. These materials and supplies should have been relieved to cost of goods sold as the related inventory was sold. The correction to reduce inventory balances resulted in lower cost of goods sold in subsequent periods as the nursery stock was sold.
 
The effects of the correction of this error on the condensed consolidated balance sheets as of September 30, 2006 and December 31, 2005 resulted in a decrease in inventory of approximately $3,300 and $4,200, respectively.

The effects of the correction of this error on the condensed consolidated statements of operations for the three and nine months ended September 30, 2006 was a decrease in cost of goods sold of $100 and $900, respectively. The effects of the correction of this error on the condensed consolidated statements of operations for the three and nine months ended September 30, 2005 was a decrease in cost of goods sold of $200 and $800, respectively.
 
Miami and Vacaville Property Sales 
We sold two properties located in Miami, Florida and Vacaville, California in November 2005 and April 2006, respectively. We did not correctly record these transactions in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 98, “Accounting for Leases,” as financing transactions. The effects of the correction of these errors on the September 30, 2006 and December 31, 2005 condensed consolidated balance sheets associated with the Miami, Florida sale was the recognition of a financing obligation of $47,040, reinstatement of the carrying value of the property of $7,160, reclassification of deferred tax assets of $15,750 from non-current to current and a decrease in deferred gain on land sale of $39,880. The effects of the correction of these errors on the September 30, 2006 condensed consolidated balance sheets associated with the Vacaville, California sale was the recognition of a financing obligation of $16,700, reinstatement of the carrying value of the property of approximately $500 and a decrease in deferred gain of $16,200. The effect of the correction of these errors did not have a material impact on our condensed consolidated statements of operations for the three and nine months ended September 30, 2006.
 

2



Lower of Cost or Market and Excessive Inventory Write Off
We determined that we should have recorded both a lower of cost or market adjustment for certain of our inventory and a write off of excess inventory in the third quarter of 2006 at our South Carolina facility. The lower of cost or market adjustment was caused by pricing pressures in the region as a result of increased competition and lost market share, which occurred in the third fiscal quarter of 2006. The lost market share also caused excess inventory at this facility. The effect of the correction of these two errors was an increase in cost of goods sold and a corresponding decrease in inventory of approximately $5,700 in the condensed consolidated financial statements as of and for the quarter ended September 30, 2006.

Fixed Asset Impairment
Due to the lost market share in the market served by our South Carolina facility, we determined that the expected undiscounted future cash flows to be generated by our South Carolina facility did not exceed the carrying value of the related fixed assets. As a result, we determined that the fixed assets located at the South Carolina facility were impaired in the third quarter of 2006. The effect of this correction resulted in an increase in total operating expenses of $1,477 and a corresponding decrease in fixed assets in the third quarter of 2006.

Workers’ Compensation and Auto Insurance Accruals
In connection with the preparation of our 2006 consolidated financial statements, we discovered an error in the calculation of our accrued workers’ compensation and auto insurance liabilities. The effect of the correction of this error on the condensed consolidated statements of operations for the three and nine months ended September 30, 2006 was a decrease in cost of goods sold of $25 and $125, respectively, a decrease in distribution expenses of $21 and $76, respectively, and an increase in loss from discontinued operations of $28 and $101, respectively.

The effect of the correction of this error on the condensed consolidated statements of operations for the three and nine months ended September 30, 2005 was a decrease in cost of goods sold of $9 and $35, respectively, a decrease in distribution expenses of $12 and $44, respectively, and an increase in loss from discontinued operations of $27 and $99, respectively.

The effect of the correction of this error on the September 30, 2006 and December 31, 2005 condensed consolidated balance sheets was a decrease in inventories of $151 and $143, respectively, and a decrease in liabilities of $648 and $337, respectively.

Asset Retirement Obligations Adjustment
In connection with the preparation of our 2006 consolidated financial statements, we discovered that we had not properly recorded our asset retirement obligations for certain of our assets located in Irvine, California upon the adoption of SFAS No. 143, "Accounting for Asset Retirement Obligations."

The effect of the correction of this error on the September 30, 2006 condensed consolidated balance sheet was a decrease to inventories of $25, a decrease in net fixed assets of $261 and an increase in liabilities of $13. The effect of the correction of this error on the December 31, 2005 condensed consolidated balance sheet was an increase in inventories of $4, an increase in net fixed assets of $60 and an increase in liabilities of $359.

The effect of the correction of this error on the three and nine months ended September 30, 2006 and 2005 condensed consolidated statements of operations was not material.
 
Tables set forth in Note 4 to the Condensed Consolidated Financial Statements summarize the impact of the adjustments described above on the condensed consolidated financial statements for the affected periods.

Unless otherwise specified, all financial information contained in this report gives effect to the restatements of our consolidated financial statements, as described in Note 4 to the Condensed Consolidated Financial Statements. We have not amended, and we do not intend to amend, our previously filed Annual Reports on Form 10-K or Quarterly Reports on Form 10-Q for each of the fiscal years and fiscal quarters of 2004 and 2005. Financial information included in our previously filed Annual Reports on Form 10-K for the fiscal years ended December 31, 2005 and 2004 and Quarterly Reports on Form 10-Q for each of the quarters of 2004 and 2005 and for the first three quarters of 2006 should not be relied upon and are superseded by the information in this Amendment No. 1 to Form 10-Q for the quarterly period ended September 30, 2006, Amendment No. 1 to Form 10-Q for the quarterly period ended March 31, 2006, Amendment No. 1 to Form 10-Q for the quarterly period ended June 30, 2006 and in the 2006 Annual Report on Form 10-K for the year ended December 31, 2006, all filed on July 10, 2007.


3


PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

HINES HORTICULTURE, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
September 30, 2006 and December 31, 2005
(Dollars in thousands, except share data)
(Unaudited, as restated - see Note 4)
 
ASSETS
 
September 30,
 
December 31,
 
 
 
2006
 
2005
 
CURRENT ASSETS:
         
Cash and cash equivalents
 
$
7,882
 
$
62
 
Accounts receivable, net
   
23,543
   
16,444
 
Inventories
   
128,586
   
159,733
 
Consigned inventories
   
1,546
   
138
 
Prepaid expenses and other current assets
   
1,496
   
2,666
 
Assets held for sale
   
55,172
   
72,391
 
Total current assets
   
218,225
   
251,434
 
 
         
FIXED ASSETS, net
   
87,409
   
82,851
 
 
         
DEFERRED FINANCING COSTS, net
   
5,131
   
6,207
 
DEFERRED INCOME TAXES
   
-
   
6,676
 
GOODWILL
   
38,818
   
43,926
 
 
 
$
349,583
 
$
391,094
 
 
         
LIABILITIES AND SHAREHOLDERS' EQUITY
         
 
         
CURRENT LIABILITIES:
         
Accounts payable
 
$
16,414
 
$
12,624
 
Accrued liabilities
   
6,610
   
8,591
 
Accrued payroll and benefits
   
6,469
   
4,453
 
Accrued interest
   
9,077
   
4,711
 
Borrowings on revolving credit facility
   
-
   
10,080
 
Deferred income taxes
   
35,242
   
56,542
 
Liabilities related to assets held for sale
   
6,747
   
8,079
 
Total current liabilities
   
80,559
   
105,080
 
 
         
LONG-TERM DEBT
   
175,000
   
175,000
 
FINANCING OBLIGATIONS
   
63,739
   
47,040
 
DEFERRED INCOME TAXES
   
4,072
   
-
 
OTHER LIABILITIES
   
5,492
   
8,260
 
               
SHAREHOLDERS' EQUITY
         
Preferred stock
         
Authorized - 2,000,000 shares, $0.01 par value; none outstanding
   
-
   
-
 
Common stock
         
Authorized - 60,000,000 shares, $0.01 par value;
         
issued and outstanding - 22,072,549 shares at September 30, 2006 and December 31, 2005
   
221
   
221
 
Additional paid-in capital
   
128,781
   
128,781
 
Accumulated deficit
   
(108,281
)
 
(73,288
)
Total shareholders' equity
   
20,721
   
55,714
 
 
 
$
349,583
 
$
391,094
 

The accompanying notes are an integral part of these condensed consolidated financial statements.
4


HINES HORTICULTURE, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
Three Months and Nine Months Ended September 30, 2006 and 2005
(Dollars in thousands, except share and per share data)
(Unaudited, as restated - see Note 4)

 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
 
 
2006
 
2005
 
2006
 
2005
 
 
 
 
 
 
 
 
 
 
 
Sales, net
 
$
37,478
 
$
37,939
 
$
208,266
 
$
222,111
 
Cost of goods sold
   
27,716
   
19,492
   
120,952
   
108,621
 
Gross profit
   
9,762
   
18,447
   
87,314
   
113,490
 
 
                 
Distribution expenses
   
8,789
   
8,680
   
46,647
   
47,291
 
Selling, general and administrative expenses
   
12,051
   
9,391
   
41,256
   
39,086
 
Other operating expenses (income)
   
406
   
(7
)
 
2,282
   
523
 
Asset impairment charges
   
1,477
   
-
   
1,477
   
-
 
Total operating expenses
   
22,723
   
18,064
   
91,662
   
86,900
 
 
                 
Operating (loss) income
   
(12,961
)
 
383
   
(4,348
)
 
26,590
 
 
                 
Other expenses (income)
                 
Interest, net
   
4,636
   
5,376
   
14,971
   
17,446
 
Interest rate swap agreement income
   
-
   
-
   
-
   
(895
)
Amortization of deferred financing costs
   
648
   
467
   
1,397
   
1,356
 
 
   
5,284
   
5,843
   
16,368
   
17,907
 
 
                 
(Loss) income from continuing operations before income taxes
   
(18,245
)
 
(5,460
)
 
(20,716
)
 
8,683
 
 
                 
Income tax (benefit) provision
   
(7,050
)
 
(1,974
)
 
(7,997
)
 
3,129
 
 
                 
(Loss) income from continuing operations
   
(11,195
)
 
(3,486
)
 
(12,719
)
 
5,554
 
 
                 
(Loss) income from discontinued operations, net of income taxes
   
(19,057
)
 
(1,845
)
 
(22,274
)
 
3,410
 
 
                 
Net (loss) income
 
$
(30,252
)
$
(5,331
)
$
(34,993
)
$
8,964
 
 
                 
 
                 
Basic and diluted (loss) earnings per share:
                 
 
                 
(Loss) income from continuing operations
 
$
(0.51
)
$
(0.16
)
$
(0.58
)
$
0.25
 
(Loss) income from discontinued operations, net of income taxes
   
(0.86
)
 
(0.08
)
 
(1.01
)
 
0.16
 
Net (loss) income per common share
 
$
(1.37
)
$
(0.24
)
$
(1.59
)
$
0.41
 
 
                 
 
                 
Weighted average shares outstanding--Basic
   
22,072,549
   
22,072,549
   
22,072,549
   
22,072,549
 
 
                 
Weighted average shares outstanding--Diluted
   
22,072,549
   
22,072,549
   
22,072,549
   
22,119,345
 

The accompanying notes are an integral part of these condensed consolidated financial statements.

5



HINES HORTICULTURE, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
Nine Months Ended September 30, 2006 and 2005
(Dollars in thousands)
(Unaudited, as restated - see Note 4)

     
2006 
   
2005 
 
CASH FLOWS FROM OPERATING ACTIVITIES
   
   
 
Net (loss) income
 
$
(34,993
)
$
8,964
 
Loss (income) from discontinued operations
   
22,274
   
(3,410
)
Adjustments to reconcile (loss) income from continuing operations to net cash provided by operating activities:
   
   
 
Depreciation
   
6,296
   
5,269
 
Accretion of asset retirement obligations
   
46
   
33
 
Amortization of deferred financing costs
   
1,397
   
1,356
 
Interest rate swap agreement income
   
-
   
(895
)
Loss (gain) on sale of assets
   
14
   
(184
)
Asset impairment charges
   
1,477
   
-
 
Deferred income taxes
   
(7,997
)
 
3,129
 
 
   
   
 
Changes in working capital accounts:
   
   
 
Accounts receivable
   
(7,099
)
 
(8,955
)
Inventories
   
23,431
   
4,688
 
Prepaid expenses and other current assets
   
1,163
   
613
 
Accounts payable and accrued liabilities
   
7,878
   
11,699
 
Net cash provided by continuing operations
   
13,887
   
22,307
 
Net cash (used in) provided by discontinued operations
   
(2,259
)
 
4,876
 
Net cash provided by operating activities
   
11,628
   
27,183
 
 
   
   
 
CASH FLOWS FROM INVESTING ACTIVITIES
   
   
 
Purchase of fixed assets
   
(7,666
)
 
(7,514
)
Proceeds from sale of fixed assets
   
3
   
107
 
Proceeds from land sale option
   
-
   
2,000
 
Net cash used in continuing operations
   
(7,663
)
 
(5,407
)
Net cash (used in) provided by discontinued operations
   
(42
)
 
344
 
Net cash used in investing activities
   
(7,705
)
 
(5,063
)
 
   
   
 
CASH FLOWS FROM FINANCING ACTIVITIES
   
   
 
Borrowings on revolving credit facility
   
164,813
 
 
230,693
 
Repayments on revolving credit facility
   
(174,893
)  
(249,300
)
Repayments of long-term debt
   
-
   
(3,815
)
Financing obligation
   
14,297
   
-
 
Deferred financing costs incurred
   
(320
)
 
(192
)
Net cash provided by (used in) financing activities
   
3,897
   
(22,614
)
 
   
   
 
NET CHANGE IN CASH
   
7,820
   
(494
)
 
   
   
 
CASH AND CASH EQUIVALENTS, beginning of period
   
62
   
600
 
 
   
   
 
CASH AND CASH EQUIVALENTS, end of period
 
$
7,882
 
$
106
 
 
   
   
 
Supplemental disclosure of cash flow information:
   
   
 
Cash paid for interest
 
$
10,465
 
$
13,301
 
Cash paid for income taxes
 
$
1,112
 
$
25
 
 
The accompanying notes are an integral part of these condensed consolidated financial statements.

6

 

HINES HORTICULTURE, INC.
NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except share and per share data)

1.     Description of Business:

Hines Horticulture, Inc. (“Hines Horticulture”), a Delaware corporation, produces and distributes horticultural products through its wholly owned subsidiaries, Hines Nurseries, Inc. (“Hines Nurseries”) and Hines Fertilizer, Inc. (“Hines Fertilizer”), formerly known as Enviro-Safe Laboratories, Inc., which no longer actively conducts business. Unless otherwise specified, references to “Hines” or the “Company” refer to Hines Horticulture, Inc. and its subsidiaries.
 
Hines is a leading national supplier of ornamental shrubs, color plants and container-grown plants and our continuing operations consist of eight commercial nursery facilities located in Arizona, California, Oregon, South Carolina and Texas. Hines markets its products to retail and commercial customers throughout the United States and Canada.
 
The Condensed Consolidated Financial Statements include the accounts of Hines Horticulture and its wholly owned subsidiaries after elimination of intercompany accounts and transactions.
 
2.     New Accounting Standards:

In November 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 151, “Inventory Costs,” which clarifies the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material. The Company adopted SFAS No. 151 on January 1, 2006. The adoption of SFAS No. 151 did not have a material impact on the Company’s consolidated financial position, results of operations or cash flows.
 
In December 2004, the FASB issued SFAS No. 153, “Exchange of Non Monetary Assets - an amendment of APB Opinion No. 29,” which requires non monetary asset exchanges to be accounted for at fair value. The Company is required to adopt the provisions of SFAS No. 153 for non monetary exchanges occurring in fiscal periods beginning after June 15, 2005. The Company adopted SFAS No. 153 on January 1, 2006. The adoption of SFAS No. 153 did not have an impact on the Company’s consolidated financial position, results of operations or cash flows.

In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections - a replacement of APB Opinion No. 20 and FASB Statement No. 3.” SFAS No. 154 changes the requirements for the accounting for and reporting of a change in an accounting principle. This statement applies to all voluntary changes in an accounting principle. It also applies to changes required by an accounting pronouncement if that the pronouncement does not include specific transition provisions. When a pronouncement includes specific transition provisions, those provisions should be followed. APB Opinion No. 20 previously required that most voluntary changes in an accounting principle be recognized by including in net income of the period of the change the cumulative effect of changing to the new accounting principle. SFAS No. 154 requires retrospective application to prior periods’ financial statements of changes in an accounting principle. The Company adopted SFAS No. 154 on January 1, 2006. The adoption of SFAS No. 154 did not have an impact on the Company’s consolidated financial position, results of operations or cash flows.

In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments - an amendment of FASB Statements No. 133 and 140.” SFAS No. 155 simplifies the accounting for certain hybrid financial instruments that contain an embedded derivative that otherwise would have required bifurcation. SFAS No. 155 also eliminates the interim guidance in SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” which provides that beneficial interest in securitized financial assets is not subject to the provisions of SFAS No. 133. SFAS No. 155 is effective for all financial instruments acquired or issued in fiscal years beginning after September 15, 2006. The Company does not believe that the adoption of SFAS No. 155 will have a material impact on its consolidated financial position, results of operations or cash flows.

Effective the beginning of the first quarter of fiscal year 2006, the Company adopted the provisions of SFAS No. 123(R), “Share Based Payment,” using the modified prospective transition method. Under this method, prior periods are not restated. The provisions of SFAS 123(R) apply to new stock options and stock options outstanding, but not yet vested, on the effective date. As of December 31, 2005, all outstanding options were fully vested.

In June 2006, the FASB issued FIN 48, “Accounting for Uncertainty in Income Taxes -an interpretation of FASB Statement No. 109.” FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with SFAS No. 109, “Accounting for Income Taxes.” FIN 48 is effective for all uncertainty in income taxes recognized in the financial statements in fiscal years beginning after December 15, 2006. The Company is evaluating the effect the adoption of FIN 48 may have a on its consolidated financial position, results of operations and cash flows.

7



In June 2006, the FASB ratified Emerging Issues Task Force Issue No. 06-3, “How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (That Is, Gross versus Net Presentation)” (“EITF 06-3”). The scope of EITF 06-3 includes any tax assessed by a governmental authority that is directly imposed on a revenue-producing transaction between a seller and a customer. This issue provides that a company may adopt a policy of presenting taxes either gross within revenue or net. If taxes subject to this issue are significant, a company is required to disclose its accounting policy for presenting taxes and the amount of such taxes that are recognized on a gross basis. The Company does not believe the adoption of EITF 06-3 will have a material impact on its consolidated financial statements.

In September 2006, the Securities and Exchange Commission (the “SEC”) issued Staff Accounting Bulletin (“SAB”) 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (“SAB 108”). SAB 108 provides guidance on the consideration of the effects of prior year misstatements in quantifying current year misstatements for the purpose of determining whether the current year’s financial statements are materially misstated. SAB 108 is effective for fiscal years ending after November 15, 2006. The Company does not expect SAB 108 to have a material impact on its consolidated financial statements.
 
In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements.” This standard defines fair value, establishes a framework for measuring fair value in accounting principles generally accepted in the United States of America, and expands disclosure about fair value measurements. This pronouncement applies to other accounting standards that require or permit fair value measurements. Accordingly, this statement does not require any new fair value measurement. This statement is effective for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The Company is currently evaluating the requirements of SFAS 157 and the impact that the adoption of this statement will have on its consolidated financial statements.
 
3.     Unaudited Financial Information:

The unaudited financial information furnished herein, in the opinion of management, reflects all adjustments (consisting of only normal recurring adjustments except for the restatement discussed in Note 4) which are necessary for a fair statement of the consolidated financial position, results of operations and cash flows of the Company as of and for the periods indicated. The Company presumes that users of the interim financial information herein have read or have access to the Company's audited consolidated financial statements on Form 10-K for the year ended December 31, 2006, which restates and amends the consolidated financial statements for the years ended December 31, 2005 and 2004, and that the adequacy of additional disclosure needed for a fair presentation may be determined in that context.
 
Accordingly, footnotes and other disclosures, which would substantially duplicate the disclosures contained in the Company’s Form 10-K for the year ended December 31, 2006, filed on July 10, 2007 by Hines under the Securities Exchange Act of 1934, as amended, have been omitted. The financial information herein is not necessarily representative of a full year's operations. The year-end condensed balance sheet was derived from audited restated financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States of America.

8

 
4.     Restatement of Financial Statements:

In connection with the preparation of the Company’s consolidated financial statements for the year ended December 31, 2006, the Company identified errors which the full year and affected each of the fiscal quarters of 2004 and 2005 and the first, second and third fiscal quarters of 2006. 

As a result of the foregoing, the Company is restating herein the following financial statements:
 
·
the Company’s condensed consolidated balance sheets as of September 30, 2006 and December 31, 2005;
 
·
the Company’s condensed consolidated statements of operations for the three and nine months ended September 30, 2006 and 2005; and
 
·
the Company’s condensed consolidated statements of cash flows for the nine months ended September 30, 2006 and 2005.

Inventory Costs  
The Company determined that certain materials and supplies were incorrectly capitalized as a component of nursery stock after the related inventory was sold, thereby misstating inventory and costs of goods sold for the full year and each of the quarters of 2004 and 2005 and the first, second and third quarters of 2006. These materials and supplies should have been relieved to cost of goods sold as the related inventory was sold. The correction to reduce inventory balances resulted in lower cost of goods sold in subsequent periods as the nursery stock was sold.
 
The effects of the correction of this error on the condensed consolidated balance sheets as of September 30, 2006 and December 31, 2005 resulted in a decrease in inventory of approximately $3,300 and $4,200, respectively.

The effects of the correction of this error on the condensed consolidated statements of operations for the three and nine months ended September 30, 2006 was a decrease in cost of goods sold of approximately $100 and $900, respectively. The effects of the correction of this error on the condensed consolidated statements of operations for the three and nine months ended September 30, 2005 was a decrease in cost of goods sold of approximately $200 and $800, respectively.
 
Miami and Vacaville Property Sales
The Company sold two properties located in Miami, Florida and Vacaville, California in November 2005 and April 2006, respectively. The Company did not correctly record these transactions in accordance with SFAS No. 98, “Accounting for Leases,” as financing transactions. The effects of the correction of these errors on the September 30, 2006 and December 31, 2005 condensed consolidated balance sheets associated with the Miami, Florida sale was the recognition of a financing obligation of $47,040, reinstatement of the carrying value of the property of $7,160, reclassification of deferred tax assets of $15,750 from non-current to current and a decrease in deferred gain on land sale of $39,880. The effects of the correction of these errors on the September 30, 2006 condensed consolidated balance sheet associated with the Vacaville, California sale was the recognition of a financing obligation of $16,700, reinstatement of the carrying value of the property of approximately $500 and a decrease in deferred gain of $16,200. The effect of the correction of these errors did not have a material impact on the condensed consolidated statements of operations for the three and nine months ended September 30, 2006.
 
Lower of Cost or Market Adjustment and Excessive Inventory Write Off
The Company determined that it should have recorded both a lower of cost or market adjustment for certain of its inventory and a write off of excess inventory in the third quarter of 2006 at its South Carolina facility. The lower of cost or market adjustment was caused by pricing pressures in the region as a result of increased competition and lost market share, which occurred in the third fiscal quarter of 2006. The lost market share also caused excess inventory at this facility. The effect of the correction of these two errors was an increase in cost of goods sold and a corresponding decrease in inventory of approximately $5,700 in the condensed consolidated financial statements as of and for the quarter ended September 30, 2006.

Fixed Asset Impairment
Due to the lost market share in the market served by the Company's South Carolina facility, the Company determined that the expected undiscounted future cash flows to be generated by the South Carolina facility did not exceed the carrying value of the related fixed assets. As a result, the Company determined that the fixed assets located at the South Carolina facility were impaired in the third quarter of 2006. The effect of this correction resulted in an increase in total operating expenses of $1,477 and a corresponding decrease in fixed assets in the third quarter of 2006.

9


Workers’ Compensation and Auto Insurance Accruals
In connection with the preparation of the 2006 consolidated financial statements, the Company discovered an error in the calculation of accrued workers’ compensation and auto insurance liabilities. The effect of the correction of this error on the condensed consolidated statements of operations for the three and nine months ended September 30, 2006 was a decrease in cost of goods sold of $25 and $125, respectively, a decrease in distribution expenses of $21 and $76, respectively, and an increase in loss from discontinued operations of $28 and $101, respectively.
 
The effect of the correction of this error on the condensed consolidated statements of operations for the three and nine months ended September 30, 2005 was a decrease in cost of goods sold of $9 and $35, respectively, a decrease in distribution expenses of $12 and $44, respectively, and an increase in loss from discontinued operations of $27 and $99, respectively.
 
The effect of the correction of this error on the September 30, 2006 and December 31, 2005 condensed consolidated balance sheets was a decrease in inventories of $151 and $143, respectively, and a decrease in liabilities of $648 and $337, respectively.
 
Asset Retirement Obligations Adjustment
In connection with the preparation of the 2006 consolidated financial statements, the Company discovered that it had not properly recorded its asset retirement obligations for certain of the assets located in Irvine, California upon the adoption of SFAS No. 143, "Accounting for Asset Retirement Obligations."

The effect of the correction of this error on the September 30, 2006 condensed consolidated balance sheet was a decrease in inventories of $25, a decrease in net fixed assets of $261 and an increase in liabilities of $13. The effect of the correction of this error on the December 31, 2005 condensed consolidated balance sheet was an increase in inventories of $4, an increase in net fixed assets of $60 and an increase in liabilities of $359.

The effect of the correction of this error on the three and nine months ended September 30, 2006 and 2005 condensed consolidated statements of operations was not material.

The tables set forth below summarize the impact of the adjustments described above on the individual line items on the Company’s consolidated financial statements for the affected periods. A reconciliation of the December 31, 2005 consolidated balance sheet can be found in the Company’s Annual Report on Form 10-K for the year ended December 31, 2006 filed on July 10, 2007.
 

10

 

 
 
Three Months Ended
 
Nine Months Ended
 
 
 
September 30, 2006
 
September 30, 2006
 
 
 
As Originally Reported
 
As Restated for Correction of Errors
 
As Originally Reported
 
As Restated for Correction of Errors
 
Statement of Operations:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Cost of goods sold
 
$
22,119
 
$
27,716
 
$
116,194
 
$
120,952
 
Gross profit
 
 
15,268
 
 
9,762
 
 
91,789
 
 
87,314
 
Distribution expenses
 
 
8,794
 
 
8,789
 
 
46,724
 
 
46,647
 
Asset impairment charges
 
 
-
 
 
1,477
 
 
-
 
 
1,477
 
Total operating expenses
 
 
21,015
 
 
22,723
 
 
89,801
 
 
91,662
 
Operating (loss) income
 
 
(5,747
)
 
(12,961
)
 
1,988
 
 
(4,348
)
Loss from continuing operations before income taxes
 
 
(11,209
)
 
(18,245
)
 
(14,558
)
 
(20,716
)
Income tax benefit
 
 
(4,504
)
 
(7,050
)
 
(5,876
)
 
(7,997
)
Loss from continuing operations
 
 
(6,705
)
 
(11,195
)
 
(8,682
)
 
(12,719
)
Loss from discontinued operations, net of income taxes
 
 
(19,870
)
 
(19,057
)
 
(23,091
)
 
(22,274
)
Net loss
 
 
(26,575
)
 
(30,252
)
 
(31,773
)
 
(34,993
)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Basic and diluted loss per share:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Loss from continuing operations
 
$
(0.30
)
$
(0.51
)
$
(0.39
)
$
(0.58
)
Loss from discontinued operations, net of income taxes
 
 
(0.90
)
 
(0.86
)
 
(1.05
)
 
(1.01
)
Net loss per common share
 
(1.20
)
$
(1.37
)
$
(1.44
)
$
(1.59
)
 
 
 
 
Nine Months Ended
 
 
 
September 30, 2006
 
 
 
As Originally Reported
 
As Restated for Correction of Errors
 
Statement of Cash Flows:
 
 
 
 
 
 
 
Net loss (a)
 
$
(31,773
)
$
(34,993
)
Loss from discontinued operations (a)
 
 
23,091
 
 
22,274
 
Depreciation
 
 
6,344
 
 
6,296
 
Accretion of asset retirement obligations
 
 
25
 
 
46
 
Fixed asset impairment
 
 
-
 
 
1,477
 
Deferred income taxes
 
 
(5,726
)
 
(7,997
)
Inventories
 
 
18,513
 
 
23,431
 
Accounts payable and accrued liabilities
 
 
8,038
 
 
7,878
 
Net cash provided by continuing operations from operating activities
 
 
14,335
 
 
13,887
 
Net cash used in discontinued operations from operating activities
 
 
(2,707
)
 
(2,259
)
 
 
 
 
 
 
 
 
Proceeds from sale of fixed assets
 
 
14,297
 
 
3
 
Net cash provided by (used in) continuing operations from investing activities
 
 
6,631
 
 
(7,663
)
Net cash used in discontinued operations from investing activities
 
 
(39
)
 
(42
)
Net cash provided by (used in) investing activities
 
 
6,592
 
 
(7,705
)
 
 
 
 
 
 
 
 
Financing obligation
 
 
-
 
 
14,297
 
Net cash (used in) provided by financing activities
 
 
(10,400
)
 
3,897
 

(a) Theses line items originally reported combined in loss from continuing operations
 
11

 
 
 
September 30, 2006
 
 
 
As Originally Reported
 
As Restated for Correction of Errors
 
Balance Sheet:
 
 
 
 
 
 
 
Inventories
 
$
143,912
 
$
128,586
 
Assets held for sale
 
 
28,005
 
 
55,172
 
Total current assets
 
 
206,384
 
 
218,225
 
Fixed assets, net
 
 
84,753
 
 
87,409
 
Deferred income taxes
 
 
13,711
 
 
-
 
Total assets
 
 
348,797
 
 
349,583
 
 
 
 
 
 
 
 
 
Accrued liabilities
 
 
10,691
 
 
6,610
 
Deferred income taxes, current portion
 
 
39,583
 
 
35,242
 
Total current liabilities
 
 
88,981
 
 
80,559
 
Deferred gain on land sale
 
 
56,109
 
 
-
 
Financing obligation
 
 
-
 
 
63,739
 
Deferred income taxes, long-term portion
 
 
-
 
 
4,072
 
Other liabilities
 
 
2,072
 
 
5,492
 
               
Accumulated deficit
 
 
(102,367
)
 
(108,281
)
Shareholders' equity
 
 
26,635
 
 
20,721
 
Total liabilities and shareholders' equity
 
 
348,797
 
 
349,583
 
 
 
 
Three Months Ended
 
Nine Months Ended
 
 
 
September 30, 2005
 
September 30, 2005
 
 
 
As Originally Reported
 
As Restated for Correction of Errors
 
As Originally Reported
 
As Restated for Correction of Errors
 
Statement of Operations:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Cost of goods sold
 
$
19,757
 
$
19,492
 
$
109,465
 
$
108,621
 
Gross profit
 
 
18,182
 
 
18,447
 
 
112,646
 
 
113,490
 
Distribution expenses
 
 
8,690
 
 
8,680
 
 
47,335
 
 
47,291
 
Total operating expenses
 
 
18,175
 
 
18,064
 
 
86,944
 
 
86,900
 
Operating income
 
 
7
 
 
383
 
 
25,702
 
 
26,590
 
(Loss) income before income taxes
 
 
(5,836
)
 
(5,460
)
 
7,795
 
 
8,683
 
Income tax (benefit) provision
 
 
(2,393
)
 
(1,974
)
 
3,196
 
 
3,129
 
(Loss) income from continuing operations
 
 
(3,443
)
 
(3,486
)
 
4,599
 
 
5,554
 
(Loss) income from discontinued operations
 
 
(1,730
)
 
(1,845
)
 
3,217
 
 
3,410
 
Net (loss) income
 
 
(5,173
)
 
(5,331
)
 
7,816
 
 
8,964
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Basic and diluted (loss) earnings per share:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
(Loss) income from continuing operations
 
$
(0.16
)
$
(0.16
)
$
0.21
 
$
0.25
 
(Loss) income from discontinued operations
 
 
(0.07
)
 
(0.08
)
 
0.14
 
 
0.16
 
Net (loss) income per common share
 
$
(0.23
)
$
(0.24
)
$
0.35
 
$
0.41
 


12

 
 
 
Nine Months Ended
 
 
 
September 30, 2005
 
 
 
As Originally Reported
 
As Restated for Correction of Errors
 
Statement of Cash Flows:
 
 
 
 
 
 
 
Net income (a)
 
$
7,816
 
$
8,964
 
Income from discontinued operations (a)
 
 
(3,217
)
 
(3,410
)
Depreciation
 
 
5,257
 
 
5,269
 
Accretion of asset retirement obligations
 
 
51
 
 
33
 
Deferred income taxes
 
 
3,196
 
 
3,129
 
Inventories
 
 
5,353
 
 
4,688
 
Accounts payable and accrued liabilities
 
 
12,047
 
 
11,699
 
Net cash provided by continuing operations from operating activities
 
 
22,438
 
 
22,307
 
Net cash provided by discontinued operations from operating activities
 
 
4,777
 
 
4,876
 
Net cash provided by operating activities
 
 
27,215
 
 
27,183
 
 
 
 
 
 
 
 
 
Purchase of fixed assets
 
 
(8,165
)
 
(7,514
)
Net cash used in continuing operations from investing activities
 
 
(5,356
)
 
(5,407
)
Net cash provided by discontinued operations from investing activities
 
 
261
 
 
344
 
Net cash used in investing activities
 
 
(5,095
)
 
(5,063
)

(a) These line items originally reported combined in loss from continuing operations
 
5.     Discontinued Operations:

Miami Asset Sales
On October 2, 2006, the Company entered into asset purchase agreements to sell certain inventory, vehicles, equipment and other assets located at its Miami, Florida facility. Total proceeds from the sale of these assets were $4,099, of which $1,764 was used to payoff outstanding lease obligations related to the assets which were sold. In connection with entering into the asset purchase agreements, the Company ceased active operations at its Miami, Florida facilities.
 
On November 8, 2006, the Company completed the evaluation of the fair value of the assets at its Miami, Florida facility, which are described above. As a result of the evaluation, the Company recorded an impairment charge of $5,253 to reflect the fair value of these assets. This impairment charge was recorded in the condensed consolidated statements of operations as a component of loss from discontinued operations for the period ended September 30, 2006.
 
In addition, on October 30, 2006, the Company entered into a commercial contract to sell one of the two remaining real properties located in Miami, Florida. The contract, which contains closing and other customary conditions, provides for the sale of approximately 138 acres of land in Miami-Dade County, Florida and certain other assets of the Company which are to be identified during the prospective buyer’s inspection and due diligence period. The expected sales price for the land and the other assets is approximately $12,455, assuming the transaction closes. During the fourth quarter of 2006, the Company anticipates recording a net gain from the sale of the 138 acres of land, which would be recorded as a component of discontinued operations.
 
As of September 30, 2006, all of the Company’s remaining assets, inventories and related liabilities related to the Miami, Florida operations have been reclassified on the balance sheet as “assets held for sale” and “liabilities related to assets held for sale.”
 
Northeast Facilities
In August 2006, the Company made a decision to pursue the sale of the four Northeast nursery operations as provided for in the Company’s credit facility. These operations consist of the Company’s facilities in Danville and Pipersville, Pennsylvania and Newark, and Utica, New York. The fixed assets, inventories and related liabilities of these four facilities have been reclassified on the balance sheet as “assets held for sale” and “liabilities related to assets held for sale.”

13

 

In reviewing long-lived assets for impairment in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” the Company determined that its four nursery facilities located in the Northeast were impaired because the carrying values of the long-lived assets exceeded the estimated undiscounted future cash flows of the assets. The Company used an independent third party appraisal in order to determine fair value, which resulted in an impairment charge of $8,041. The charge was recorded by the Company in its condensed consolidated financial statements in the second quarter of 2006.

In October 2006, two major customers withdrew substantial future sales commitments from three of the four Northeast facilities, which withdrawal occurred subsequent to the original announcement of the sale of the four Northeast facilities. The withdrawal represented a reduction of approximately 75% of the 2007 annual sales commitments for the three facilities, greatly reducing the fair market value of these assets. As a result, it was determined that the long-lived assets associated with these facilities were impaired. The fair value used to determine the impairment was based on letters of intent the Company received in connection with the sale of the Northeast facilities. As a result, the Company recorded an additional impairment charge of $11,084 in the third quarter of 2006 to reflect the revised estimate of the fair value of these assets. This impairment charge was recorded as a component of loss from discontinued operations.
 
Goodwill Impairment
In connection with the Company’s decision to sell the four Northeast facilities and the Miami, Florida facility, the Company allocated $5,108 of goodwill to these facilities. This allocation was based on the relative fair values of these facilities. Prior to the allocation, the Company reported total goodwill of approximately $43,926, which was initially recorded based on purchase price allocations from various acquisitions made by the Company. Subsequent to the allocation of the goodwill to the operations to be disposed of, the Company concluded that the carrying value of the goodwill allocated to the four Northeast color facilities and the Miami, Florida facility was impaired. As a result, the Company recorded a goodwill impairment charge of $5,108. The goodwill impairment charge was recorded as a component of the loss from discontinued operations in the condensed consolidated statements of operations. At September 30, 2006, the Company determined the remaining goodwill of $38,818 was not impaired.
 
Summarized financial information for discontinued operations is set forth below:

 
 
 Three Months Ended
 
 Nine Months Ended
 
 
 
September 30,
 
September 30,
 
September 30,
 
September 30,
 
 
 
2006
 
2005
 
2006
 
2005
 
 
 
(as restated)
 
(as restated)
 
(as restated)
 
(as restated)
 
 
 
 
 
 
 
 
 
 
 
Sales, net
 
$
9,141
 
$
11,432
 
$
50,392
 
$
68,143
 
(Loss) income before income taxes
 
 
(32,034
)
 
(3,006
)
 
(37,442
)
 
5,553
 
Income tax (benefit) provision
 
 
(12,977
)
 
(1,161
)
 
(15,168
)
 
2,143
 
(Loss) income from discontinued operations
 
$
(19,057
)
$
(1,845
)
$
(22,274
)
$
3,410
 
 
As of September 30, 2006 and December 31, 2005, the components of assets and liabilities of discontinued operations in the consolidated balance sheets under assets and liabilities held for sale are as follows:

 
 
September 30,
 
December 31,
 
 
 
2006
 
2005
 
 
 
(as restated)
 
(as restated)
 
Inventories
 
$
17,081
 
$
20,454
 
Fixed assets, net
 
 
22,493
 
 
46,603
 
Deferred income taxes
 
 
15,598
 
 
4,850
 
Assets held for sale
 
$
55,172
 
$
71,907
 
 
 
 
 
 
 
 
 
Deferred income taxes
 
$
6,747
 
$
8,079
 
Liabilities related to assets held for sale
 
$
6,747
 
$
8,079
 


The 2005 assets held for sale in the above table does not include $484 related to the Company’s Vacaville, California facility because this facility is part of continuing operations as of December 31, 2005.

14

 
6.     Earnings Per Share:

Earnings per share are calculated in accordance with SFAS No. 128, “Earnings per Share,” which requires the Company to report both basic earnings per share, based on the weighted-average number of common shares outstanding, and diluted earnings per share, based on the weighted-average number of common shares outstanding adjusted to include the potentially dilutive effect of outstanding stock options and warrants using the treasury method. For the three and nine months ended September 30, 2006, the incremental shares related to underlying employee stock options from total outstanding options of 847,227, were excluded from the computation of diluted earnings per share because they would have been anti-dilutive. For the three and nine months ended September 30, 2005, the incremental shares related to the underlying employee stock options were 0 and 2,067, respectively, from total outstanding options of 1,066,273. In addition, for the three and nine months ended September 30, 2005, the incremental shares related to 440,000 warrants outstanding were 0 and 44,729, respectively. The 440,000 warrants expired on December 31, 2005.

7.     Stock-Based Compensation:

The Company’s 1998 Long-Term Equity Incentive Plan (the “1998 Stock Plan”), which has been approved by the shareholders, permits the grant of stock options, stock appreciation rights, restricted stock, performance awards and any combination of the foregoing to certain directors, officers and employees of the Company and its subsidiaries. Option awards are generally granted with an exercise price equal to or greater than the market price of the Company’s stock at the date of grant; those option awards generally vest over a period of four years subject to continuous service and have 10-year contractual terms.

Effective the beginning of the first quarter of fiscal year 2006, the Company adopted the provisions of SFAS No. 123(R), “Share-Based Payment,” using the modified prospective transition method. Under this method, prior periods are not restated. The provisions of SFAS No. 123(R) apply to new stock options and stock options outstanding, but not yet vested, on the effective date. As of December 31, 2005, all outstanding options were fully vested.

Prior to January 1, 2006, the Company measured stock compensation expense using the intrinsic value method of accounting in accordance with Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations (APB No. 25). Thus, expense was generally not recognized for the Company’s employee stock option plans. Results for prior periods have not been restated.

The following table shows net income and EPS had the Company applied the fair value method of accounting for stock-based compensation in accordance with SFAS No. 123 during the third quarter of 2005.

 
 
Three Months Ended
 
Nine Months Ended
 
 
 
September 30, 2005
 
September 30, 2005
 
Net (loss) income, as restated
 
$
(5,331
)
$
8,964
 
Stock-based compensation expense, net of tax
 
 
(11
)
 
(32
)
Pro forma net (loss) income, as restated
 
$
(5,342
)
$
8,932
 
 
 
 
 
 
 
 
 
Net (loss) income per share:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Basic and diluted - as restated
 
$
(0.24
)
$
0.41
 
Basic and diluted - pro forma, as restated
 
$
(0.24
)
$
0.41
 
 

15

 
Valuation Method - The Company estimates the fair value of stock options granted using the Black-Scholes option-pricing model and a single option award approach. 

Expected Dividend - No dividends are expected to be paid.

Expected Volatility - The computation of expected volatility is based on the historical volatility.
 
Risk-Free Interest Rate - The risk-free interest rate used in the Black-Scholes valuation method is based on the implied yield currently available on U.S. Treasury securities with an equivalent remaining term.

Expected Term - The expected term represents the period the Company’s stock-based awards are expected to be outstanding and was determined based on historical experience with similar awards, giving consideration to the contractual terms of the stock-based awards, vesting schedules and expectations of future employee behavior as influenced by changes to the terms of its stock-based awards.

Forfeiture Rate - The forfeiture rate is an estimate of the percentage of granted stock options that will be cancelled prior to becoming vested. The Company has estimated this to be 0% because of the historically small amount of forfeitures in prior periods with the exception of the stock option exchange that took place in 2002. In this exchange a large number of options were cancelled and reissued to the same individuals.

There were no stock option grants during the three and nine months ended September 30, 2006; accordingly, there was no determination of fair value during this period.

A summary of the status of the Company’s stock option plan as of September 30, 2006 follows:

 
 
 
 
Weighted Average
 
 Aggregate
 
 
Shares
 
Exercise Price
 
 Intrinsic Value
 
 
 
 
 
 
  
Outstanding at December 31, 2005
 
 
869,110
 
 
$ 6.22
 
 
 
Cancelled
 
 
(21,883
)
 
   7.01
 
 
 
Outstanding at September 30, 2006
 
 
847,227
 
 
$ 6.20
 
 
$    -
 
 
 
 
 
 
 
 
 
 
Exercisable
 
 
847,227
 
 
$ 6.20
 
 
$    -
 
 
 
 
 
 
 
 
 
 
 

16


The aggregate intrinsic value represents the difference between the exercise prices of the underlying awards and the quoted price of the Company’s common stock for those awards that have an exercise price below the quoted price on September 30, 2006. The Company had no options outstanding on September 30, 2006 with an exercise price below the quoted price of the Company’s common stock resulting in an aggregate intrinsic value of $0.

The weighted average remaining contractual life was five years at September 30, 2006. As of September 30, 2006, expiration dates ranged from June 22, 2008 to February 18, 2013.

 
 
Outstanding and Exercisable
 
 
 
 
 
Average
 
Weighted
 
 
 
Number of
 
Remaining
 
Average of
 
Range of exercise price
 
 
Options
 
 
Contract Life
 
 
Exercise Price
 
$3.32 to $5.00
 
 
81,000
 
 
4.81
 
 
$  4.53
 
$5.50
 
 
618,127
 
 
5.63
 
 
   5.50
 
$6.00 to $8.00
 
 
33,000
 
 
3.08
 
 
   6.73
 
$11.00
 
 
115,100
 
 
1.81
 
 
 11.00
 
 
 
 
 
 
 
 
 
 
 
 
Total
 
 
847,227
 
 
4.95
 
 
$  6.20
 


8.     Inventories:

Inventories consisted of the following:

 
 
September 30,
 
December 31,
 
 
 
2006
 
2005
 
 
 
(as restated)
 
(as restated)
 
Inventories from continuing operations:              
               
Nursery stock
 
$
118,765
 
$
151,992
 
Material and supplies
 
 
9,821
 
 
7,741
 
Inventories
 
 
128,586
 
 
159,733
 
Consigned inventories
 
 
1,546
 
 
138
 
Total continuing operations inventories
 
 
130,132
 
 
159,871
 
 
 
 
 
 
 
 
 
Inventories from discontinued operations included in assets held for sale:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Nursery stock
 
 
13,867
 
 
16,795
 
Material and supplies
 
 
2,161
 
 
2,695
 
Inventories
 
 
16,028
 
 
19,490
 
Consigned inventories
 
 
1,053
 
 
964
 
Total discontinued operations inventories
 
 
17,081
 
 
20,454
 
 
 
 
 
 
 
 
 
Total inventories
 
$
147,213
 
$
180,325
 
 

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9.     Senior Credit Facility:

On September 30, 2003, the Company amended and restated its Senior Credit Facility. Hines Nurseries and its domestic operating subsidiaries are borrowers under the Senior Credit Facility. The Senior Credit Facility currently consists of a revolving loan which, subject to applicable borrowing base calculations, provides for borrowings which are not to exceed revolving utilization limits which range between $10,800 and $23,300 depending on the fiscal quarter. The revolving loan also permits the ability to obtain letters of credit up to a separate sub-limit.

The Senior Credit Facility was amended by the First Amendment to Credit Agreement dated as of June 30, 2005 (the “First Amendment”), then again pursuant to a Waiver Regarding Financial Covenants dated as of October 13, 2005 (the “Waiver”), and by the Second Amendment to Credit Facility dated as of February 3, 2006 (the “Second Amendment”). The Senior Credit Facility was also amended as of August 8, 2006 pursuant to the Third Amendment to Credit Agreement (the “Third Amendment”). On November 8, 2005, in accordance with the Waiver, at the Company’s request the availability of the revolving loan was reduced from $145,000 to $120,000 (subject to borrowing base limits). On August 8, 2006, in accordance with the Third Amendment, the availability of revolving loans was reduced by the imposition of revolving utilization limits which range from $10,800 to $23,300 depending on the fiscal quarter.

Guarantees; Collateral. Obligations under the Senior Credit Facility are guaranteed by Hines and any of its domestic subsidiaries that are not borrowers under the Senior Credit Facility. Borrowings under the Senior Credit Facility are collateralized by substantially all of the Company’s assets.

Restrictions; Covenants. The Senior Credit Facility places various restrictions on Hines Nurseries and its subsidiaries, including, but not limited to, limitations on the Company’s ability to incur additional debt, pay dividends or make distributions, sell assets or make investments. The Senior Credit Facility specifically restricts Hines Nurseries and its subsidiaries from making distributions to Hines Horticulture. Distributions to Hines Horticulture are limited to (i) payments covering customary general and administrative expenses, not to exceed $500 in any fiscal year, (ii) payments to discharge any consolidated tax liabilities, (iii) and payments, not to exceed as much as $8,300 in any fiscal year or $9,300 over the term of the Senior Credit Facility, to enable Hines Horticulture to repurchase its own outstanding common stock from holders other than its majority shareholder. Dividends to Hines Horticulture are disallowed under the Senior Credit Facility.

The Senior Credit Facility requires Hines Nurseries and its subsidiaries to meet specific covenants and financial ratios, including a minimum fixed charge coverage test, a maximum leverage test and a maximum capital expenditure test. The Senior Credit Facility contains customary representations and warranties and customary events of default and other covenants. As of September 30, 2006, the Company was not in compliance with the minimum fixed charge coverage ratio covenant; however, as discussed below, the non-compliance was waived in connection with the Third Amendment.

The covenants under the Senior Credit Facility may affect the Company’s ability to operate its business, may limit its ability to take advantage of business opportunities as they arise and may adversely affect the conduct of its current business. A breach of a covenant in the Company’s debt instruments could cause acceleration of a significant portion of its outstanding indebtedness. In the event the Company breaches the covenants in its debt instruments and it is unable to obtain waivers in connection therewith, it may not be able to obtain alternative financing for its debt on reasonable terms or otherwise. In that event, in order to pay the principal of the Company’s debt, it would be required to sell its equity securities, sell its assets or take other actions. The foregoing actions may not enable the Company to pay the principal of its debt.

First Amendment To Senior Credit Facility. Effective June 30, 2005, Hines Nurseries negotiated and entered into the First Amendment to the Senior Credit Facility. The First Amendment amended the Senior Credit Facility to require that the proceeds from the sale of 122 acres of unimproved property in Miami, Florida on November 7, 2005 (“Miami Property Sale”) be used to pay down the term loan. In accordance with the First Amendment, the Company repaid the term loan in its entirety on November 8, 2005 with the completion of the Miami Property Sale. The First Amendment also amended the calculation of the fixed charge coverage ratio and the leverage ratio to allow as an addition to Earnings Before Interest, Taxes, Depreciation and Amortization (“EBITDA”) certain adjustments related to work force reductions and requires Hines to meet less restrictive minimum fixed charge coverage ratio for the last fiscal quarter of 2005, for each fiscal quarter of 2006 and for the first fiscal quarter of 2007 and maximum leverage ratios for the last fiscal quarter of 2005, for each fiscal quarter of 2006 and the first and second fiscal quarters of 2007.

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Second Amendment To Senior Credit Facility. In February 2006, Hines Nurseries negotiated and entered into the Second Amendment to the Senior Credit Facility. The Second Amendment amends the calculation of the minimum fixed charge coverage ratio for the first quarter of 2006 and thereafter. The Second Amendment also eliminates the maximum leverage ratio.

Third Amendment To Senior Credit Facility. In August 2006, Hines Nurseries negotiated and entered into the Third Amendment to the Senior Credit Facility. The Third Amendment waived the requirement that the Company comply with the minimum fixed charge coverage ratio covenant for the periods ended June 30, 2006 and September 30, 2006. The Third Amendment also instituted maximum revolving utilization restrictions under the credit facility which, subject to applicable borrowing base calculations, limit the Company’s borrowings to limits which range from $10,800 to $23,300 depending on the fiscal quarter. It also increased the interest rate spread by 25 basis points on outstanding prime and London Interbank Offered Rate (“LIBOR”) borrowings, increased unused line fees and established new fixed charge covenant ratios beginning in the fourth quarter of 2006. In addition, the Third Amendment requires the Company to sell its four color nursery facilities in the Northeast and certain assets in Miami, Florida by no later than December 31, 2006. The sales of these assets are required to generate a predetermined minimum amount of aggregate proceeds.

Interest Rate; Fees. The interest rate on the loans under the Senior Credit Facility may be, at the Company’s option, Prime rate loans or LIBOR rate loans. Prime rate loans under the revolving loan bear interest at the Prime lending rate plus an additional amount that ranges from 1.00% to 2.00%, depending on its consolidated leverage ratio. Currently, the applicable margin for Prime rate loans is 2.00% for the revolving loan

LIBOR rate loans under the revolving loan bear interest at the LIBOR rate plus an additional amount that ranges from 2.00% to 3.00%, depending on its consolidated leverage ratio. Currently, the applicable margin for LIBOR rate loans is 3.00% for the revolving loan. In addition to paying interest on outstanding principal, the Company is required to pay a commitment fee on the daily average unused portion of the revolving loan which accrues based on the utilization of the revolving loan.

Borrowing Base. Availability of borrowings under the revolving loan are subject to a borrowing base consisting of the sum of (i) 85% of eligible accounts receivable plus (ii) the lesser of (x) up to 55% of eligible inventory or (y) 85% of the appraised net orderly liquidation value of eligible inventory.

The Company must deliver borrowing base certificates and reports at least monthly. The borrowing base also may be subject to certain other adjustments and reserves to be determined by the agent. Eligible accounts receivable of both The Home Depot, the Company’s largest customer, and Lowe’s Companies, Inc., its second largest customer, may not exceed 30% of total eligible accounts receivable at any time. At September 30, 2006, the Company had $68,664 of available unused borrowings under the Senior Credit Facility.

10.     Long-Term Debt:

Senior Notes. On September 30, 2003, Hines Nurseries issued $175,000 of senior subordinated notes that mature on October 1, 2011 (the "Senior Notes"). The Senior Notes bear interest at the rate of 10.25% per annum and will be payable semi-annually in arrears on each April 1 and October 1, which commenced on April 1, 2004.

Guarantees. Hines Horticulture and each of its subsidiaries, subject to certain exceptions, have jointly and severally, fully and unconditionally guaranteed, on a senior unsecured basis, the obligations of Hines Nurseries under the Senior Notes.

Redemption. Prior to October 1, 2006, up to 35% of the aggregate principal amount of the Senior Notes may be redeemed with the net cash proceeds from one or more public equity offerings, at the Company’s option, at a redemption price of 110.250% of the principal amount thereof plus accrued interest, if any, to the date of redemption. On or after October 1, 2007, the Company is entitled, at its option, to redeem all or a portion of the Senior Notes at redemption prices ranging from 100.000% to 105.125%, depending on the redemption date plus accrued and unpaid interest.
 
Restrictions. The indenture pursuant to which the Senior Notes were issued imposes a number of restrictions on Hines Nurseries and its subsidiaries. Subject to certain exceptions, the Company may not incur additional indebtedness, make certain restricted payments, make certain asset dispositions, incur additional liens or enter into significant transactions. A breach of a material term of the indenture or other material indebtedness that results in acceleration of the indebtedness under the Senior Notes also constitutes an event of default under its Senior Credit Facility.

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Repurchase or a change of control. The Senior Notes contain a put option whereby the holders have the right to put the Senior Notes back to Hines at 101.000% of the principal amount thereof on the date of purchase plus accrued and unpaid interest if a change of control occurs.

11.     Vacaville and Miami Property Sales (Previously “Deferred Gain on Land Sales”):

On March 1, 2006, the Company received notice that Triad Communities, L.P. exercised its option to purchase, pursuant to the previously disclosed Option Agreement dated April 30, 2003 (“Option Agreement”), its 168-acre property in Vacaville, California. The total book value of assets related to the sale was approximately $500. The Option Agreement provided that the gross purchase price of the property be $15,100. On April 3, 2006, the Company sold the property for a net purchase price of approximately $14,300. Total proceeds from the Option Agreement and sale of the property were approximately $16,900, which included approximately $2,600 in option payments previously received.

Under the terms of the Option Agreement, the Company is able to transition off the property in three phases from 2006 to 2008. The first phase of transition was completed on July 1, 2006 and consisted of 24 acres. The second phase of transition will be July 1, 2007 and the third phase of the transition will be July 1, 2008, and will consist of approximately 88 acres and 56 acres, respectively. The Company is continuing to develop replacement acreage and infrastructure at its 842-acre Winters South facility in Northern California. Because the Company is not paying rent, the Company is in a sale-leaseback with continuing involvement position with respect to this property. The Company originally recognized the sale of the property and deferred the gain on the Lagoon Valley property. However, in order to conform to SFAS No. 98, as of June 30, 2006, the Company has reinstated the net book value of the assets and recorded the proceeds received as a financing obligation. When the Company completes the transition on July 1, 2008, the Company will remove the net book value of the assets and expects to recognize a gain of approximately $16,200.

On November 7, 2005, the Company successfully completed the sale of 122 acres of unimproved property in Miami, Florida and received net proceeds of approximately $47,000. In accordance with an amendment to the existing senior credit facility, the proceeds from the Miami Property Sale were used to pay off the entire outstanding balance of the term loan, with the residual amount was used to pay down the revolving credit facility. As part of the Miami Property Sale, the Company entered into a two-year lease agreement with the buyer while transitioning operations to other locations. The Company leased the entire property for a one year period, with a thirty-day extension right, and then vacated approximately 33 acres. The Company is leasing the remaining 89 acres until June 30, 2007, and is subleasing the property for the remainder of the lease term. The Company pays the buyer rent of five hundred dollars per acre annually during the lease term plus fifty percent of the rent the Company receives from subleasing the property. In addition, the Company is entitled to additional amounts if the buyer is successful in obtaining zoning for a certain number of residential lots. When the Company exits the lease on June 30, 2007, the Company will remove the net book value of the assets and expects to recognize a gain of $39,880. The Company recorded the transaction as a financing transaction in accordance with SFAS No. 98 due to the Company’s continuing involvement in the property. This treatment gives effect to the restatement discussed in Note 4.
 
12.     Guarantor/Non-guarantor Disclosures:
 
The Senior Notes issued by Hines Nurseries (the “issuer”) have been guaranteed by the Company (the “parent guarantor”) and by both Hines SGUS and Hines Fertilizer, (collectively, Hines SGUS and Hines Fertilizer are the “subsidiary guarantors”). The issuer is a 100% owned subsidiary of the parent guarantor. The subsidiary guarantors are 100% owned subsidiaries of the issuer. The parent and subsidiary guaranties are full, unconditional and joint and several. The parent guarantor has no independent assets, liabilities or operations and subsidiary guarantors are minor with no material assets, liabilities or operations. In addition, under the Senior Notes, the parent guarantor is unable to obtain dividends or loans from the issuer or subsidiary guarantors. As a result of the foregoing, separate financial statements of Hines Nurseries, Hines SGUS and Hines Fertilizer are not presented.

20

 
Item 2.   MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

Unless the context otherwise requires, the term (1) “Hines Horticulture” means Hines Horticulture, Inc., a Delaware corporation, (2) the term “Hines Nurseries” means Hines Nurseries, Inc., a California corporation, and a wholly owned subsidiary of Hines Horticulture, (3) the term “Hines Fertilizer” means Hines Fertilizer, Inc., formerly known as Enviro-Safe Laboratories, Inc., a Florida Corporation, and a wholly owned subsidiary of Hines Nurseries and (4) the terms “we,” “us” and “our” mean, collectively, the combined entity of Hines Horticulture and its wholly owned subsidiaries.
 
The following discussion and analysis of our financial condition and results of operations gives effect to the restatement discussed in Note 4 to the Condensed Consolidated Financial Statements (unaudtied) and should be read in conjunction with our consolidated financial statements and related notes included elsewhere in this Quarterly Report on Form 10-Q/A.
 
Executive Summary and Market Trends

Since the third quarter of 2004, our earnings have declined on a quarter over comparable prior year quarter basis. Various factors have contributed to the decline in our earnings, including declining net sales and increasing production and distribution costs.
 
Our net sales in the Eastern region of the United States (which is serviced primarily by our Northeast, mid-Atlantic, and Southeast facilities and also, to a lesser extent, by certain of our Western facilities) have continued to decline on a quarter over comparable prior year quarter basis since the third quarter of 2004. As a result of this continued decline, we had been considering internally the divestiture of all four Northeast nursery facilities located in Danville, Pennsylvania, Pipersville, Pennsylvania, Utica, New York and Newark, New York, as well as assets located in Miami, Florida. In addition, our decline required us to seek amendments and waivers in connection with our Senior Credit Facility as a result of our inability to comply with all of our financial covenants as described more fully below.
 
On August 8, 2006, we negotiated and entered into the Third Amendment to Credit Agreement (the “Third Amendment”) relating to the Senior Credit Facility dated as of September 30, 2003. In accordance with the terms of the Third Amendment, we obtained waivers of financial covenants, reduced the aggregate revolving loan availability under our Senior Credit Facility and as a result of our recommendation made to the lenders of the Senior Credit Facility, we committed to the divestiture of our four Northeast facilities and our assets in Miami, Florida for predetermined minimum aggregate proceeds by no later than December 31, 2006. On August 8, 2006, in connection with the Third Amendment, our Board of Directors approved the aforementioned divestitures.
 
On August 10, 2006, we announced our decision to divest all four Northeast nursery facilities as well as assets located in Miami, Florida. On August 18, 2006, we decided, after further evaluation of the matter, to discontinue all of our nursery operations in Miami, Florida by the end of the third quarter of 2006.
 
Our recommendation to the lenders of our Senior Credit Facility to divest the Northeast and Miami nursery facilities was based on several significant factors. As mentioned above, our net sales have deteriorated in the Eastern region. Despite our efforts to reverse this decline, our Northeast, mid-Atlantic and Southeastern facilities have continued to lose market share in the Eastern region during this period. Intense competition, significant pricing pressures and customer consolidations have all contributed to the decline in market share. Moreover, net sales in the Southeastern region were adversely impacted by inclement weather as we estimate that the impact of hurricanes reduced our net sales by as much as $10.0 million in this region during 2004 and 2005.
 
Liquidity was another important factor that we considered when making the recommendation to divest these facilities. As a result of our declining performance, we were unable to meet our current financial debt covenant, the minimum fixed charge coverage ratio, which led to increasing concerns from our lenders. By divesting these assets, we are reducing the need for future outstanding borrowings under our revolver, reducing our future net interest expense, assisting in the funding of our capacity transitions and possibly enabling us to reduce other outstanding debt in the future.

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The last significant factor we considered was our return on assets. As a result of the upcoming expiration of our lease at our Irvine, California facility and the sale of our Lagoon Valley facility in Northern California, we are faced with replacing lost capacity at these sites. These replacements will require significant amounts of capital expenditures over the next several years. Based on these circumstances, we determined that cash generated from operations in addition to borrowing availability did not enable us to move forward with these capacity transitions and the investments required to turnaround operations at our Northeast and Miami facilities. Having assessed the potential returns from the various facilities, we decided to move forward with the capacity transitions in the West and to utilize the proceeds from the divestitures of the Northeast and Miami facilities to fund the capital expenditures.
 
While net sales in the Eastern region have continued to significantly decline, as described above, our net sales throughout the rest of the country had remained relatively stable during 2004 and 2005 (when compared to the comparable prior year periods), and have declined by approximately $7 million during the nine months ended September 30, 2006 compared to the same period a year ago. While inclement weather has from time to time adversely impacted sales outside of the Eastern region, or otherwise contributed to short-term fluctuations in such sales, inclement weather has not historically had the same impact on our net sales in these areas as it has had in the Eastern region.
 
Since the second quarter of 2005, we have experienced increases in cost of goods sold, when expressed as a percentage of our net sales, as a result of increased production costs. Since the fourth quarter of 2004, our distribution expenses have also increased when expressed as a percentage of net sales. Contributing to these increases have been the increasing cost of petroleum as well as other inflationary costs. A number of items which are components of our production and distribution costs are, directly, or indirectly, related to petroleum based products. Examples include diesel fuel, resin based plastic containers and heating fuel, the costs for which have increased over the past two years. Higher third party carrier charges have also contributed significantly to increased distribution costs. Higher costs in other non-petroleum based components, such as labor costs, also contributed to the increased production costs and we estimate that labor costs account for close to one-half of our production costs.
 
In response to rising costs which have negatively impacted our results of operations, we have commenced labor productivity initiatives intended to improve our gross profit margins. To date, we believe that we have made progress in this regard at a certain number of our facilities and we intend to continue to seek to implement these initiatives at our remaining facilities as well as continuing to explore other cost-savings opportunities throughout our operations.
 
Forward Looking Statements and Risk Factors
 
Except for historical information contained herein, this quarterly report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, as amended, which involve certain risks and uncertainties. Forward-looking statements are included with respect to, among other things, the company’s current business plan and strategy and strategic operating plan. These forward-looking statements are identified by their use of such terms and phrases as “intends,” “intend,” “intended,” “goal,” “estimate,” “estimates,” “expects,” “expect,” “expected,” “project,” “projected,” “projections,” “plans,” “anticipates,” “anticipated,” “should,” “designed to,” “foreseeable future,” “believe,” “believes” and “scheduled” and similar expressions. Our actual results or outcomes may differ materially from those anticipated. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date the statement was made. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. For any forward-looking statements, we claim the protection of the safe harbor for forward-looking statements in Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934.
 
There are a number of risks, uncertainties and important factors that might cause actual results to differ from any results expressed or implied by such forward looking statements. In addition to the risks, uncertainties and other factors discussed elsewhere in this Form 10-Q/A, the risks, uncertainties and other factors that could cause or contribute to actual results differing materially from those expressed or implied in the forward looking statements include, without limitation, those set forth under Part I. Item 1A - Risk Factors in the Company’s Annual Report on Form 10-K for the year ended December 31, 2006, filed on July 10, 2007.

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Factors which could cause actual results to differ materially from any forward-looking information contained herein include, but are not limited to, general economic trends and seasonality, including those specifically impacting the nursery business, general agricultural risks beyond our control including risks associated with disease and pests, including sudden oak death, adverse weather conditions, increases in prices for water, petroleum and raw materials, our substantial leverage and ability to service our debt, our ability to comply with the covenants contained in our debt facilities, competitive practices in the industry in which we compete, fluctuations in our operating costs, revenues and cash flows from operations, our dependence on a limited number of key customers, increases in transportation and fuel costs, factors with regard to the challenges associated with pay by scan and other factors. Additional factors that may influence our results in the future include the fact that we may not achieve the minimum level of aggregate proceeds from the asset sales required by our Third Amendment and the fact that such anticipated sales of assets and properties may be subject to various conditions and may not close for a number of reasons, including reasons outside our control.

Overview
 
We are a leading national supplier of ornamental shrubs, color plants and container-grown plants and our continuing operations consists of eight commercial nursery facilities located in Arizona, California, Oregon, South Carolina and Texas. We produce approximately 4,000 varieties of ornamental shrubs and color plants and we sell to more than 1,170 retail and commercial customers, representing more than 6,700 outlets throughout the United States and Canada. As of September 30, 2006, Hines Horticulture produced and distributed horticultural products through its wholly owned subsidiary, Hines Nurseries.
 
United States Tax Matters
 
As a result of our business activities, we qualify for a special exception under the U.S. federal tax code that allows us to use the cash method of accounting for federal income tax purposes. Under the cash method, sales are included in taxable income when payments are received and expenses are deducted as they are paid. We derive significant tax benefits by being able to deduct the cost of inventory as the cost is incurred. As a result of our ability to utilize the cash method of accounting, we have historically generated net operating losses for federal income tax purposes and have not been required to pay cash income taxes. During 2005, we were required to pay federal cash income taxes in the form of alternative minimum tax as a result of the sale of land in Miami, Florida (“Miami Property Sale”). At December 31, 2005, we had $2.3 million in net operating loss carryforwards for federal income tax purposes, which begin to expire in 2024. In addition, we had approximately $6.6 million in net operating loss carryforwards for state income tax reporting purposes. Our state net operating losses in certain states begin expiring in 2008.
 
Based on our current projections, we anticipate that we will not pay cash income taxes for federal or state income tax purposes through 2010.
 
The use of the cash method of accounting for federal income tax purposes results in a current deferred tax liability for accounting purposes. At September 30, 2006, we had a current deferred liability for deferred income taxes of $35.0 million related to the use of the cash method of accounting. The deferred tax liability is deemed current for accounting purposes because the majority of the items to which this liability relates are comprised of current assets and current liabilities in our balance sheet (such as inventory, accounts receivable and accounts payable). The classification of this liability as a current item, however, does not mean that it is required to be paid within the next twelve months.
 
Seasonality
 
Our business is highly seasonal. The seasonal nature of our operations results in a significant increase in our working capital between the growing and selling cycles. As a result, operating activities in the first and fourth quarters use significant amounts of cash, and in contrast, operating activities in the second and third quarters historically have generated cash as we ship inventory and collect accounts receivable. We have experienced, and expect to continue to experience, significant variability in net sales, operating income and net income on a quarterly basis.

23


Sale of 168 Acres in Vacaville, California
 
On March 1, 2006, we received notice that Triad Communities, L.P. exercised its option to purchase, pursuant to the previously disclosed Option Agreement dated April 30, 2003 (“Option Agreement”), our 168-acre property in Vacaville, California. The total book value of assets related to the sale was approximately $0.5 million. The Option Agreement provided that the gross purchase price of the property be $15.1 million. On April 3, 2006, we sold the property for a new purchase price of $14.3 million. Total proceeds from the Option Agreement and sale of the property were approximately $16.9 million, which included approximately $2.6 million in option payments previously received.

Under the terms of the Option Agreement, we are able to transition off the property in three phases from 2006 to 2008. The first phase of transition was completed on July 1, 2006 and consisted of 24 acres. The second phase of transition will be July 1, 2007 and the third phase of the transition will be July 1, 2008, and will consist of approximately 88 acres and 56 acres, respectively. We are continuing to develop replacement acreage and infrastructure at our 842-acre Winters South facility in Northern California. Because we are not paying rent, we are in a sale-leaseback with continuing involvement position with respect to this property. We originally recognized the sale of the property and deferred the gain on the Lagoon Valley property. However, in order to conform with Statement of Financial Accounting Standards (“SFAS”) No. 98, as of June 30, 2006 and subsequent periods we have reinstated the net book value of the assets and recorded the proceeds received as a financing obligation as, more fully disclosed in Note 4 to the Condensed Consolidated Financial Statements. When we complete the transition, which is expected to be completed on July 1, 2008, we will remove the net book value of the assets and expect to recognize a gain of approximately $16.2 million.
 
Discontinued Operations
 
Miami Asset Sales
On October 2, 2006, we entered into asset purchase agreements to sell certain inventory, vehicles, equipment and other assets located at our Miami, Florida facility. Total proceeds from the sale of these assets were approximately $4.1 million, of which approximately $1.8 million was used to payoff outstanding lease obligations related to the assets which were sold. In connection with entering into the asset purchase agreements, we ceased active operations at our Miami, Florida facilities.
 
On November 8, 2006, we completed the evaluation of the fair value of our Miami, Florida assets, which are described above. As a result of the evaluation, we recorded an impairment charge of approximately $5.3 million to reflect the fair value of these assets. This impairment charge was recorded in the statements of operations as a component of the loss from discontinued operations for the period ended September 30, 2006.
 
In addition, on October 30, 2006, we entered into a commercial contract to sell one of our two remaining real properties located in Miami, Florida. The contract, which contains closing and other customary conditions, provides for the sale of approximately 138 acres of land in the Miami-Dade County, Florida and certain other assets of the Company which are to be identified during the prospective buyer’s inspection and due diligence period. The expected sales price for the land and the other assets is approximately $12.5 million, assuming the transaction closes. During the fourth quarter of 2006, we anticipate recording a net gain of approximately $9.1 million from the sale of the 138 acres of land, which would be recorded as a component of discontinued operations.
 
As of September 30, 2006, all of our remaining assets, inventories and related liabilities related to our Miami, Florida operations have been reclassified on the consolidated balance sheet as “assets held for sale” and “liabilities related to assets held for sale.”
 
Northeast Facilities
In August 2006, we made a decision to be pursue the sale of our four Northeast nursery operations as provided for in the Third Amendment. These operations consist of our facilities in Danville and Pipersville, Pennsylvania and Newark and Utica, New York. The fixed assets, inventories and related liabilities of these four facilities have been reclassified on the balance sheet as “assets held for sale” and “liabilities associated with assets held for sale.”

In reviewing our long-lived assets for impairment in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”, we determined that our four nursery facilities located in the Northeast as well as certain assets located in Miami, Florida were impaired because the carrying values of the long-lived assets exceeded the estimated undiscounted future cash flows of the assets. We used an independent third party appraisal in order to determine fair value, which resulted in an impairment charge of $8.0 million. The charge was recorded in our condensed consolidated financial statements in the second quarter of 2006.

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In October 2006, two major customers withdrew substantial future sales commitments from three of the four Northeast facilities, which withdrawal occurred subsequent to the original announcement of the sale of the four Northeast facilities. The withdrawal represented a reduction of approximately 75% of the 2007 annual sales commitments for the three facilities, greatly reducing the fair market value of these assets. As a result, we determined that the long-lived assets associated with these facilities were impaired. The fair value used to determine the impairment was based on letters of intent we received in connection with the sale of the Northeast facilities. As a result, we recorded an additional impairment charge of $11.1 million in the third quarter of 2006 to reflect the revised estimate of the fair value of these assets. This impairment charge was recorded as a component of loss from discontinued operations.
 
Goodwill Impairment
 
In connection with our decision to sell the four Northeast facilities and the Miami, Florida assets, we allocated approximately $5.1 million of goodwill to these facilities and assets. This allocation was based on the relative fair value of these facilities obtained from appraisals of our assets performed by third party appraisers. Prior to the allocation, we reported total goodwill of approximately $43.9 million, which was initially recorded based on purchase price allocations from various acquisitions made by us. Subsequent to the allocation of the goodwill to the operations to be disposed of, we concluded that the carrying value of the goodwill allocated to the four Northeast color facilities and the Miami, Florida assets was impaired. As a result, we recorded a goodwill impairment charge of approximately $5.1 million. The goodwill impairment charge was recorded as a component of loss from discontinued operations in the statements of operations for the period ended September 30, 2006.
 
Pay By Scan
 
In January 2005, we entered into an agreement with our largest customer to sell a portion of our product under a pay by scan program. Under this program, our customer does not take ownership of the inventory at its stores until the product is scanned at the check out register. Sales under this program began in February 2005. Revenue is recorded at the point the store sells our product to its customer. Annuals, perennials and groundcovers are our only products impacted by this agreement.
 
Despite the implementation of the new pay by scan program, we did not encounter any material variances with the quality and variability of our earnings and cash flows during 2005.
 
Results of Operations
 
The following discussion of results of operations gives effect to the restatement discussed in Note 4 to the Condensed Consolidated Financial Statements and should be read in conjunction with our condensed consolidated financial statements and related notes included elsewhere in this Quarterly Report on Form 10-Q/A.
 
Three Months Ended September 30, 2006 compared to Three Months Ended September 30, 2005
 
Net Sales. Net sales of $37.5 million for the three months ended September 30, 2006 decreased $0.5 million, or 1.2%, from net sales of $37.9 million for the comparable period in 2005. The decline in net sales was mainly due to one of the west coast facilities and resulted from weaker demand during the quarter for that site’s existing product mix. As a result of the capacity transition from southern to northern California, some of our higher demand crops were unavailable for sale and this directly impacted the product mix that our southern California facility was able to sell during the period. This decrease was partially offset by increases in net sales at our other continuing operations facilities.
 
Gross Profit. Gross profit of $9.8 million for the three months ended September 30, 2006 decreased $8.7 million, or 47.1%, from gross profit of $18.4 million for the comparable period in 2005. Gross profit as a percentage of sales for the quarter decreased to 26.0% from 48.6% for the comparable period in 2005. The decline in gross profit and gross profit margin was mainly due to the decline in net sales, as discussed above, as well as higher cost inventory, which was produced during 2005.

Distribution Expenses. Distribution expenses of $8.8 million for the three months ended September 30, 2006 increased $0.1 million, or 1.3%, from $8.7 million for the comparable period in 2005. As a percentage of net sales, distribution expenses for the quarter increased to 23.5% from 22.9% in the third quarter of 2005. This slight increase was mainly due to increased third party carrier charges.

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Selling, General and Administrative Expenses. Selling, general and administrative expenses of $12.1 million for the three months ended September 30, 2006 increased by $2.7 million, or 28.3%, from $9.4 million in the third quarter of 2005. The increase in selling expenses was mainly due to a higher amount of third party product merchandising costs which have been increasingly required by certain customers. Third party merchandising costs are typically more expensive than utilizing our in-house merchandising labor force. The increase in general and administrative expenses was mainly due to an increase in personnel and higher costs related to the implementation of Sarbanes-Oxley.
 
Other Operating Expense. Other operating expenses of $0.4 million for the three months ended September 30, 2006 increased by $0.4 million from nominal other operating expense for the comparable period in 2005. Other operating expenses for the third quarter of 2006 consisted primarily of consulting fees relating to our productivity improvement initiatives.
 
Operating (Loss) Income. Operating loss for the three months ended September 30, 2006 was $13.0 million compared to $0.4 million of operating income for the comparable period in 2005. The swing from operating income to operating loss resulted from a decline in gross profit for the period of $8.7 million, an increase of $2.7 million in selling, general and administrative expenses and an increase of other operating expenses to $0.4 million.
 
Other Expenses. Other expenses of $5.3 million for the three months ended September 30, 2006 decreased $0.6 million, or 9.6%, from $5.8 million for the comparable period in 2005 primarily due to lower interest expense. Interest expense for the three months ended September 30, 2006 declined $0.7 million, or 13.8%, primarily as a result of lower outstanding debt, partially offset by higher interest rates. This was offset by an increase in deferred financing expenses which resulted from the write-off of a portion of the deferred financing expenses in connection with our third amendment to the Senior Credit Facility.
 
Income Tax Benefit. Our effective income tax rate was 38.6% for the three months ended September 30, 2006, up from 36.2% from the comparable period a year ago. Benefit from income taxes was $7.1 million for the three months ended September 30, 2006 compared to $2.0 million for the comparable period in 2005. The increase in income tax benefit is primarily due to lower income from continuing operations before income taxes. In addition, included in the three months ended September 30, 2006, is the reversal of $0.2 million of tax liabilities due to the closure of certain tax years for tax audit purposes.
 
Loss from Continuing Operations. Loss from continuing operations of $11.2 million for the three months ended September 30, 2006 increased $7.7 million, or 221%, from $3.5 million for the comparable period in 2005. The increase in the loss from continuing operations was attributable to lower net sales, gross margin decline and other factors discussed above.
 
Loss from Discontinued Operations. Loss from discontinued operations, net of tax, of $19.1 million for the three months ended September 30, 2006 increased $17.2 million from $1.8 million for the comparable period in 2005. The increase in loss from discontinued operations was primarily due to asset and other impairment charges.
 
Net Loss. Net loss for the three months ended September 30, 2006 of $30.3 million increased $24.9 million compared to $5.3 million for the comparable period in 2005. The increase in net loss was mainly attributable to the loss on discontinued operations recorded during the third quarter, as well as other factors discussed above.
 
Nine Months Ended September 30, 2006 compared to Nine Months Ended September 30, 2005
 
Net Sales. Net sales of $208.3 million for the nine months ended September 30, 2006 decreased by $13.8 million, or 6.2%, from net sales of $222.1 million for the comparable period in 2005. The decline in net sales during the nine month period is mainly due to the persistent rain in the Pacific Northwest, northern California and Southwest during the late winter and early spring months as well as lost market share in the mid-Atlantic markets. The late winter and early spring rains reduced consumer demand at the retail level and also delayed certain product availability for up to three weeks, which also impacted sales. Additionally, our facility in South Carolina reported less sales volume as a result of lost market share primarily in the mid-Atlantic markets.

Gross Profit. Gross profit of $87.3 million for the nine months ended September 30, 2006 decreased $26.2 million, or 23.1%, from gross profit of $113.5 million for the comparable period in 2005. The decline in gross profit and gross profit margin was mainly due to the decline in net sales, as discussed above, as well as higher cost inventory produced during 2005.

26

 
Distribution Expenses. Distribution expenses of $46.6 million for the nine months ended September 30, 2006 decreased $0.6 million, or 1.4%, from $47.3 million for the comparable period in 2005. The decrease is due primarily to lower sales. As a percentage of net sales, distribution expenses for the nine months ended September 30, 2006 increased to 22.4% from 21.3% for the comparable period in 2005. This increase is primarily due to increased diesel fuel costs and third party carrier costs.
 
Selling, General and Administrative Expenses. Selling, general and administrative expenses of $41.3 million for the nine months ended September 30, 2006 increased $2.2 million, or 5.6%, from $39.1 million for the comparable period in 2005. The increase in selling and general and administrative expenses is primarily due to an increase in third party product merchandising costs, which have been increasingly required by certain customers, as well as an increase in general and administrative personnel and higher costs related to the implementation of Sarbanes-Oxley.
 
Other Operating Expenses. Other operating expenses of $2.3 million for the nine months ended September 30, 2006 increased by $1.8 million from $0.5 million for the comparable period a year ago. Other operating expenses consisted primarily of consulting fees relating to our productivity improvement initiatives.
 
Operating (Loss) Income. Operating loss of $4.3 million for the nine months ended September 30, 2006 decreased by $30.9 million, or 116.4 %, from income of $26.6 million for the comparable period in 2005. The decline in operating income resulted from lower sales volume, gross profit decline, and an increase in selling and general and administrative expenses and other expenses, as discussed above.
 
Other Expenses. Other expenses of $16.4 million for the nine months ended September 30, 2006 decreased by $1.5 million, or 8.6%, from $17.9 million for the comparable period a year ago. The decrease was primarily due to a reduction in interest expense of $2.5 million related to lower outstanding debt and partially offset by higher interest rates. The decrease in interest expense was further offset by the swap agreement income in 2005 of $0.9 million. The swap agreement matured in February of 2005.
 
Income Tax (Benefit) Provision. Our effective tax rate was 38.6% for the nine months ended September 30, 2006, up from an effective tax rate of 36.0% for the comparable period in 2005. Benefit from income taxes was $8.0 million for the nine months ended September 30, 2006 compared to a provision for income tax of $3.1 million for the comparable period in 2005. The shift from provision to benefit is due to lower income from continuing operations before income taxes. In addition, included in the nine months ended September 30, 2006, is the reversal of approximately $0.2 million of tax liabilities due to the closure of certain tax years for tax audit purposes. 
 
(Loss) Income from Continuing Operations. Loss from continuing operations for the nine months ended September 30, 2006 of $12.7 million was $18.3 million less than income from continuing operations of $5.6 million for the comparable period in 2005. The shift from income to loss was mainly due to lower operating income, partially offset by a decrease in interest expense.
 
(Loss) Income from Discontinued Operations. Loss from discontinued operations, net of tax, for the nine months ended September 30, 2006 of $22.3 million was $25.7 million less than income from discontinued operations, net of tax, of $3.4 million for the comparable period in 2005. The shift from income to loss was primarily due to a decrease in sales and gross profit margins from the facilities which comprise discontinued operations.
 
Net (Loss) Income. Net loss for the nine months ended September 30, 2006 of $35.0 million was $44.0 million less than net income of $9.0 million for the comparable period in 2005. The shift from net income to net loss is primarily due to lower net sales volume, gross profit margin, the loss from discontinued operations and other factors discussed above.

Liquidity and Capital Resources
 
Our primary sources of liquidity are funds generated by operations and borrowings under our Senior Credit Facility. The seasonal nature of our operations results in a significant fluctuation in certain components of working capital (primarily accounts receivable and inventory) during the growing and selling cycles. As a result, operating activities during the first and fourth quarters use significant amounts of cash, and in contrast, operating activities for the second and third quarters historically have generated cash as we ship inventory and collect accounts receivable. The covenants under our Senior Credit Facility may affect our ability to operate our business, may limit our ability to take advantage of business opportunities as they arise and may adversely affect the conduct of our current business. A breach of a covenant in our debt instruments could cause acceleration of a significant portion of our outstanding indebtedness. In the event we breach the covenants in our debt instruments and we are unable to obtain waivers in connection therewith, we may not be able to obtain alternative financing for our debt on reasonable terms or otherwise. In that event, in order to pay the principal of our debt, we would be required to sell our equity securities, sell our assets or take other actions which could adversely impact our business, operations and shareholders. The foregoing actions may not enable us to pay the entire principal of our debt.

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Net cash provided by operating activities of continuing operations was $13.9 million for the nine months ended September 30, 2006 compared to $22.3 million for the comparable period in 2005. The decrease in cash provided by operating activities was mainly due to the decline in gross profit during the period, partially offset by reduced working capital levels. The decline in gross profit was primarily due to the decrease in net sales and the sell-through of higher cost inventory that was produced in 2005. The reduced working capital requirements were mainly due to reduced accounts receivable and inventory balances at quarter end. The decline in accounts receivable resulted mainly from the reduction in net sales. The decline in inventory resulted from fewer units in production as we better align production with forecasted sales as well as units we are now capturing into inventory with lower production costs resulting from our internal labor productivity initiatives.

Net cash used in investing activities from continuing operations was $7.7 million for the nine months ended September 30, 2006 compared to net cash used in investing activities from continuing operations of $5.4 million for the same period a year ago. The increase in cash used in investing activities was mainly due to a $0.2 million increase in capital expenditures during the period and a reduction of $2.0 million of land sale option proceeds in 2006. Capital expenditures during the period mainly consisted of general maintenance capital and expenditures related to our Irvine capacity relocation project.

Net cash provided by financing activities was $3.9 million for the nine months ended September 30, 2006 compared to net cash used in financing activities of $22.6 million for the same period in 2005. The swing from net cash used in financing activities to net cash provided by financing activities was primarily due to the receipt of $14.3 million of cash proceeds from the Lagoon Valley property sale and smaller repayments on our outstanding debt of $12.3 million compared to the same period a year ago.
 
We typically draw down our revolving loan in the first and fourth quarters to fund our seasonal inventory buildup and seasonal operating expenses. Based on past history, approximately 72-74% of our sales generally occur in the first half of the year, generally allowing us to reduce borrowing under our revolving loan in the second and third quarters. After applying the borrowing base limitations and letters of credits to our available borrowings as of September 30, 2006 we were limited to a maximum borrowing availability of $10.8 million based on the utilization limits in place for the quarter.

At September 30, 2006, we did not have any indebtedness outstanding under our Senior Credit Facility and we had $175.0 million principal amount of our Senior Notes outstanding.

We do not have any off balance sheet financing or any financial arrangements with related parties, other than operating leases. The following table discloses aggregate information about our contractual obligations and commercial commitments for our continuing operations as of September 30, 2006.

 
 
 
 
Payments Due by Period
 
 
 
 
 
(Dollars in millions)
 
 
 
 
 
Less than
 
 
 
 
 
After
 
Contractual Cash Obligations
 
Total
 
1 year
 
1-3 years
 
4-5 years
 
5 years
 
Senior Notes
 
$
175.0
 
$
-
 
$
-
 
$
175.0
 
$
-
 
Interest
 
 
93.3
 
 
18.9
 
 
55.0
 
 
19.4
 
 
-
 
Operating Leases
 
 
4.0
 
 
1.6
 
 
2.0
 
 
0.4
 
 
-
 
Total
 
$
272.3
 
$
20.5
 
$
57.0
 
$
194.8
 
$
-
 
 
We believe that cash generated by operations and from borrowings expected to be available under our Senior Credit Facility will be sufficient to meet our anticipated working capital, capital expenditures and debt service requirements for at least the next twelve months.
 
Our Senior Credit Facility

We entered into our Senior Credit Facility on September 30, 2003. Hines Nurseries and its domestic operating subsidiaries are borrowers under the Senior Credit Facility. The credit facility currently consists of a revolving loan which, subject to applicable borrowing base calculations, provides for borrowings which are not to exceed revolving utilization limits which range between $10.8 million and $23.3 million depending on the fiscal quarter. The revolving loan also permits us to obtain letters of credit up to a separate sub-limit.

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The Senior Credit Facility was amended by the First Amendment to Credit Agreement dated as of June 30, 2005 (the “First Amendment”), then again pursuant to a Waiver Regarding Financial Covenants dated as of October 13, 2005 (the “Waiver”), and by the Second Amendment to Credit Facility dated as of February 3, 2006 (the “Second Amendment”). On November 8, 2005, in accordance with the Waiver, at our request the availability of the revolving loan was reduced from $145.0 million to $120.0 million (subject to borrowing base limits). On August 8, 2006, in accordance with the Third Amendment to the Senior Credit Facility, the Senior Credit Facility was amended again and the availability of the revolving loan was reduced by the imposition of revolving utilization limits which range from $10.8 million to $23.3 million depending on the fiscal quarter.

Guarantees; Collateral. Obligations under the Senior Credit Facility are guaranteed by us and any of our domestic subsidiaries that are not borrowers under the credit facility. Borrowings under the Senior Credit Facility are collateralized by substantially all of our assets.

Restrictions; Covenants. The Senior Credit Facility places various restrictions on Hines Nurseries and its subsidiaries, including, but not limited to, limitations on our ability to incur additional debt, pay dividends or make distributions, sell assets or make investments. The Senior Credit Facility specifically restricts Hines Nurseries and its subsidiaries from making distributions to Hines Horticulture. Distributions to Hines Horticulture are limited to (i) payments covering customary general and administrative expenses, not to exceed $0.5 million in any fiscal year, (ii) payments to discharge any consolidated tax liabilities, (iii) and payments, not to exceed as much as $8.3 million in any fiscal year or $9.3 million over the term of the Senior Credit Facility, to enable Hines Horticulture to repurchase its own outstanding common stock from holders other than our majority shareholder. Dividends to Hines Horticulture are disallowed under the Senior Credit Facility.

The Senior Credit Facility requires Hines Nurseries and its subsidiaries to meet specific covenants and financial ratios, including a minimum fixed charge coverage test, a maximum leverage test and a maximum capital expenditure test. The Senior Credit Facility contains customary representations and warranties and customary events of default and other covenants. As of September 30, 2006, we were in compliance with our covenants.

The covenants under the Senior Credit Facility may affect our ability to operate our business, may limit our ability to take advantage of business opportunities as they arise and may adversely affect the conduct of our current business. A breach of a covenant in our debt instruments could cause acceleration of a significant portion of our outstanding indebtedness. In the event we breach the covenants in our debt instruments and we are unable to obtain waivers in connection therewith, we may not be able to obtain alternative financing for our debt on reasonable terms or otherwise. In that event, in order to pay the principal of our debt, we would be required to sell our equity securities, sell our assets or take other actions. The foregoing actions may not enable us to pay the principal of our debt.

First Amendment To Senior Credit Facility. Effective June 30, 2005, Hines Nurseries negotiated and entered into the First Amendment to the Senior Credit Facility. The First Amendment amended the Senior Credit Facility to require that the proceeds from the Miami Property Sale be used to pay down the term loan. In accordance with the First Amendment, we repaid the term loan in its entirety on November 8, 2005 with the completion of the Miami Property Sale. The First Amendment also amended the calculation of the fixed charge coverage ratio and the leverage ratio to allow as an addition to Earnings Before Interest, Taxes, Depreciation and Amortization (“EBITDA”) certain adjustments related to work force reductions and requires Hines to meet less restrictive minimum fixed charge coverage ratios for the last fiscal quarter of 2005, for each fiscal quarter of 2006 and for the first fiscal quarter of 2007 and maximum leverage ratios for the last fiscal quarter of 2005, for each fiscal quarter of 2006 and the first and second fiscal quarters of 2007.

Second Amendment To Senior Credit Facility. In February 2006, Hines Nurseries entered into Second Amendment to the Senior Credit Facility. The Second Amendment amends the calculation of the minimum fixed charge coverage ratio for the first quarter of 2006 and thereafter. The Second Amendment also eliminates the maximum leverage ratio.

Third Amendment To Senior Credit Facility. In August 2006, Hines Nurseries negotiated and entered into the Third Amendment to the Senior Credit Facility. The Third Amendment waived the requirement that we comply with the minimum fixed charge coverage ratio covenant for the periods ended June 30, 2006 and September 30, 2006. The Third Amendment also instituted maximum revolving utilization restrictions under the credit facility which, subject to applicable borrowing base calculations, limit the Company’s borrowings to limits which range from $10.8 million to $23.3 million depending on the fiscal quarter. It also increased the interest rate spread by 25 basis points on outstanding prime and London Interbank Offered Rate (“LIBOR”) borrowings, increased unused line fees and established new fixed charge covenant ratios beginning in the fourth quarter of 2006. In addition, the Third Amendment requires us to sell ours four color nursery facilities in the Northeast and certain assets in Miami, Florida by no later than December 31, 2006. The sales of these assets are required to generate a predetermined amount of aggregate proceeds.
 
Critical Accounting Policies
 
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. We believe that the following areas represent our most critical accounting policies related to actual results that may vary from those estimates.
 
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Revenue Recognition.
 
We record revenue, net of sales discounts and allowances, when all of the following have occurred: an agreement of sale exists, product delivery and acceptance has occurred and collection is reasonably assured.

Sales with pay by scan arrangements are recognized when the products are sold by the retailers.
 
Sales Returns and Allowances.
 
Amounts accrued for sales returns and allowances are maintained at a level believed adequate by management to absorb probable losses in the trade receivables due to sales discounts and allowances. The provision rate is established by management using the following criteria: past sales returns experience, current economic conditions and other relevant factors. The rate is re-evaluated on a quarterly basis. Provisions for sales discounts and allowances charged against income increase the allowance. We record revenue, net of sales discounts and allowances, when the risk of ownership is transferred to the customer. Allowances are provided at the time revenue is recognized in accordance with SFAS No. 48, “Revenue Recognition When Right of Return Exists.”
 
Allowance for Doubtful Accounts.
 
The allowance for bad debts is maintained at a level believed by management to adequately reflect the probable losses in the trade receivable due to customer defaults, insolvencies or bankruptcies. The provision is established by management using the following criteria: customer credit history, customer current credit rating and other relevant factors. The provision is re-evaluated on a quarterly basis. Provisions to bad debt expense charged against income increase the allowance. All recoveries on trade receivables previously charged off are credited to the accounts receivable recovery account charged against income, while direct charge-offs of trade receivables are deducted from the allowance.

Impairment of Long-Lived Assets.
 
In accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” long-lived assets and intangible assets with determinate lives are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. We evaluate potential impairment by comparing the carrying amount of the asset with the estimated undiscounted future cash flows associated with the use of the asset and its eventual disposition.
 
Accounting for Goodwill Impairment.
 
On January 1, 2002, we adopted SFAS No. 142, “Goodwill and Other Intangible Assets.” In accordance with this standard, goodwill has been classified as indefinite-lived assets no longer subject to amortization. Indefinite-lived assets are subject to impairment testing upon adoption of SFAS No. 142 and at least annually thereafter. In accordance with SFAS No. 142, this involves a two step process. First, we must determine if the carrying amount of equity exceeds the fair value based upon the quoted market price of our common stock. If we determine that goodwill may be impaired, we compare the “implied fair value” of the goodwill, as defined by SFAS No. 142, to its carrying amount to determine the impairment loss, if any.
 
Accrued Liabilities.
 
The accrued liabilities include amounts accrued for expected claims costs relating to our insurance programs for workers’ compensation and auto liabilities. We have large deductibles for these lines of insurance, which means we must pay the portion of each claim that falls below the deductible amount. Our expected claims costs are based on an actuarial analysis that considers our current payroll and automobile profile, recent claims history, insurance industry loss development factors and the deductible amounts. We accrue our expected claims costs for each year on a ratable monthly basis with a corresponding charge against income. Management reviews the adequacy of the accruals at the end of each quarter. The accruals for the expected costs relating to our insurance programs for workers compensation and auto liability are maintained at levels believed by our management to adequately reflect our probable claims obligations.
 
New Accounting Standards.

In June 2006, the Financial Accounting Standards Board (“FASB”) issued FIN 48, “Accounting for Uncertainty in Income Taxes - an Interpretation of FASB Statement No. 109.” FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with SFAS No. 109, “Accounting for Income Taxes.” FIN 48 is effective for all uncertainty in income taxes recognized in financial statement in fiscal years beginning after December 15, 2006. We are evaluating the effect of the adoption of FIN 48 may have on our consolidated financial position, results of operations and cash flows.

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In November 2004, the FASB issued SFAS No. 151, “Inventory Costs,” which clarifies the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material. We adopted SFAS No. 151 on January 1, 2006. The adoption of SFAS No. 151 did not have a material impact on our consolidated financial position, results of operations or cash flows.

In December 2004, the FASB issued SFAS No. 153, “Exchange of Non Monetary Assets - an amendment of APB Opinion No. 29,” which requires non monetary asset exchanges to be accounted for at fair value. We were required to adopt the provisions of SFAS No. 153 for non monetary exchanges occurring in fiscal periods beginning after June 15, 2005. We adopted SFAS No. 153 on January 1, 2006. The adoption of SFAS No. 153 did not have an impact on our consolidated financial position, results of operations or cash flows.

In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections - a replacement of APB Opinon No. 20 and FASB Statement No. 3.” SFAS No. 154 changes the requirements for the accounting for and reporting of a change in an accounting principle. This statement applies to all voluntary changes in an accounting principle. It also applies to changes required by an accounting pronouncement if the pronouncement does not include specific transition provisions. When a pronouncement includes specific transition provisions, those provisions should be followed. APB Opinion No. 20 previously required that most voluntary changes in an accounting principle be recognized by including in net income of the period of the change the cumulative effect of changing to the new accounting principle. SFAS No. 154 requires retrospective application to prior periods’ financial statements of changes in an accounting principle. We adopted SFAS No. 154 on January 1, 2006. The adoption of SFAS No. 154 did not have an impact on our consolidated financial position, results of operations or cash flows.

In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments - an amendment of FASB Statements No. 133 and 140.” SFAS No. 155 simplifies the accounting for certain hybrid financial instruments that contain an embedded derivative that otherwise would have required bifurcation. SFAS No. 155 also eliminates the interim guidance in SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” which provides that beneficial interest in securitized financial assets is not subject to the provisions of SFAS No. 133. SFAS No. 155 is effective for all financial instruments acquired or issued in fiscal years beginning after September 15, 2006. We do not believe that the adoption of SFAS No. 155 will have a material impact on its consolidated financial position, results of operations or cash flows.

In June 2006, the FASB ratified Emerging Issues Task Force Issue No. 06-3, “How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (That Is, Gross versus Net Presentation)” (“EITF 06-3”). The scope of EITF 06-3 includes any tax assessed by a governmental authority that is directly imposed on a revenue-producing transaction between a seller and a customer. This issue provides that a company may adopt a policy of presenting taxes either gross within revenue or net. If taxes subject to this issue are significant, a company is required to disclose its accounting policy for presenting taxes and the amount of such taxes that are recognized on a gross basis. We do not believe the adoption of EITF 06-3 will have a material impact on our consolidated financial statements.
 
In September 2006, the Securities and Exchange Commission (the “SEC”) issued Staff Accounting Bulletin (“SAB”) 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (“SAB 108”). SAB 108 provides guidance on the consideration of the effects of prior year misstatements in quantifying current year misstatements for the purpose of determining whether the current year’s financial statements are materially misstated. SAB 108 is effective for fiscal years ending after November 15, 2006. We do not expect SAB 108 to have a material impact on our consolidated financial statements.

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements.” This standard defines fair value, establishes a framework for measuring fair value in accounting principles generally accepted in the United States of America, and expands disclosure about fair value measurements. This pronouncement applies to other accounting standards that require or permit fair value measurements. Accordingly, this statement does not require any new fair value measurement. This statement is effective for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. We are currently evaluating the requirements of SFAS No. 157 and the impact that the adoption of this statement will have on our consolidated financial statements.

Effective the beginning of the first quarter of fiscal year 2006, we adopted the provisions of SFAS No. 123(R), “Share-Based Payment,” using the modified prospective transition method. Under this method, prior periods are not restated. The provisions of SFAS 123(R) apply to new stock options and stock options outstanding, but not yet vested, on the effective date. As of December 31, 2005, all outstanding options were fully vested.


31



Effects of Inflation
 
Management believes our results of operations have not been materially impacted by inflation over the past three years.
 
Item 4. Controls and Procedures
 
As discussed in Part II, Item 9A “Controls and Procedures” of our 2006 Annual Report on Form 10-K, filed on July 10, 2007, we identified the following material weaknesses in our internal control over financial reporting:

  We did not have adequate policies and procedures and adequate review and oversight relating to the recording of inventory. For example, there was no policy or mechanism in place to identify abnormal scrap using statistical metrics, and there was no appropriate process in place to analyze the net realizable value of inventory. This lead to adjustments recorded in the restatement of the consolidated financial statements for the quarter ended September 30, 2006. In addition, there was no process in place to appropriately review and approve significant changes to our inventory costing methodology, resulting in errors which began in fiscal 2004 and continued into 2005 and the first three quarters of 2006. These deficiencies represent a material weakness in internal control over financial reporting because they did or could lead to material misstatements in our consolidated financial statements.
 
  We did not perform sufficient analysis and review of significant estimates and accounts, and certain journal entries were recorded without an appropriate level of documentation and support. For example, certain transactions were not appropriately analyzed, including the sale-leaseback transactions for the disposition of our Miami facility in 2005 and the disposition of our Vacaville property in 2006, nor did we properly analyze the recoverability of our assets associated with our South Carolina facility. These matters represent a material weakness in internal control over financial reporting because they could result in material misstatements to interim and annual consolidated financial statements that were not properly prevented or detected by our internal control. All identified errors related to this material weakness have been corrected in connection with the restatement of the consolidated financial statements for the applicable periods.
 
  We had information technology general control deficiencies that in the aggregate were deemed to represent a material weakness in the control environment and were the result of a lack of communication and enforcement of control consciousness. These deficiencies in the aggregate represented more than a remote likelihood that a material misstatement of our interim or annual financial statements would not have been prevented or detected. These deficiencies included deficiencies related to logical and physical access requests, configuration changes, updates of control documentation and data backup and storage.
 
We have taken, or are in the process of taking, a number of corrective actions with respect to the material weaknesses in our internal control over financial reporting identified above. These actions include improving the documentation and review of our inventory accounting policies and procedures and the communication of such policies and procedures within our organization. In this regard, we have implemented policies and procedures to analyze scrap by facility on a quarterly basis using statistical metrics, and determine the net realizable value of inventory by facility on a quarterly basis. We have also implemented additional policies and procedures to analyze and approve all changes to our inventory costing methodology.
 
With regard to the analysis and review of significant estimates and accounts, we have established a formal process to identify key estimates and accounts and have assigned additional levels of analysis and review with respect to such key estimates and accounts. We have also established a formal process regarding the review and analysis of significant transactions. In addition, we are designing and implementing procedures for increased documentation and additional levels of review regarding journal entries.
 
In addition, a senior information technology manager has been assigned to lead the review of all information technology internal controls and a remediation plan has been put into place beginning in March 2007. It includes establishing controls related to logical and physical access requests, configuration changes, updates of control documentation and data backup and storage.

32

 
In addition to the remediation actions outlined above, we have taken steps to hire additional personnel with appropriate backgrounds in accounting to enhance our existing capabilities and we have taken steps to enhance the training and education provided to our finance and accounting personnel, including newly hired employees. We have also engaged outside consultants to advise us in connection with the design, implementation, documentation and testing of our internal controls over financial reporting.
 
In light of the above-referenced information, our management, under the supervision and with the participation of our principal executive officer and principal financial officer, re-evaluated the assessment of the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended) as of the end of the period covered by this report. Based upon that evaluation, our principal executive officer and principal financial officer concluded that, solely as a result of the material weaknesses referenced above, our disclosure controls and procedures were not effective as of the end of the fiscal quarter ended September 30, 2006.

There was no change in our internal control over financial reporting that occurred during the fiscal quarter covered by this report that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II. OTHER INFORMATION

Item 1.   Legal Proceedings

On July 18, 2006, Mr. Jean-Paul filed an action against us and other defendants in the Eleventh Judicial Circuit, Dade County, Florida, alleging negligence in connection with an automobile accident involving one of our trailers and a third-party carrier.  The claim is scheduled for trial in August 2007.  We are defended in these actions by our insurance carrier, and are fully insured with respect to this matter, beyond a deductible.  Because this suit is in the initial phases of discovery, the potential loss associated with this claim is not probable or estimable and no loss accrual beyond our deductible has been recorded.

From time to time, the Company is involved in various disputes and litigation matters, which arise in the ordinary course of business.  The litigation process is inherently uncertain and it is possible that the resolution of these disputes and lawsuits may adversely affect the Company’s financial position.  Management believes, however, that the ultimate resolution of such matters will not have a material adverse impact on the Company’s consolidated financial position, results of operations or cash flows.
 
Item 6. Exhibits
 
See index to Exhibits at page 35 for a list of exhibits included herewith.

33



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.

 
 
 
 
HINES HORTICULTURE, INC.
(Registrant)
 
 
 
 
 
 
 
By:  
/s/ CLAUDIA M. PIEROPAN                                           
 
Claudia M. Pieropan
Chief Financial Officer,
Secretary and Treasurer
(Principal financial officer
and duly authorized officer)

Date: July 10, 2007

34

 
HINES HORTICULTURE, INC.
QUARTERLY REPORT ON FORM 10-Q
FOR THE FISCAL QUARTER ENDED SEPTEMBER 30, 2006

INDEX TO EXHIBITS 
 

Exhibit No.
Description
   
31.1
Certification of Chief Executive Officer Pursuant To Rules 13a-14(a) and 15d-14(a) under the Securities Exchange Act of 1934, as amended. (+)
 
 
31.2
Certification of Chief Financial Officer Pursuant To Rules 13a-14(a) and 15d-14(a) under the Securities Exchange Act of 1934, as amended. (+)