-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, T2wlm5/uKVS2YrQJhc+SQnHHBtLC12VDPpKO3KvORj/VlU6Rh5jOMT3iHnEtUM54 NPj19fRp0dA+tIRzAoEbtA== 0001019056-07-000288.txt : 20070323 0001019056-07-000288.hdr.sgml : 20070323 20070323172814 ACCESSION NUMBER: 0001019056-07-000288 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 9 CONFORMED PERIOD OF REPORT: 20061231 FILED AS OF DATE: 20070323 DATE AS OF CHANGE: 20070323 FILER: COMPANY DATA: COMPANY CONFORMED NAME: MONTEREY GOURMET FOODS CENTRAL INDEX KEY: 0000913032 STANDARD INDUSTRIAL CLASSIFICATION: MISCELLANEOUS FOOD PREPARATIONS & KINDRED PRODUCTS [2090] IRS NUMBER: 770227341 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: 1934 Act SEC FILE NUMBER: 001-11777 FILM NUMBER: 07716139 BUSINESS ADDRESS: STREET 1: 1528 MOFFETT ST STREET 2: STE 500 CITY: SALINAS STATE: CA ZIP: 93905 BUSINESS PHONE: 4087536262 MAIL ADDRESS: STREET 1: 1528 MOFFETT ST STREET 2: SUITE 500 CITY: SALINAS STATE: CA ZIP: 93905 FORMER COMPANY: FORMER CONFORMED NAME: MONTEREY PASTA CO DATE OF NAME CHANGE: 19931005 10-K 1 monterey_10k06.txt FORM 10-K UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON DC 20549 FORM 10-K (Mark one) - ---------- [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 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 001-11777 MONTEREY GOURMET FOODS, INC. (Exact name of registrant as specified in its charter) Delaware 77-0227341 ------------------------ ------------------------------------ (State of incorporation) (IRS employer identification number) 1528 Moffett Street , Salinas, California 93905 ----------------------------------------- ---------- (Address of Principal Executive Offices) (Zip Code) (831) 753-6262 - ---------------------------------------------------- ----------------------- (Registrant's telephone number, including area code) - ---------------------------------------------------- ----------------------- Securities registered pursuant to Section 12(b) of the Act: Title of each class Name of each exchange on which registered Common Stock, $.001 par value NASDAQ Stock Market, LLC Securities registered pursuant to Section 12(g) of the Act: Common Stock, $.001 par value ----------------------------- Title of each class ------------------- Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes [ ] No [X] Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act. Yes [ ] No [X] Indicate by a 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 [X] No [ ] Indicate by a check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (ss.229.405 of this chapter) is not contained herein and will not be contained, to the best of the Registrant's knowledge, in definitive proxy or information statements incorporated by reference in PART III of this Form 10-K, or any amendment to this Form 10-K. [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 a check mark whether the Registrant is a shell company (as defined in Exchange Act Rule 12b-2). Yes [ ] No [X] The approximate aggregate market value of the voting and non-voting common equity held by non-affiliates of the issuer as of June 30, 2006 was $37,346,000. The number of shares outstanding of the issuer's common stock as of March 21, 2007 was 17,323,025.
TABLE OF CONTENTS - ---------------------------------------------------------------------------------------------------------------- PART I. Page - ---------------------------------------------------------------------------------------------------------------- Item 1. Business 3 - ---------------------------------------------------------------------------------------------------------------- Item 1A. Risk Factors 9 - ---------------------------------------------------------------------------------------------------------------- Item 1B. Unresolved Staff Comments 12 - ---------------------------------------------------------------------------------------------------------------- Item 2. Properties 12 - ---------------------------------------------------------------------------------------------------------------- Item 3. Legal Proceedings 12 - ---------------------------------------------------------------------------------------------------------------- Item 4. Submission of Matters to a Vote of Securities Holders 12 - ---------------------------------------------------------------------------------------------------------------- - ---------------------------------------------------------------------------------------------------------------- PART II. - ---------------------------------------------------------------------------------------------------------------- Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer 12 Purchases of Equity Securities - ---------------------------------------------------------------------------------------------------------------- Item 6. Selected Financial Data 14 - ---------------------------------------------------------------------------------------------------------------- Item 7. Management's Discussion and Analysis of Financial Condition and Results of 15 Operations - ---------------------------------------------------------------------------------------------------------------- Item 7A. Quantitative and Qualitative Disclosures about Market Risk 26 - ---------------------------------------------------------------------------------------------------------------- Item 8. Financial Statements and Supplementary Data 27 - ---------------------------------------------------------------------------------------------------------------- Item 9. Changes In and Disagreements with Accountants on Accounting and Financial 27 Disclosure - ---------------------------------------------------------------------------------------------------------------- Item 9A. Controls and Procedures 27 - ---------------------------------------------------------------------------------------------------------------- Item 9B. Other Information 28 - ---------------------------------------------------------------------------------------------------------------- - ---------------------------------------------------------------------------------------------------------------- PART III. - ---------------------------------------------------------------------------------------------------------------- Item 10. Directors and Executive Officers of the Registrant 28 - ---------------------------------------------------------------------------------------------------------------- Item 11. Executive Compensation 30 - ---------------------------------------------------------------------------------------------------------------- Item 12. Security Ownership of Certain Beneficial Owners and Management and Related 37 Stockholder Matters - ---------------------------------------------------------------------------------------------------------------- Item 13. Certain Relationships and Related Transactions 39 - ---------------------------------------------------------------------------------------------------------------- Item 14. Principal Accountant Fees and Services 39 - ---------------------------------------------------------------------------------------------------------------- - ---------------------------------------------------------------------------------------------------------------- PART IV. - ---------------------------------------------------------------------------------------------------------------- Item 15. Exhibits, Financial Statement Schedules 40 - ---------------------------------------------------------------------------------------------------------------- - ---------------------------------------------------------------------------------------------------------------- REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM 41 - ---------------------------------------------------------------------------------------------------------------- - ---------------------------------------------------------------------------------------------------------------- SIGNATURES 71 - ---------------------------------------------------------------------------------------------------------------- - ---------------------------------------------------------------------------------------------------------------- EXHIBIT 23.1 74 - ---------------------------------------------------------------------------------------------------------------- EXHIBIT 31.1 75 - ---------------------------------------------------------------------------------------------------------------- EXHIBIT 31.2 76 - ---------------------------------------------------------------------------------------------------------------- EXHIBIT 32.1 77 - ---------------------------------------------------------------------------------------------------------------- EXHIBIT 32.2 78 - ---------------------------------------------------------------------------------------------------------------- - ---------------------------------------------------------------------------------------------------------------- - ----------------------------------------------------------------------------------------------------------------
2 PART I ITEM 1. BUSINESS Information Concerning Forward-Looking Statements Certain of the statements contained in this report (other than the historical financial data and other statements of historical fact), including, without limitation, statements as to management's expectations and beliefs, are forward-looking statements. Forward-looking statements are made based upon management's good faith expectations and beliefs concerning future developments and their potential effect upon the Company. There can be no assurance that future developments will be in accordance with such expectations or that the effect of future developments on the Company will be those anticipated by management. Forward-looking statements can be identified by the use of words such as "believe," "expect," "plans," "strategy," "prospects," "estimate," "project," "anticipate," "intends" and other words of similar meaning in connection with a discussion of future operating results or financial performance. This Report on Form 10-K includes important information as to risk factors in "Item 1. Business", "Item 1A. Risk Factors", and "Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations." Many important factors could cause actual results to differ materially from management's expectations, including: o Weather could impact the price of raw materials the Company purchases. o The extent to which the Company can reduce costs according to its cost reduction initiatives. o Unpredictable difficulties or delays in the development of new products or the Company's ability to forecast consumer trends. o Changes in U.S. economic conditions such as inflation, or interest rate fluctuations. o Pricing changes of raw materials, freight, or impacts for competitive pricing. o Inherent risks of food production. o Labor relations. o Integration of acquired businesses. o Difficulties in obtaining or retaining the management and other human resource competencies that the Company needs to achieve its business objectives. o The impact on the Company from the loss of a significant customer or a few customers. o Changes in the regulatory environment. o Capital spending requirements. o Adoption of new accounting pronouncements promulgated by the Financial Accounting Standards Board or other accounting standard setting agencies such as the Public Company Accounting Oversight Board. Introduction Monterey Gourmet Foods, Inc. ("the Company") began its business in 1989 as a producer and distributor of refrigerated gourmet pasta and sauces to restaurants and grocery stores in the Monterey, California area. The Company has since expanded its operations to include a more diversified range of gourmet refrigerated food products, which it provides to grocery and club stores throughout the United States, as well as selected regions in Canada, the Caribbean, Latin America, and Asia Pacific. The Company's overall strategy is to enhance the value of the Monterey Gourmet Foods brands by distributing its gourmet food products through multiple channels of distribution, while selectively participating in private label partnerships. The Company currently produces and/or markets premium quality refrigerated gourmet pastas, gnocchi, pasta sauces, prepared entrees, salsas, tamales, dips, hummus, polenta, cheeses, spreadable cheeses, and gourmet sausages, emphasizing superior flavors and innovative products. The Company seeks to build brand recognition and customer loyalty by employing a marketing program that focuses on developing multiple points of sale for the Company's products, and increasing consumer awareness of the Company's offerings primarily through in-store sampling and advertising and cooperative advertising with its customers. The Company markets and sells its products primarily through grocery and club stores with limited distribution to a select few foodservice accounts. The Company offers seven core brands in ten key categories over 250 varieties of contemporary gourmet food products that are produced using the Company's proprietary recipes. In 2006, the Company continued to expand its line and distribution of whole wheat pasta. The Company entered the frozen category with its "OneStep Gourmet" product which offers consumers a complete meal in less than 13 minutes. It also introduced several Hispanic products including two flavors of premium tamales. On September 5, 2006, the Board of Directors of the Company appointed Eric Eddings as President and Chief Executive Officer of Monterey Gourmet Foods following the resignation of James M. Williams effective September 5, 2006. Mr. 3 Eddings has been the President of the Natural Foods Division of Monterey Gourmet Foods; previously Mr. Eddings was the Chief Operating Officer and minority shareholder of CIBO Naturals, LLC which he and his associates purchased in June 2002. CIBO Naturals was acquired by Monterey Gourmet Foods in January 2004 and later became part of the Natural Foods Division of Monterey Gourmet Foods. Prior to his employment with CIBO Naturals, Mr. Eddings was the Vice President Wholesale/Plant operations of Tully's Coffee Corporation in Seattle, Washington. Mr. Eddings has also previously worked for Dreyers Grand Ice Cream, Haagen - Dazs Company and Frito Lay, Inc. Mr. Eddings has a Masters of Business Administration degree from the University of Redlands and a Bachelors of Arts degree in Business Administration from California State University at Fullerton. On January 12, 2006, Monterey Gourmet Foods, Inc. ("Monterey"), Suekat LLC ("Suekat") and CIBO Naturals, LLC ("CIBO"), amended their previous agreement for the purchase and sale of limited liability company units, as a result of which Monterey acquired the remaining 15.5% of CIBO from Suekat in exchange for 300,000 unregistered shares of Monterey common stock with a market value of $1.2 million. CIBO Naturals LLC ("CIBO"), a leading manufacturer of premium sauces and spreads located in Seattle, Washington, produces a variety of refrigerated gourmet sauces and spreads including fresh pesto sauces, flavored cheeses, bruschetta toppings and tapenade spreads. Their products are sold nationally through club stores, supermarket delis and specialty food stores. The CIBO acquisition continues to meet the Company's strategy for growth in the premium refrigerated foods category. CIBO, through its "CIBO Naturals" brand, sells unique, high quality products and has developed a strong position in its markets which has great growth potential in both expanded distribution and in new products. The brand has been fully integrated into Monterey Gourmet Foods. On November 3, 2006, Monterey Gourmet Foods, Inc., Casual Gourmet Foods, Inc. ("Casual"), and the shareholders of Casual ("Shareholders") completed the agreement entered into on September 29, 2006 (the "Amendment") to amend the Purchase Agreement dated January 11, 2005, pursuant to which the Company agreed to acquire all of the outstanding shares of Casual. Prior to entry into the Amendment, the Company owned 70% of the outstanding shares of Casual. The Amendment accelerated the Company's purchase of the remaining 30% of Casual's outstanding shares and established a revised purchase price of $23,000. The Company sells a line of refrigerated gourmet chicken sausages under the Casual Gourmet Foods brand. The Company is also utilizing the Casual Gourmet Foods brand to market other refrigerated and frozen products to its customers. On April 7, 2005, the Company purchased 80% of Sonoma Foods, Inc. ("Sonoma") outstanding shares. Sonoma markets a variety of refrigerated branded specialty cheese items, including their flagship products, Sonoma Jack Cheeses in a variety of flavors. Sonoma's products are sold in retail supermarkets, club stores, and specialty food stores across the US with the greatest penetration in the Western US markets. Some of the most popular cheese flavors include Hot Pepper Jack Cheese, Garlic Jack Cheese, Mediterranean Jack Cheese and Pesto Jack Cheese. Sonoma maintains its headquarters in Sonoma, CA. The Company's web site, www.montereygourmetfoods.com, supports its brands by providing both consumer and investor information. The site provides insight into the Company's profile, product offerings, and financial strength, as well as consumer tips for those interested in gourmet food and links to its recently acquired brands. The success of the Company's sales efforts will depend in large part on four key factors: (1) whether grocery and club store chains will continue to increase the number of their stores offering the Company's products, (2) whether the Company can continue to increase the number of grocery and club store chains offering its products, (3) whether the Company continues to introduce new products that meet consumer acceptance and (4) whether the Company can continue to diversify into other complementary businesses and leverage its strengths to continue to grow revenues and profits at levels attractive to its investors. Grocery and club store chains continually re-evaluate the products carried in their stores, and no assurances can be given that the chains currently offering the Company's products will continue to do so in the future. Monterey Gourmet Foods was originally incorporated in California in June 1989 and was reincorporated in Delaware in August 1996. The Company's executive offices and principal facilities are located at 1528 Moffett Street, Salinas, California 93905. The Company's telephone number is (831) 753-6262. Investors and other interested parties can obtain copies of the Company's periodic reports and proxy material from the Company's website free of charge, as well as from the SEC's website at www.sec.gov. Industry Overview The Company believes that the U.S. retail market for refrigerated specialty foods is fragmented and growing with a number of national, regional and local competitors. The Company believes that it can be successful in this market by offering high quality, upscale products with superior flavor profiles. The Company also believes that it can leverage its existing presence in club stores and retail grocery chain stores to gain distribution of its other gourmet food products. 4 The organic food business has been growing at a double-digit rate since the 1960s and has reached over $13 billion in retail sales, according to Organic Trade Associations 2006 Manufacturing Survey. New Federal standards, under the auspices of the United States Department of Agriculture ("USDA"), were adopted for the industry in October 2002. The purpose of the new standards was to provide a framework for organic content of product with the use of the USDA seal for those products meeting the "organic" definition (95% organic content), and set standards for product quality and food safety so as to improve the overall strength of the organic foods industry and protect the consumer. Emerald Valley Kitchen and other credible producers who meet the standards to be labeled "USDA organic" are in an excellent position to participate in the future growth of the industry. Currently all Emerald Valley products qualify for the USDA designation. The Company's future organic offerings will be produced and formulated with the objective of qualifying for the USDA designation. The California Milk Advisory Board stated that Americans consumed 9.3 billion pounds of cheese in 2005. Cheese consumption has increased from 11.1 pounds per person in 1987 to 31.4 pounds in 2005. The specialty cheese category in which the Company competes has grown from 420 million pounds consumed in 1994 to 930 million pounds in 2005. Specialty cheeses represent almost 10% of all cheese consumed in the United States. The Company believes this is a growing category and that Sonoma Cheese is well positioned to grow with this category and also expand market share. Starting in 2005, consumers have increased consumption of refrigerated pasta products following two years of decline due to in-part to low-carbohydrate diets. The refrigerated pasta category continued to grow in 2006 because of the gourmet quality of these products and their quick preparation. Monterey Gourmet Foods believes its products are well positioned to take advantage of the growing trend to more gourmet food products. No assurance can be given that the market for refrigerated gourmet food products will expand further and that space will be made available at the store level to house refrigerated products. Nor can there be any assurance that current trends in healthy gourmet eating or consumer demand for quick meal solutions, or consumer spending levels in the specialty food category will continue in the future. Additionally, as the Company expands into different geographic regions and new product categories, it may encounter different consumer perceptions, diet trends, attitudes, behavior and competition. This may adversely impact the Company's expansion strategy and cause it to incur greater expenses than anticipated in the promotion of its products. Strategy Monterey Gourmet Foods' overall objective is to become a leading national marketer of refrigerated gourmet food products through distribution of its products to grocery and club stores and through key acquisitions. The principal elements of the Company's strategy include the following: o Expand the Company's market share through same-store revenue growth, addition of new grocery and club stores, geographic and product line diversification, including creation of additional meal solutions using Monterey Gourmet Foods products. o Introduce new products on a timely basis to maintain customer interest and to respond to changing consumer tastes. In order to maximize its margins, the Company will focus most of its efforts on those new products that can be manufactured and distributed out of its Salinas, California, Eugene, Oregon or Seattle, Washington facilities, and may supplement this effort by selected co-packing arrangements that compliment its existing product lines. o Reduce operating costs as a percentage of sales through continual evaluation of administrative and production staffing and procedures. The Company will consider additional capital improvements at its manufacturing facilities in order to increase production efficiencies and capacities, and to reduce the Company's cost of goods on a per unit basis. The Company continues to rationalize its production capabilities and may consolidate facilities as management deems necessary. o Create brand awareness by communicating to the consumer that Monterey Gourmet Foods and its sister brands provide a healthy and nutritious line of products, and therefore, promote repeat business by reinforcing positive experiences with the Company's products. o Utilize the current national sales force of the Company to expand distribution and sales of the newly acquired brands without adding additional sales overhead. o Consider the acquisition of other compatible companies or product lines to expand distribution, or the range of product offerings, or to accomplish other synergies where the acquisition is expected to create long-term stockholder value, and be accretive to earnings in the first year. 5 The Company will continue to direct its advertising and promotional activities to specific programs customized to suit its grocery and club store accounts as well as to reach target consumers. These will include in-store demonstrations, coupon programs, temporary price reduction promotions, cross promoting of products, and other related activities. There can be no assurance that the Company will be able to increase its net revenues from grocery and club stores. Because the Company will continue to make expenditures associated with the expansion of its business, the Company's results of operations may be affected. The success of the Company's acquisition strategy is dependent upon its ability to generate cash from current operations, attract new capital, find suitable acquisition candidates, and successfully integrate new businesses and operations. There is no assurance that acquisitions can be financed from current cash flow, and, if not, that outside sources of capital will be available to supplement internally-generated funds. There is no assurance that management can successfully select suitable acquisition candidates and that these new businesses can be successfully integrated to create long term stockholder value. Products The Company produces and markets a variety of gourmet refrigerated pastas; including borsellini, ravioli, tortelloni, tortellini; pasta sauces; salsas; dips; hummus; Sonoma Jack cheeses, chicken sausages, and polenta under the Monterey Gourmet Foods, Monterey Pasta, Arthur's, CIBO Naturals, Emerald Valley Kitchen, Isabella's Kitchen, Sonoma Cheese, and Casual Gourmet brands, as well as private labels. The Emerald Valley Kitchen brand was acquired as part of the Emerald Valley acquisition in August 2002. The CIBO Naturals brand was acquired as part of the CIBO Naturals LLC acquisition in 2004. The Sonoma Cheese brand was acquired as part of the Sonoma Foods acquisition in 2005. The Casual Gourmet brand was acquired as part of the Casual Gourmet Foods acquisition in 2005. For further information, see "Liquidity, Capital Resources, and Business Acquisitions". The Company is committed to diversifying its offerings with innovative new product line extensions, complementary products, and other gourmet food products. The Company's product development chefs and product development consultants focus on creating new products that innovatively blend complementary tastes, food textures and ingredients while strictly adhering to the Company's emphasis on freshness, healthfulness and quality. The Company will spend its product development resources to meet market and customer demands, utilize current production expertise, and to fill the capacity of the Company's plants. The Company has increased it spending on product development as the Company increases its focus on product quality and product innovation. As new products are introduced, selected items will be discontinued to help ensure that the product line is focused on consumer demand, to maximize the Company's return on its shelf space in grocery and club stores, and to respond to changing trends and consumer preferences. The Company's refrigerated products are packaged predominantly in clear lightweight containers, which reveal the fresh appearance of its products. Monterey Gourmet Foods presents its products with a colorful logo, distinctive graphics, ingredient information and cooking instructions to communicate the gourmet, fresh and healthful qualities of its products. All of the Company's products feature innovative packaging graphics to maximize shelf impact and generate increased consumer interest in the products, with increased emphasis on quickly informing the consumer about the products. The Company will continue to emphasize packaging and presentation to maximize appeal on the shelf. The goal of the Company is to introduce new products on a timely and regular basis, to increase customer interest and to respond to changing consumer tastes. There can be no assurance that the Company's efforts to achieve such goals will result in successful new products or that new products can be developed and introduced on a timely and regular basis. If the Company's new products are not successful, the Company's grocery and club store sales may be adversely affected as customers seek new products. Production The Company currently produces pasta, pasta sauce and tamales in a 43,700 square foot Monterey County, California facility. The Company also leases 87,100 square feet of space three miles from the main production facility. Within this 87,100 square foot facility, the Company has its refrigerated distribution center and ambient storage. In addition, the Company produces organic salsas, dips, and hummus at its 19,000 square foot organically certified facility in Eugene, Oregon, which was integrated into the business as part of the Emerald Valley acquisition. CIBO Naturals LLC operates out of three different facilities comprising of a total of 47,500 square feet in Seattle, WA. The California facilities are strategically located in one of the largest produce-growing regions in the United States and are near several major vendors and food distributors. The California facility is certified by the USDA and utilizes state of the art thermal processing, chilling and packaging processes. Refrigerated pasta is manufactured at the California facilities using high quality ingredients such as Extra Fancy Durham Wheat Flour, whole eggs, fresh and dry herbs and spices, Individually Quick Frozen ("IQF") vegetables, chicken and other proteins, various fresh cheeses, and milk products. The ingredients are mixed in accordance with the Company's proprietary recipes. After filling with fresh and unusual ingredients such as snow crab, spinach, feta cheese, lobster, chicken, and other types of specialty cheeses, the pasta 6 products receive a prescribed thermal process, or pasteurization to insure product safety and to preserve flavor, quality and shelf life. The products are then chilled immediately and packaged in controlled atmosphere trays. Pasta sauces, salsas, dips, and spreadable cheeses are mixed and processed in individual batches in accordance with the Company's proprietary processes and recipes and then directly packed and sealed in plastic containers. The new "quick preparation" baked entrees are baked in new rotary tray ovens. After preparation, processing, chilling and packaging, all pasta, baked entrees, and sauces are kept in cold storage to preserve quality and shelf life. Cheeses and sausages are produced and packaged by outside companies under agreements to protect recipes and provide the quality that the Company requires. The Company's salsas, hummus, dips, and sauces are designed, processed and monitored under strict quality assurance plans in order to insure that the finished products deliver on customer expectations for these products. The Company regularly reviews a variety of potential capital projects for the production department and in the past three years has spent approximately $4.9 million on capital improvements. These included significant upgrades and improvements to the pasta production lines, two packaging lines, capacity for chunky ravioli, clean rooms, increased sauce capacity and efficiency, and boiler and utility upgrades to accommodate capacity increases. Capital resources were used to improve borsellini pasta production capability, increase tamale production capacity, and combine the two Salinas production facilities. In 2006, the Company increased capacity on its tamale production line, consolidated the two manufacturing plants in Salinas, added new pasta packaging equipment, added new cup filling equipment in Eugene, OR and Seattle, WA, and increased capacity in the Seattle facility to manufacture cooked/chilled sauces. Future additions of assets will be evaluated for increased efficiency, flexibility and capacity needs. Raw Materials The Company purchases its raw materials from vendors throughout the United States and the world, although the majority of its raw materials come from domestic sources. All raw material purchases are transacted in U.S. dollars. Vendor selection is based on ability to meet specifications and pricing. Because the ingredients are agricultural products, the Company uses a combination of contracts which are for one year or less in duration, as well as open market purchases to minimize the pricing risks and uncertainty of supply. The most significant ingredients used are dairy-based ingredients, eggs, flour, cooked seafood, cooked chicken and other meats, spinach, basil, tomatoes, and spices. Management is unaware of any current restrictions or other factors that would have a material adverse effect on the availability of these raw materials. The Company's purchasing policies are designed to provide more than one credible source for all ingredients. Distribution The Company's success depends upon an effective system of distribution for its products. The Company delivers products directly to warehouses for several Northern California chains. Sonoma Cheese delivers certain cheese products to local wineries on Company trucks and these deliveries arrive the same day they leave our warehouse. The Company distributes its products to other customers and other parts of the country using common carriers. While common carrier method of delivery has been reliable, there can be no assurance that the Company's delivery system will not be disrupted for reasons including, but not limited to, adverse weather, natural disasters, increasing fuel oil, or labor disputes in the trucking industry. During 2004, 2005, and 2006 fuel costs increased compared to previous years, which impacted the Company's operating margins. Grocery Chain and Club Store Sales Monterey Gourmet Foods sells its products to supermarket chains and club stores. The Company has two customers that represent more than ten percent of net revenues. Combined these two customers represent over 60% of the Company's revenues for the past three years. Net revenues are detailed as follows: Years Ended ------------------------------------------ 2006 2005 2004 ------------------------------------------ Costco 48% 45% 36% Sam's Club Stores 17% 17% 24% All other customers 35% 38% 40% ------------------------------------------ Total 100% 100% 100% ========================================== 7 The increase in the percent of sales to Costco comes from additional sales to Costco from the recently acquired companies and the increase in the number of items being sold to Costco. The Company currently sells its products to eight separate US Costco regions, Mexico, and Canada which make purchasing decisions independently of one another. These regions re-evaluate, on a regular basis, the products carried in their stores. There can be no assurance that these Costco regions will continue to offer Monterey Gourmet Foods products in the future or continue to allocate Monterey Gourmet the same amount of shelf space. The Company currently supplies its products to Sam's Club stores where the purchasing decisions are made at the company headquarters with input from the store level. During the 4th quarter of 2004 Sam's Club implemented an item reduction program which reduced the number of items that the Company sells to Sam's Club and correspondingly has reduced the amount of shelf space for the Company's products. During 2005, the Company spent significant resources increasing sales to Sam's Club. While the Company is in the ninth year of its relationship with Sam's Club, there can be no assurance that Sam's Club stores will continue to carry its products. The loss of either Costco or Sam's Club as customers could materially and adversely affect the Company's business operations. During 2006, 2005 and 2004 net revenues to foreign customers represented 1.4%, 2.2% and 3.4% of total net revenues, with Canada and Mexico accounting for over 90% of those sales, and the remainder going to Asia Pacific. Marketing The Company's marketing strategy is to create and sell innovative premium quality products in the categories in which it competes, to communicate to consumers that Monterey Gourmet Foods provides a gourmet-quality nutritious line of products and to promote repeat business by reinforcing positive experiences with the Company's products. The Company's approach includes the introduction of new products on a timely basis to increase customer interest and to respond to changing consumer tastes. Additionally, the Company will continue to expand its sales into those geographic regions that will best support the purchase of the Company's upscale premium grade products. Competition The Company's business is subject to significant competition. The refrigerated food industry is highly competitive and is dominated by large multinational companies including among others Nestle and Kraft. There are also a number of regional competitors especially in the sauce and cheese product lines. Multinational competitors have significantly more brand name recognition, marketing personnel, and cash resources than the Company. Moreover, competition for shelf space in club and grocery stores is intense and poses great difficulty for smaller food companies. The Company has developed several products which the Company is using to increase market share in the refrigerated sector, including whole wheat pasta, tamales, spreadable cheeses, flavored jack cheese, gourmet sausages and quick preparation gourmet entrees. Management will continue to try to produce distinctive products, which fill specific consumer needs. Competitive factors in the refrigerated food market include brand awareness, product quality and taste, perceived healthfulness, price and availability of grocery and club store shelf space. The Company's prices are higher than most of its competitors' prices on most items due to higher quality ingredients and the overall premium quality of its product line. The Company believes the excellent quality, taste and perceived healthfulness of its products are superior to that of most of its competitors. The Company also believes that the quality of its products and the variety of its product lines provide a competitive advantage over many companies which market more traditional products. Management Information relating to directors and executive officers of the Company is set forth in Part III of this report. Government Regulation The Company is subject to the regulations of the U.S. Food and Drug Administration ("FDA"), USDA, state, local, and organic industry regulations relating to cleanliness, maintenance of food production equipment, food storage, cooking and cooling temperatures, food handling, and organic ingredient content of products, and is subject to unannounced on-site inspections of production facilities. Regulations in new markets, new regulations in existing markets, and future changes in existing regulations may adversely impact the Company by raising the cost of production and delivery of its products and/or by affecting the perceived healthfulness of the Company's products. Effective January 2006, all food products were required to declare the content of "trans fatty acids" on individual labels. The Company has complied with this requirement and has declared that its products contain no trans fatty acids. A failure to comply with one or more regulatory requirements could result in a variety of sanctions, including fines and the withdrawal of the Company's products from store shelves. 8 The Company is not aware of any currently existing facts or circumstances that it is not addressing which would cause it to fail to comply with any of the regulations to which it is currently subject. Seasonality of Revenues During 2006, 24% of the Company's revenues were generated in the first quarter, 25% were generated in the second quarter, 23% in the third quarter and 28% in the fourth quarter. The seasonality of the Company's revenues continues to change as different product lines have different seasonality profiles. In the fourth quarter of 2006, the Company had increased revenues of tamales, dips, and cheese trays which sell well during the holiday season when consumers entertain. Pasta items sell less during the summer and more during winter months. Conversely, chicken sausages have higher revenues during the summer months. Employees As of December 31, 2006, the Company employed a total of 299 persons at all locations, including 57 administrative personnel, 13 sales personnel, 4 drivers, and 225 distribution and production personnel. None of the Company's employees are represented by a labor union and the Company believes its relations with its employees are good. Trademarks and Service Marks The Company or its subsidiaries has registered the "Monterey Pasta Company", "CIBO Naturals", "Sonoma", "Sonoma Jack", "Casual Gourmet", "Borsellini", and "Homestyle Fresh Soups" names and, in the case of Monterey Pasta Company, corresponding logo design with the United States Patent and Trademark Office. The Company is currently in the process of registering "One Step gourmet", "Isabella's Kitchen", "Emerald Valley Kitchen" and "Chef's Finest". There can be no assurance that competitors will not adopt similar names or logo designs outside the protection of the Company's trademark registration. In March of 1999, the Company acquired the right to use the "Arthur's" label with its acquisition of the Frescala Foods, Inc. business. In December 2000, it acquired the right to use the "Nate's" label through its acquisition of the Nate's polenta business. Also the Company acquired the rights to the unregistered trademarks, "La Frescala" as part of acquisitions of businesses. ITEM 1A RISK FACTORS Any of the following factors could materially adversely affect the Company's future operating results. Certain characteristics and dynamics of the Company's business and financial markets generally create risks to the Company's long-term success and to predictable quarterly results. Other factors are included in "Management's Discussion and Analysis of Financial Condition and Results of Operations." These risks include: o Lack of Recent Profitability. The Company reported losses for the years 2005 and 2006 and at December 31, 2006, the Company had an accumulated deficit of $9,550,000. There can be no assurance that the Company will generate profits in the short or long term. o Liquidity; Access to Capital. Management believes that the Company's current cash balances, and future operating projections will provide adequate liquidity to meet the Company's planned capital and operating requirements for normal operations and capital expenditures through the 2007 calendar year. See Note 7 to the consolidated financial statements (Item 15) for a description of the credit facility. The Company generated $7.0 million in cash from operating activities during 2006 and raised $11.6 million through a private equity transaction. There can be no assurance that the Company will continue to generate cash in the future. If the Company's operations do not provide cash sufficient to fund its operations and capital requirements; the Company may be required to seek outside financing and there can be no assurance that the Company will be able to obtain such financing when needed, on acceptable terms, or at all. In addition, any future equity financing or convertible debt financing could cause the Company's stockholders to incur dilution in net tangible book value per share of the Company's Common Stock. o Acquisitions; Potential Impairment of Intangible Assets. The Company has acquired four companies since 2003. The Company as part of its assessment of its intangible assets impaired its intangible investment in Casual Gourmet Foods in the third quarter of 2006 by $3.1 million. There are no guarantees that additional investments may need to be written down in the future. The Company has recorded net intangible assets of $7.1 million and goodwill of $13.2 million as part of the acquisitions. Some of these intangible assets are amortized over a certain amount of time. If these assets become impaired, the assets will be expensed in the periods they become impaired which will impact profitability. o Hiring and Retention of Key Personnel. The success of the Company depends on its ability to retain key executives, and to motivate and retain other key employees and officers. Former CEO James Williams joined the Company in October 2002 and resigned his position in September 2006. Mr. Eric Eddings was named the Company's new CEO effective September 5, 2006. Scott Wheeler, the Company's CFO joined the Company in April 2003. Part of the Company's acquisition strategy is to maintain the current management of each acquired company and motivate them appropriately to help garner synergies and grow 9 their respective brands. The Company's CEO and the management of Casual Gourmet and Sonoma Foods have employment contracts to help ensure the Company's future growth. There can be no assurance that key management will remain stable; significant management turnover could disrupt the Company's operations with consequent adverse effect on the business. o Material Weakness in Internal Controls. The Company's management evaluated the effectiveness of the Company's disclosure controls and procedures pursuant to Rule 13a-15(b) of the Exchange Act as of December 31, 2005. In its form 10-K for 2005, the Company reported a material weakness in internal control and stated that its controls and procedures were not fully effective. During 2006, the Company took steps to improve its internal controls and procedures and management has concluded that as of December 31, 2006, these improvements were effective to eliminate the material weakness. (See Item 9A, which is incorporated here by reference.) If the weaknesses return or other weaknesses are identified, financial statement accuracy may be at risk. o Impact of Inflation. Freight rate increases related to fuel surcharges have impacted the Company's financial performance as it ships and sources raw ingredients from across the country. Medical benefits continued to increase at rates higher than the consumer price index. Increases in labor, employee benefits, freight, ingredients and packaging, rents and other operating expenses have adversely affected the Company's profitability and may continue to impact the Company in future periods. The Company cannot predict whether such increases will occur in the future or their magnitude if they do occur. Also, the Company cannot predict if it can pass these higher costs along to its customers. o Risks Inherent in Food Production. The Company faces all of the risks inherent in the production and distribution of refrigerated food products, including contamination, adulteration, spoilage, and the associated risks of product liability litigation, which may occur even with an isolated event. Although the Company has modern production facilities, and has obtained USDA approval for them, and employs what it believes are the necessary processes and equipment in order to insure food safety, there can be no assurance that the Company's procedures will be adequate to prevent the occurrence of such events. o Dependence on Major Customers. During 2006, two of the Company's customers, Costco and Wal-Mart (including its subsidiary, Sam's Club), accounted for 48% and 17%, respectively, of the Company's total revenues. The Company currently sells its products to eight separate US Costco regions and its international regions which currently make purchasing decisions independently of one another. These regions re-evaluate, on a regular basis, the products carried in their stores. There can be no assurance that these Costco regions will continue to offer the Company's products in the future or continue to allocate Monterey Pasta the same amount of shelf space. There can be no assurance that Sam's Club will continue to carry the Company's products. Loss of either of these customers, Costco or Sam's Club, or a significant reduction in sales to either, would have a material adverse effect on the Company. Additionally, liberalized pricing or allowance terms would create downward pressure on gross margins. o Diversification of Product Line. Over the last four years, the Company has acquired four new subsidiaries. A major reason for the acquisitions is the diversification of the Company's gourmet food product line. Each acquisition brings new product lines, management talents and skills, and customers. There can be no assurance that the acquisition strategy will be profitable in the near or long term. o Changing Consumer Preferences. Consumer preferences change, sometimes quickly, and the success of the Company's food products depends on the Company's ability to identify the tastes and dietary habits of consumers and offer products that appeal to their preferences. The Company introduces new products and improved products, and incurs development and marketing costs associated with new products. If the Company's products fail to meet consumer preferences, then the Company's strategy to grow sales and profits with new products will be less successful. o Seasonality and Quarterly Results. The Company's grocery and club store accounts are expected to experience seasonal fluctuations to some extent with the corresponding impact upon quarterly results. o Competition. The Company's business is dominated by several very large competitors, who have significantly greater resources than the Company; such competitors can outspend the Company and negatively affect the Company's market share and results of operations. o Dependence on Common Carriers. The Company also is dependent on common carriers to distribute its products. Any disruption in its distribution system or increase in the costs thereof could have a material adverse impact on the Company's business. o California Energy Supply and Pricing. Because the majority of the Company's operations are in California, its operating costs are affected by regional increases in electricity and natural gas prices. As a result, the Company's operating results have been affected by the increased cost of energy and in addition, natural disasters can impact the availability and pricing of energy. 10 o Capacity. The plant in Salinas, California is currently operating below planned capacity for certain products, which increases unit costs of production at the plant. If sales of products produced at this plant do not increase or additional costs cannot be reduced, these products will remain unprofitable which will impact future earnings of the Company. Conversely, the plant in Seattle, WA and Eugene, OR are seeing increased costs in order to keep up with the demand for their products. The Company is not benefiting from additional volume as production costs are growing faster than the growth in sales. o Volatility of Stock Price. The market price of the Company's common stock has fluctuated substantially since the initial public offering of the Company's common stock in 1993. Such volatility may, in part, be attributable to the Company's operating results or to changes in the direction of the Company's expansion efforts. In addition, changes in general conditions in the economy, the financial markets or the food industry, natural disasters or other developments affecting the Company or its competitors could cause the market price of the Company's common stock to fluctuate substantially. In addition, in recent years, the stock market has experienced extreme price and volume fluctuations. This volatility has had a significant effect on the market prices of securities issued by many companies, including the Company, for reasons sometimes unrelated to the operating performance of these companies. Moreover, any announced shortfall in the Company's net sales or earnings from levels expected by securities analysts or the market could have an immediate and significant adverse effect on the trading price of the Company's common stock in any given period. Additionally, the Company may not learn of such shortfalls until late in any fiscal quarter, shortly before operating results are due to be announced. The announcement, together or in succession, of such a shortfall and of lower than expected quarterly operating results, could result in an even more immediate and significant adverse impact on the trading price of the Company's common stock upon announcement of the shortfall or quarterly operating results. o Marketing and Sales Risks. The future success of the Company will depend on a number of factors, including whether grocery and club store chains will continue to expand the number of their individual stores offering the Company's products and whether allowances and other incentives will expand retail distribution. Expansion into new markets increases the risk of significant product returns resulting from the Company's supply of slower selling items to its customers. In addition, grocery and club store chains continually re-evaluate the products carried in their stores and no assurances can be given that the chains currently offering the Company's products will continue to do so in the future, either in the same measure or at all. Should these channels choose to reduce or eliminate products, the Company could experience a significant reduction in its product sales. The Company remains dependent on the use of slotting allowances and other incentives to expand retail distribution. o Compliance with laws applicable to its business. The company's facilities and products are subject to many laws and regulations administered by the United States Department of Agriculture, the Federal Food and Drug Administration, and other federal, state, local, and foreign governmental agencies relating to the processing, packaging, storage, distribution, advertising, labeling, quality, and safety of food products. The company's failure to comply with applicable laws and regulations could subject it to administrative penalties and injunctive relief, civil remedies, including fines, injunctions and recalls of its products, and negative publicity. o Sarbanes Oxley Act: The Company is also subject to the rules and regulations of the Securities and Exchange Commission and recently passed laws regarding publicly traded companies including the Sarbanes Oxley Act of 2002. The Company is not an accelerated filer and therefore is not yet required to comply with Section 404 of this Act which requires publication of an annual report by management, attested by the Company's registered public accounting firm assessing the effectiveness of the Company's internal controls and procedures for financial reporting. The Company spent $82,000 on consultants' fees plus a significant amount of internal resources documenting its internal controls in its efforts to become compliant with Sarbanes-Oxley Section 404. The Company believes that it will need to spend additional significant resources to become compliant with this Act. o Deductible Worker's Compensation Program. The Company's California and Oregon locations entered into a partially self-insured worker's compensation program for fiscal year 2003 and have continued the program into 2007. This program features a fixed annual payment, with a deductible on a per occurrence basis. The annual expense consists of a base fee paid to an insurance company to administer the program, direct cash expenses to pay for injuries, an estimate for potential injuries that may have occurred but have not been reported, an estimate by the insurance company of costs to close out each injury, and an estimate for injury development. The Company has been on this partially self-insured program for four years and has limited history of claim resolution available to support the Company's specific actuarial projections. Therefore the Company is using published industry actuarial data from an insurance carrier and reviewing each claim individually to determine the amount of reserves that should be established. Management believes that its current safety program and its good safety record will provide the foundation to enable the Company to realize the premium savings partially self-insured programs are designed to achieve; however, estimated reserves may vary from future cash outlays. o Fluctuations in revenues due to natural disasters or other causes. The Company may experience sales fluctuations for many reasons, including variations in the mix of products sold, competitive factors, price changes, supply changes, weather-related disruptions, and other natural disasters. The Company's main operating facility is located where earthquakes are 11 common and the Company lacks a viable plan to continue producing if a major natural disaster were to damage its operating plant. Sales may also fluctuate because of delays in introducing new products or customer delays in issuing purchase orders for new or current products. ITEM 1B. UNRESOLVED STAFF COMMENTS Inapplicable ITEM 2. PROPERTIES The Company leases approximately 130,800 square feet in Salinas, California, comprised of 43,700 square feet at its headquarters facility and 87,100 square feet at its distribution facility three miles from its headquarters. The headquarters facility is dedicated to manufacturing operations, offices and its test kitchen. The distribution complex is comprised of refrigerated and ambient storage. The current Monterey County production facility/headquarters lease was renewed until October 2014 and the distribution facility's lease was renewed until May 2012. In 2004, the Company purchased CIBO Naturals LLC which operates out of three separate leased facilities comprising 47,540 square feet in Seattle, WA part of which expires in May 2008. The facilities represent 20,300 square feet of manufacturing space, 4,900 office space and 22,340 of warehousing space. The Company acquired a lease for the 19,000 square foot production facility and offices as part of its acquisition of Emerald Valley in Eugene, Oregon. The lease expires December 31, 2007, with three five-year renewal options. As part of the Sonoma Cheese acquisition, the Company leases 5,800 square feet of office space and refrigerated storage to operate its delivery service. This lease expires in December 2015. Management feels that its facilities are adequate to support sales growth for at least 24 months. ITEM 3. LEGAL PROCEEDINGS There are no material legal proceedings pending to which the Company or any of its subsidiaries is a party or to which any of its property is subject. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to vote of the security holders during the fourth quarter of 2006. PART II ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES Price Range of Common Stock The Company's Common Stock is traded on the NASDAQ Global Market under the symbol "PSTA." The following table sets forth for the periods indicated the high and low sales prices of shares of the Common Stock on the NASDAQ Global Market. 12 Calendar year 2005: High Low ---- --- First quarter $3.93 $3.13 Second quarter 3.38 2.87 Third quarter 4.37 3.13 Fourth quarter 4.80 3.84 Calendar year 2006: High Low ---- --- First quarter 4.40 3.76 Second quarter 7.14 4.31 Third quarter 5.60 3.68 Fourth quarter 4.38 3.69 As of February 1, 2007, there were 193 stockholders of record of the Common Stock and approximately 3,600 investors with shares in street name. Dividend Policy The Company has not paid any cash dividends to Common stockholders since 1997. The Company's line of credit currently prohibits the payment of dividends. In addition, the Company intends to retain future earnings in its business and does not anticipate paying cash dividends on the outstanding Common stock in the near future. Equity Compensation Plan The information regarding stock plans approved by Shareholders and not approved by Shareholders required by this Item is incorporated by reference from Notes 9 to the consolidated financial statements (Item 15) included in this document. On June 23, 2005 the Company accelerated the vesting of all stock options outstanding under the Company's 2002 Stock Option Plan (formerly the 1993 Stock Option Plan) that have exercise prices per share higher than the closing price of the Company's stock on June 23, 2005, which was $3.07. Options to purchase 422,600 shares of the Company's common stock became exercisable immediately. These options range in price from a low of $3.25 to a high of $4.99 with an average of $3.53. The primary purpose of the accelerated vesting was to eliminate future compensation expense the Company would otherwise recognize in its statement of operations with respect to these accelerated options upon the adoption of SFAS 123R ("Share-Based Payment"). The acceleration of the vesting of these options did not impact the Company's financial statements in 2005. The Company has also changed the vesting period of all stock options issued after November 1, 2005 from a two year vesting period to a three year vesting period. In addition, the Company has reduced the size of the pool of employees eligible to receive stock options in order to reduce the overall Company's stock-based compensation expense. Comparison of Stockholder Return Set forth below is a line graph comparing the annual percentage change in the cumulative total return on the Company's Common Stock with the cumulative total return of the NASDAQ Global Market Index (U.S. Companies) and peer issuers for the period commencing on December 31, 2001 (1) and ending on December 31, 2006. Comparison of Cumulative Total Return from December 31, 2001 through December 31, 2006: Monterey Gourmet Foods, NASDAQ Global Index (U.S. Companies) and Peer Issuers 13 [GRAPHIC OMITTED]
Dec. 31, Dec. 31, Dec. 26, Dec. 23, Dec. 30, Dec. 30, -------- -------- -------- -------- -------- -------- 2001 2002 2003 2004 2005 2006 ---- ---- ---- ---- ---- ---- Monterey Gourmet Foods 100.0 50.3 46.9 43.2 54.0 58.7 NASDAQ Stock Market (U.S.) 100.0 69.1 101.9 111.7 114.9 126.2 Peer Issuers 100.0 80.0 90.3 83.4 100.5 118.5
ITEM 6. SELECTED FINANCIAL DATA The following table sets forth consolidated financial data for the Company. These data should be read in conjunction with the Consolidated Financial Statements and related Notes included in Item 15. 14
Years Ended --------------------------------------------------------------------------- 2006 2005 2004 2003 2002 --------------------------------------------------------------------------- (dollar amounts in thousands except per share data) Consolidated Statements of Operations Data: Net revenues $ 94,297 $ 85,248 $ 62,491 $ 60,490 $ 61,679 Gross profit 27,439 (b) 23,232 16,468 18,569 22,262 SG&A 26,754 (b) 23,590 18,224 17,161 15,654 Operating income (loss) (2,462) (a) (b) (358) (1,761) 1,408 6,540 Net income (loss) (3,112) (a) (b) (537) (1,344) 1,035 9,491 Basic net income per common share ($0.19) (b) ($0.04) ($0.09) $0.07 $0.68 Diluted income per common share ($0.19) (b) ($0.04) ($0.09) $0.07 $0.65 Weighted average basic shares outstanding 16,100,250 14,450,251 14,343,386 14,206,627 14,039,902 Weighted average diluted shares outstanding 16,100,250 14,450,251 14,343,386 14,414,931 14,664,762 Years Ended --------------------------------------------------------------------------- 2006 2005 2004 2003 2002 --------------------------------------------------------------------------- (dollar amounts in thousands) Consolidated Statements of Income Data as Percent of Net Revenues Net revenues 100.0% 100.0% 100.0% 100.0% 100.0% Gross profit 29.1% 27.3% 26.4% 30.7% 36.1% SG&A 28.4% 27.7% 29.2% 28.4% 25.4% Operating income (loss) (2.6)% (0.4)% (2.8)% 2.3% 10.6% Net income (loss) (3.3)% (0.6)% (2.2)% 1.7% 15.4% Consolidated Balance Sheet Data: Working capital $11,496 $5,019 $7,753 $16,704 $16,880 Total assets $62,468 $62,205 $46,873 $44,204 $43,799 Total debt and capital lease obligations $1,147 $13,654 $2,459 $3 $17 Stockholders' equity $50,263 (b) $39,110 $39,216 $40,035 $38,941
(a) Includes a loss on impairment of Casual Gourmet intangible assets of $3,160. (b) For the year ended December 31, 2006, includes stock-based compensation expense related to the adoption of SFAS No. 123(R). ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion should be read in conjunction with the financial statements and related notes and other information included in this report. The financial results reported herein do not indicate the financial results that may be achieved by the Company in any future period. Background Monterey Gourmet Foods was incorporated in June 1989 as a producer and wholesaler of refrigerated gourmet pasta and sauces to restaurants and grocery stores in the Monterey, CA area. The Company has since expanded its operations to provide a variety of gourmet refrigerated food products to grocery and club stores throughout the United States, selected regions in Canada, the Caribbean, Latin America and Asia Pacific. The Company's overall strategic plan is to enhance the value of the Monterey Gourmet Foods brands by distributing its gourmet products through multiple channels of distribution. The Company's product distribution to grocery and club stores increased from approximately 25 stores as of December 1989, to over 10,200 stores by December 31, 2006. During recent years the Company added retail and club distribution through internal growth and through the Frescala Foods, Nate's, Isabella's Kitchen, Emerald Valley Kitchen, CIBO, Sonoma Cheese, and Casual Gourmet acquisitions. In 2004, the Company's shareholders approved the change of the name of the Company to Monterey Gourmet Foods, Inc. The name change was made 15 to define the Company's strategic direction more accurately. The name change also announces to the investor community, our customers and consumers, our strategic direction to become a complete supplier of gourmet refrigerated foods. In 2004 the Company began a diversification strategy to expand its product line beyond refrigerated pasta and pasta sauce. The diversification strategy was a combination of both internal product development and external acquisitions. In January 2004, the Company acquired CIBO Naturals, a maker of sauces, dips and spreads. In 2005 the Company launched new products such as Chicken Penne Gratin, Chicken and Mozzarella Ravioli, and Pork and Chicken Tamales. Additionally the Company was able to increase distribution by introducing whole wheat pastas which are high in dietary fiber, have a favorable glycemic index, and are made from whole grains. In 2005 the Company acquired two additional Companies. The Company markets under the Casual Gourmet brand (acquired January 11, 2005) flavorful low-fat, low-calorie chicken sausages, chicken burgers and soups, and under the Sonoma Cheese brand (acquired April 7 2005) an outstanding line of refrigerated specialty cheese products that features its flagship line of Sonoma Jack Cheeses. Sonoma Cheese has earned numerous awards over the years for its traditional and flavored jack cheeses. Monterey Gourmet Foods believes that the convenient gourmet food segment is growing rapidly as time-starved consumers seek high quality quick-meal solutions and the Company, with its staff of senior chefs and its flexible manufacturing facilities, is well positioned to bring new products to these consumers. In 2006, the Company focused on expanding distribution of its current products, consolidating production facilities in Salinas, improving the quality of its current products, hiring experts in product development and creativity to better utilize the Company's production equipment, improving the synergies between the different brands, and reorganizing the Company into one operating unit with one centralized sales force and one marketing department. Also during 2006, the Board of Directors of the Company appointed Eric Eddings as President and Chief Executive Officer of Monterey Gourmet Foods following the resignation of James M. Williams effective September 5, 2006. In the fourth quarter of 2005, Casual Gourmet saw a significant reduction in its sales to its two largest customers, Costco and Sam's Club. The Company took many steps to restore the sales to these two major customers, including the introduction of such items as Anti-Biotic free ("ABF") all white meat chicken sausages, nitrite free chicken sausages, sausages made with organic chicken, flavored pork sausages, and other products that fit under the Casual Gourmet label. The Company also introduced these products into the retail market place through Monterey Gourmet Foods' retail sales force. In the spring of 2006, these new items restored Casual's sales to its level of sales of the prior year and therefore the Company did not impair its intangible assets. However, between the dates of August 15, 2006 and September 9, 2006, the Company was informed that these new items would be discontinued in select divisions of Costco. Due to the lost business during the third quarter of 2006, the Company tested for the potential impairment of goodwill as the loss of business was considered a triggering event under SFAS 142 and SFAS 144 as well for amortized intangibles. As a result of the impairment test, the Company recorded a pre-tax, non-cash charge of $3.2 million in the third quarter of 2006 related to the impairment of intangible assets associated with the Casual Gourmet Foods acquisition on January 11, 2005. The success of the Company's efforts to increase revenue will depend on several key factors: (1) whether grocery and club store chains will continue to increase the number of their stores offering the Company's products, (2) whether the Company can continue to increase the number of grocery and club store chains offering its products, (3) whether the Company can continue to introduce new products that meet consumer acceptance, (4) whether the Company, by diversifying into other complementary businesses through new product offerings or acquisitions can leverage its strengths and continue to grow revenues at levels attractive to its investors, (5) whether the newly acquired acquisitions perform as planned when purchased, and (6) whether the Company can maintain and increase the number of items it is selling to its two largest customers. Grocery and club store chains continually re-evaluate the products carried in their stores, and no assurances can be given that the chains currently offering the Company's product will continue to do so in the future. The Company believes that access to capital resources and increasing sales to offset higher fixed overhead, coupled with continued reduction of its administrative and production costs as a percent of sales revenue, will be key requirements in the Company's efforts to enhance its competitive position and increase its market penetration. In order to support its expansion program, the Company continues to develop new products for consumers and revise advertising and promotional activities for its retail grocery and club store accounts. There can be no assurance that the Company will be able to increase its net revenues from grocery and club stores. Because the Company will continue to make expenditures associated with the expansion of its business, the Company's results of operations may be affected. Operations for 2006, 2005 and 2004 Net revenues were as follows (in `000s): 16
Years Ended --------------------------------------------- 2006 2005 2004 --------------------------------------------- Net Revenues $ 94,297 $ 85,248 $ 62,491 Percent change in net revenues from prior year 11% 36% 3%
The 2006 increase in sales of $9,049,000 over 2005 is due to the increased volume at our all natural brands of CIBO Naturals and Emerald Valley Organics which increased 32% or $6.7 million over 2005, the introduction of fresh tamales which sold heavily in the fourth quarter of 2006, and increases from the core pasta business. Additionally, Sonoma Foods recorded twelve months of sales in 2006 compared to only nine months in 2005, an increase of $2.8 million, because Sonoma Foods was acquired in April 2005. The Casual Gourmet product lines recorded a revenue decline of $3.1 million when comparing the twelve months ended December 31, 2006 with the twelve months ended December 31, 2005. During 2006, 2005 and 2004 the Company reduced net revenues by $363,000, $351,000 and $226,000 respectively for costs associated with placement of product in new stores in various locations. The 2005 increase compared to 2004 was due to the additional volume generated from the acquisitions of CIBO, Emerald Valley, Casual Gourmet Foods, and Sonoma Foods some of which had sales in the previous year. Excluding sales generated from these four acquisitions, net sales increased 5%. Again excluding sales generated from these four acquisitions, sales to Costco increased 33% compared to 2004; however, sales to Sam's Club declined 24% in 2005 compared to 2004. The Company's Monterey Pasta brand retail business, excluding the sales to the club stores, which has been a focus for the Company, was up 15% when compared to the previous year and was up 46% in the second half of 2005 when compared to the second half of 2004. The success of the Company's new whole wheat pastas helped fuel this growth. The change in net revenues was mostly a result of changes in volume sold and only a small portion is a result of price changes for the Company's products. In addition, Casual Gourmet, the specialty poultry sausage and soup marketer experienced several setbacks of product distribution and sales with its two largest customers during the fourth quarter of 2005. In both cases, losses were related to the customer's change in merchandising strategy and increased competition within the poultry sausage category. Casual Gourmet management responded quickly with innovative new products, including products in the much larger pork sausage category. Casual regained several product placements with key club customers during the first quarter of 2006, however these items were subsequently discontinued in the third quarter of 2006. The Company has embarked upon a diversification strategy which included the acquisition of Emerald Valley Kitchen in 2002, CIBO Naturals, LLC in 2004, and Casual Gourmet Foods and Sonoma Foods in 2005. The table below shows the percent of net revenues these four acquisitions have represented:
Years Ended --------------------------------------------- 2006 2005 2004 --------------------------------------------- Percent of net revenues from recent acquisitions 45.1% 41.4% 18.2% All other net revenues 54.9% 58.6% 81.8% --------------------------------------------- Total 100.0% 100.0% 100.0% ============================================= Gross profit and gross margin were as follows: Years Ended --------------------------------------------- 2006 2005 2004 --------------------------------------------- Gross profit $ 27,439 $ 23,232 $ 16,468 Gross margin percent 29.1% 27.3% 26.4%
The gross profit dollars for 2006 increased $4,207,000 compared to 2005 due to increased sales volume. The improvement in gross margin percent for 2006 compared to the 2005 is a function of cost savings obtained by running more efficiently and an improvement in product mix. However, in the fourth quarter of 2006, the Company experienced high labor costs associated with overtime related to cyclical demand in tamales and certain sauces (see Seasonality of Revenues, Item 1, page 9). Also in 2006, the Company experienced certain write-off costs associated with a failed frozen ravioli appetizer product. In addition, the Company announced on September 29, 2006 a reduction in its salaried work force. Part of the severances paid reduced the Company's gross margin. In 2006, the Company consolidated its two Salinas, CA plants which the Company believes will improve margins. The impact of future change on the Company's gross profit is difficult to quantify because of its sensitivity to volume through the plant. 17 The 2005 gross margin improvement of $6,764,000 compared with 2004 was a function of higher sales, higher production volume through the Company's currently operating plants, reduced fixed costs, and reduced labor costs. Gross margin percent improvement compared to prior year was a function of cost savings from higher plant volume, lower fixed costs, and also an improvement in product mix especially from recent acquisitions, offset by higher utility and rent costs. Management has continued to reorganize and reduce its workforce in Salinas, where the number of employees has been reduced by approximately 30% since 2004. The Company charged $629,000, $499,000 and $550,000 to cost of sales for 2006, 2005, and 2004 respectively, for obsolete packaging and raw material inventory. Selling, General and Administrative expenses ("SG&A") were as follows:
Years Ended --------------------------------------------- 2006 2005 2004 --------------------------------------------- SG&A Expense $ 26,754 $ 23,590 $ 18,224 SG&A Expense as a percent of net revenues 28.4% 27.7% 29.2%
The 2006 SG&A increase of $3,164,000 compared to 2005 is related to increased freight costs due to higher fuel costs of $1,403,000 or 1.5% of net revenues, non-cash expenses related to the expensing of stock options of $454,000 or 0.5% of net revenues, accrued severance and other costs associated with the workforce reduction that occurred during the month of September of $647,000 or 0.7% of net revenues, and increased costs of $227,000 or 0.2% of net revenues associated with being a public company in the form of higher audit and compliance fees. SG&A as a percent of net revenues decreased by 1.5% for 2005 compared to 2004. This decrease was due to higher revenues in 2005 compared to 2004 which spread the fixed portion of SG&A over more revenue. The Company also spent $82,000 on consultants' fees plus a significant amount of internal resources documenting its internal controls in its efforts to become compliant with Sarbanes-Oxley Section 404. Also the Company saw its audit and audit related fees increase in 2005 compared to the same period in 2004. Amortization associated with the 2005 acquisitions increased 89% when comparing 2005 to 2004. Demonstration costs paid to outside vendors were 6.1%, 6.8% and 8.1% of net revenues for the years, 2006, 2005, and 2004, respectively. Depreciation and amortization expense, included in cost of sales and SG&A, decreased to $2,926,000 or 3.1% of net revenues in 2006 compared to $3,033,000 or 3.6% of net revenues in 2005 and $2,510,000 or 4.0% of net revenues in 2004. The decrease from 2005 to 2006 is related to the impairment of intangible assets of Casual Gourmet Foods and some fixed assets becoming fully depreciated during the year. The increase in 2005 compared to 2004 relates to the recent acquisitions and to capacity expansion and equipment upgrades in the Salinas, California, Seattle, Washington and Eugene, Oregon production facilities. Amortization of intangible assets as a result of acquisitions was $875,000 in 2006 compared to $958,000 in 2005 and $482,000 in 2004. See "Liquidity, Capital Resources and Business Acquisitions", page 19. Net interest expense for 2006 was $355,000 compared to $628,000 for 2005, and $130,000 in 2004. The interest expense in 2006, 2005 and 2004 is attributable to the bank loans needed for the CIBO Naturals, Casual Gourmet Foods and Sonoma Foods acquisitions and the subordinated debt remaining on the CIBO Naturals balance sheet. The loans from Comerica Bank were paid off in July 2006 after the Company raised additional capital through a private placement. Income tax benefit (expense) for 2006, 2005, and 2004 was ($295,000), $431,000, and $505,000, respectively. The 2006 income tax expense is mainly impacted by the $1.2 million increase in the of valuation allowance for deferred tax assets. The 2005 and 2004 income tax benefits of $431,000 and $505,000 represented 45% and 27% of pretax loss respectively. The Company's deferred tax assets are comprised primarily of net operating losses that can offset future taxable income. Management has established a $1.5 million valuation allowance against future deferred tax assets based on its assessment of the sources of future taxable income and the likelihood of realization of such deferred tax assets. Additionally, the Company realized additional tax benefits as a result of the exercise of non-qualified stock options and the exercise and subsequent sale of certain incentive stock options or disqualifying dispositions in 2006, 2005, and 2004. For financial reporting purposes, when a deduction exceeds the deferred tax assets, the resulting reduction in actual income tax obligations as a result of these disqualifying dispositions is credited to additional paid in capital. See Liquidity, Capital Resources, and Business Acquisitions immediately below and Note 7 to the consolidated financial statements in Item 15. 18 Impairment Charge In the fourth quarter of 2005, Casual Gourmet saw a significant reduction in its sales to its two largest customers, Costco and Sam's Club. The Company took many steps to restore the sales to these two major customers, including the introduction of such items as Anti-Biotic free ("ABF") all white meat chicken sausages, nitrite free chicken sausages, sausages made with organic chicken, flavored pork sausages, and other products that fit under the Casual Gourmet label. The Company also introduced these products into the retail market place through Monterey Gourmet Foods' retail sales force. In the spring of 2006, these new items restored Casual's sales to its level of sales of the prior year and therefore the Company did not impair its intangible assets. However, between the dates of August 15, 2006 and September 9, 2006, the Company was informed that these new items would be discontinued in select divisions of Costco. Due to the lost business during the third quarter of 2006, the Company tested for the potential impairment of goodwill as the loss of business was considered a triggering event under SFAS 142 and SFAS 144. As a result of the impairment test, the Company recorded a pre-tax, non-cash charge of $3.2 million in the third quarter of 2006 related to the impairment of intangible assets associated with the Casual Gourmet Foods acquisition on January 11, 2005. Liquidity, Capital Resources, and Business Acquisitions During the twelve months ended December 31, 2006, $6,981,000 of cash was provide by the Company's operating activities compared to $1,104,000 of cash being used in the Company's operations in 2005, and $1,898,000 of cash provided by the Company's operations in 2004. The 2006 net loss of $3,112,000 plus the depreciation and amortization of $2,926,000, the non-cash impairment of intangible assets of $3,160,000, plus non-cash income tax expense of $282,000, plus non-cash stock compensation of $516,000, and the increase in accounts payable and other accrued current liabilities of $4,429,000 accounted for most of the increase in cash from operations which was reduced by the increase in net accounts receivable and inventories. The increase in accounts payable and other accrued current liabilities of $4.4 million is a function of the timing of payments to the Company's vendors according to the terms offered by the Company. The increase in net accounts receivable and the increase in inventory were a direct result of the increase in net revenues for December 2006. Net revenues for December were $9.8 million compared to $8.7 million in December 2005, a 16% increase. Accounts receivable, net of allowances, increased only 7%. Inventory increased 9%, which also used cash. The Company finances its operations and growth primarily with cash flows generated from operations. The Company has a $5 million working capital line of credit which was unused as of December 31, 2006, and a letter of credit in the amount of $1,100,000 which is issued in favor of an insurance company to support a self-funded worker's compensation program which decreased to $800,000 in January 2007. The interest rate on the credit line will be calculated at the bank's prime lending rate or LIBOR plus 2.00% whichever the Company chooses. The maturity date of the line of credit has been extended to June 1, 2007 and the covenants have been adjustment to accommodate the additional borrowing. Some product lines such as specialty cheeses require more working capital than other products. Cheese requires a certain amount of time to age before it can be sold. Other products such as the gourmet sausages are produced when orders are received and then shipped directly to customers. The Company currently has $11,496,000 of working capital as of December 31, 2006 compared to $5,019,000 in working capital as of December 31, 2005. The Company believes that its existing credit facilities, along with cash flows from operations, are sufficient to meet its cash needs for normal operations including all anticipated capital expenditures for the calendar year 2007. In addition to operating cash flows, the Company also received cash proceeds of $926,000, $153,000 and $470,000 from the exercise of employee stock options and sales of stock under the Company's Employee Stock Purchase Plan during 2006, 2005, and 2004, respectively. In January 2006, as part of the final purchase of CIBO Naturals, LLC, 300,000 shares of the Company's common stock were issued to the previous owners of CIBO Naturals with a computed value of $1,186,000. The Company now owns 100% of CIBO Naturals, LLC. Effective January 1, 2006, the Company adopted SFAS 123R. See note 9 to the Financial Statements (Item 15) which is incorporated here by reference. Cash balance at the end of 2006 was $4,281,000 compared with $330,000 in 2005. Purchases of equipment in 2006 were $3,010,000 with the majority of capital spending going towards upgrading the production plants. Cash balance at the end of 2005 was $330,000 and $569,000 in 2004. The cash from operations in 2004 and non-revolving bank loans were used to purchase a 60% interest in Casual Gourmet Foods, Inc. and 80% of Sonoma Foods, Inc. during 2005. Purchases of equipment were kept to a minimum during the calendar year 2005 with the majority of capital spending going towards upgrading the plants in Eugene, Oregon and Seattle, Washington. 19 Management believes that cash on hand at December 31, 2006 and projected 2007 cash flows from operations will be sufficient to fund working capital needs, expected Company growth, and anticipated capital expenditures during 2007. Alternative financing arrangements will need to be found if the Company makes further acquisitions. Contractual Obligations The Company has no raw material contracts exceeding one year in duration. The Company leases production, warehouse and corporate office space as well as certain equipment under both month-to-month and non-cancelable operating lease agreements. Most building leases have renewal options and all include cost of living adjustments. The Company's President and Chief Executive Officer Eric Eddings, accepted employment with the Company commencing January 28, 2004, and became the Company's CEO on September 5, 2006. A copy of his employment contract with the Company was filed as an exhibit to the Company 8-K report filed on September 13, 2006 and is incorporated here by reference. The following table summarizes the estimated annual obligations.
Payments due by period ------------------------------------------------------------------------ Contractual Obligations Less than 1 More than (in Thousands) Total year 1 - 3 years 3 - 5 years 5 years ------------ ------------ ------------ ------------ ------------ Long-term debt $ 1,079 $ 988 $ 89 $ 2 $ -- Capital lease obligations 68 30 38 -- -- Operating leases 10,706 1,773 4,396 2,664 1,873 ------------------------------------------------------------------------ Total $ 11,853 $ 2,791 $ 4,523 $ 2,666 $ 1,873 ========================================================================
The Company has commitments for leased manufacturing, warehouse and office space that range from one year to nine years. See discussion in Item 2 "Properties". The Company has an $800,000 standby letter of credit in favor of an insurance company for the Company's self-funded workers compensation program which will expire on December 31, 2007. Off-Balance Sheet Arrangements The Company does not have any off-balance sheet arrangements that are material to its financial position or results of operations. See Notes to the consolidated financial statements (Item 15) for information regarding capitalized leases and operating leases. Business Acquisitions On January 12, 2006, the Company, Suekat LLC ("Suekat") and CIBO Naturals, LLC ("CIBO"), amended their previous agreement for the purchase and sale of limited liability company units; as a result, the Company acquired the remaining 15.5% of CIBO from Suekat in exchange for 300,000 unregistered shares of the Company's common stock with a market value of $1,186,000. The purchase price was all allocated to goodwill. CIBO produces a variety of refrigerated gourmet sauces and spreads including fresh pesto sauces, flavored cheeses, bruschetta toppings and tapenade spreads. CIBO's products are sold nationally through club stores, specialty food stores, and regionally in supermarket delis. CIBO fits well with the Company's growth strategy in premium refrigerated foods. CIBO through its "CIBO Naturals" brand sells unique, high quality products and has developed a strong market position which the Company believes has growth potential in both expanded distribution and new products. On March 31, 2006, the Company purchased an additional 10% interest in Casual Gourmet Foods, Inc. ("Casual") pursuant to the Company's January 11, 2005 agreement with Casual and its shareholders. The purchase price for the 20 additional 10% ownership was $1,600 which increased the Company's ownership of Casual to 70%. The purchase price was all allocated to goodwill. Casual, which produces branded gourmet sausages, prepared soups and other food products, is a Florida corporation. On September 29, 2006, the Company, Casual, and the shareholders of Casual entered into an agreement to amend the Purchase Agreement dated January 11, 2005, to accelerate the Third Closing and Final Closing and to set the amount of the Third Payment and Final Payment. The amendment calls for the purchase by the Company of the remaining 30% of Casual's outstanding shares for $23,000. A copy of the Amendment to the Stock Purchase Agreement was filed on Form 8-K filed with the SEC on October 5, 2006, and is incorporated here by reference. On January 11, 2005, the Company entered into a definitive agreement with Casual Gourmet Foods, Inc. and the shareholders of Casual ("Shareholders") for the purchase by Monterey of 100% of Casual's outstanding shares. The acquisition was structured to provide that Monterey acquired 60% of Casual's outstanding shares immediately and the remaining 40% over the next three years. Casual, which produces branded gourmet sausages, prepared soups and other food products, is a Florida corporation with headquarters in Clearwater, Florida. Prior to entering into the Stock Purchase Agreement, there were no existing material relationships between or among Monterey and Casual or its Shareholders. Monterey acquired Casual in order to expand and diversify its product line in the specialty foods category in which it competes. For its initial acquisition, Monterey paid $6.0 million in cash plus acquisition costs of $159,000. The initial purchase accounting reflects the transaction as if Monterey purchased 100% of Casual. No liability was established at that time for the remaining payments to Casual's shareholders because the liability is not quantifiable. On November 3, 2006, completed the agreement to amend the Purchase Agreement dated January 11, 2005, pursuant to which the Company agreed to acquire all of the outstanding shares of Casual. The Amendment accelerated the Company's purchase of the remaining 30% of Casual's outstanding shares and established a revised purchase price of $23,000. After the agreement, the Company owns 100% of the outstanding stock of Casual Gourmet Foods, Inc. Casual markets a wide range of refrigerated branded specialty items, including chicken sausages, chicken burgers, and gourmet soups. Products are sold in club stores and retail food stores under this important brand. Some of their most popular sausage items include red bell pepper with basil, and spinach with Asiago cheese. On April 7, 2005, the Company entered into a definitive agreement with Sonoma Foods, Inc. ("Sonoma"), and the shareholders of Sonoma ("Shareholders") for the purchase by Monterey of 80% of Sonoma's outstanding shares ("Stock Purchase Agreement"). The Stock Purchase Agreement provides options for Sonoma's two other shareholders to sell their remaining 20% interest after four years and, if that option is not exercised, there is an option for Monterey to acquire the interest after seven years. Sonoma markets a variety of refrigerated branded specialty cheese items, including their flagship products, Sonoma Jack Cheeses in a variety of flavors. Sonoma's products are sold in retail supermarkets, club stores, and specialty food stores across the US with the greatest penetration in the Western US markets. Some of the most popular cheese flavors include Hot Pepper Jack Cheese, Garlic Jack Cheese, Mediterranean Jack Cheese and Pesto Jack Cheese. Sonoma maintains its headquarters in Sonoma, CA. Monterey acquired Sonoma in order to expand and diversify its product line in the specialty foods category in which it competes. For its initial acquisition of 80% of Sonoma's outstanding shares, Monterey paid $3.3 million in cash and issued 61,250 shares of Monterey Gourmet Foods common stock valued at $198,000 plus acquisition costs of $127,000. Purchase of the remaining shares will be at a price derived from a predetermined calculation based upon a percentage of earnings before taxes, interest, bonuses, depreciation and amortization during the interim periods. Sonoma has been fully integrated into the Company's systems using its sales force and distribution network All of the Company's acquisitions pursue the Company's growth strategy in the specialty premium refrigerated food category. The Company envisions expanding the existing brands, developing new products, and increasing distribution in club, retail, and potentially other channels as it pursues growth, expands its product lines and diversifies its customer base. Critical Accounting Policies and Management Judgments The discussion and analysis of the financial condition and results of operations are based on the consolidated financial statements included in Item 15. The preparation of these financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make a number of estimates and assumptions relating to the reporting of assets and liabilities, revenues and expenses, and the disclosure of contingent assets and liabilities. On an ongoing basis, management evaluates and discusses with its audit committee these estimates and assumptions, including those related to accounts receivable and allowances, goodwill and intangible assets, income taxes, inventory valuation, workers compensation reserves and revenue recognition. Management bases its estimates on historical experience and on various other assumptions believed to be reasonable under the circumstances, which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results could differ from those estimates under different assumptions or conditions. 21 Management believes the following critical accounting policies affect the more significant judgments and estimates used in the preparation of the consolidated financial statements Business Combinations The consolidated financial statements include the Company's accounts and the accounts of wholly- and majority-owned subsidiaries. The Company consolidates all of the majority-owned subsidiaries and reflects minority interest of Sonoma Foods on the consolidated balance sheet because of the uncertainty that Monterey will purchase the remaining shares from the minority shareholders. Monterey is the sole source of any financing needed by its majority-owned subsidiaries. In accordance with business combination accounting, the Company allocates the purchase price of acquired companies to the tangible and intangible assets acquired, and liabilities assumed based on their estimated fair values. Management makes estimates of fair value based upon assumptions believed to be reasonable. These estimates are based on historical experience and information obtained from the management of the acquired companies and are inherently uncertain. Critical estimates in valuing certain of the intangible assets include but are not limited to: future expected cash flows from product sales, customer lists, recipes and processes, the acquired company's brand awareness and market position, as well as assumptions about growth rates, gross margins, market penetration, and discount rates. Unanticipated events and circumstances may occur which may affect the accuracy or validity of such assumptions, estimates or actual results. For business combinations, the Company must record deferred taxes relating to the book versus tax basis differences of acquired assets and liabilities. Generally, such business combinations result in deferred tax liabilities as the book values are reflected at fair value whereas the tax basis is carried over from the acquired company. Such deferred taxes are initially estimated based on preliminary information and are subject to change as valuations and tax returns are finalized. Accounts Receivable and Allowances The Company provides allowances for estimated credit losses, product returns, spoilage, and adjustments at a level deemed appropriate to adequately provide for known and inherent risks related to such amounts. The allowances are based on reviews of the history of losses, returns, spoilage, contractual relationships with customers, current economic conditions, and other factors which warrant consideration in estimating potential losses. While management uses the best information available in making its determination, the ultimate recovery of recorded accounts, notes, and other receivables is also dependent on future economic and other conditions that may be beyond management's control. Income Taxes The Company accounts for corporate income taxes in accordance with the Financial Accounting Standards Board ("FASB") Statement of Financial Accounting Standards ("SFAS") 109, "Accounting for Income Taxes" which requires an asset and liability approach. This approach results in the recognition of deferred tax assets (future tax benefits) and liabilities for the expected future tax consequences of temporary timing differences between the book carrying amounts and the tax basis of assets and liabilities. Future tax benefits are subject to a valuation allowance to the extent of the likelihood that the deferred tax assets may not be realized. The Company's deferred tax assets include significant amounts of net operating losses ("NOLs"). During 2006, the valuation allowance was increased based on the management's judgment that it is not more-likely-than-not that all of the deferred tax assets can be realized partly due to the intangible asset impairment of the Casual Gourmet Foods which affected the Company's assessment of the realization of our NOLs. The amount of the valuation allowance is significantly dependant on management's assumptions regarding future taxable income and the availability of these NOLs to offset future taxable income. The effect on the Company's net income is significant whenever the estimate changes. For business combinations, the Company must record deferred taxes and liabilities relating to the book versus tax basis differences of acquired assets and liabilities. Generally, such business combinations result in deferred tax liabilities as the book values are reflected at fair value whereas the tax basis is carried over from the acquired company. Such deferred taxes initially are estimated based on preliminary information and are subject to change as valuations and tax returns are finalized. Inventory Valuation Inventories are stated at the lower of cost (using the first-in, first-out method) or market and consist principally of component ingredients to the Company's refrigerated pasta and sauces, finished goods, and packaging materials. Many of the ingredients used in the Company's products have a short shelf life and if not used in a certain amount of time may spoil. Management estimates that the raw material will be used in a timely manner; however, management has established certain reserves for the potential of inventory obsolescence, especially for slow moving inventory. As of December 31, 2006, the Company reduced the carrying value of its inventory by $273,000. This write-down was made to cover certain refrigerated raw material inventory that is nearing its shelf-life, and certain packaging labels for products that may be rotated out of the Club Store accounts, and products that have already been rotated out of the Club Store accounts that may or may not be rotated back into the Club Store accounts. The allowance is established based on management's estimate of 22 alternative usage or salvage value of obsolete inventory. Management believes its estimates for spoiled and obsolete inventory is adequate given the current volume of business to its current customers. Workers Compensation Reserve The Company's California and Oregon locations entered into a partially self-insured worker's compensation program for fiscal year 2003 and have continued the program into 2007. This program features a fixed annual payment, with a deductible on a per occurrence basis. The annual expense consists of a base fee paid to an insurance company to administer the program, direct cash expenses to pay for injuries, an estimate for potential injuries that may have occurred but have not been reported, an estimate by the insurance company of costs to close out each injury and an estimate for injury development. The Company has been on this partially self-insured program for just over four years and therefore has limited history of claim resolution available to support the Company's projected liabilities. Therefore the Company is using published industry actuarial data from an insurance carrier and reviewing each claim individually to determine the amount of reserves that should be established. Management believes that its current safety program and its safety record will provide the foundation to enable the Company to realize the premium savings partially self-insured programs are designed to achieve; however, estimated reserves may vary from future cash outlays. The remaining locations are on a fixed premium insurance contract that covers all costs including claims. Revenue Recognition The Company recognizes revenues through sales of its products primarily to grocery and club store chains. Revenues are recognized once there is evidence of an arrangement (such as a customer purchase order), product has been shipped or delivered to the customer depending on the customer's purchase orders, the price and terms are fixed, and collectibility is reasonably assured. Accordingly, sales are recorded when goods are shipped or delivered, at which time title and risk of loss have passed to the customer, consistent with the freight terms for most customers. Potential returns, adjustments and spoilage allowances are considered as a reduction in revenues and are provided for in accounts receivable allowances and accruals. For new products or new customers, all pricing is calculated based on FOB shipping point. The Company records its shipping cost for product delivered to customers in selling, general, and administrative expense. Any amounts charged to customers for freight and deliveries are included in revenues. Certain incentives granted to customers such as promotions, trade ads, slotting fees, terms discounts, and coupons are recorded as offsets to revenues. Valuation of Goodwill/Indefinite-lived Intangible Assets Under SFAS 142, "Goodwill and Other Intangible Assets" goodwill and intangible assets with indefinite useful lives are to be tested for impairment at least annually. The primary identifiable intangible assets of the Company's reporting unit with indefinite lives are trademarks, tradenames and goodwill acquired in business acquisitions. As of December 31, 2006, the net book value of trademarks and other identifiable indefinite-lived intangible assets was $2.7 million. The Company defines a reporting unit as a unit one level below its operating segment. A reporting unit exists if the component constitutes a business for which discrete financial information is available and segment managers regularly review the operating results of the component. As of December 31, 2006, the Company determined that it had one reporting unit based on the Company's internal reorganization which integrated the Company's brands to a more functional reporting structure. Prior to the fourth quarter of 2006, the Company had four reporting units as its acquirees' operations were not integrated. Identifiable indefinite-lived intangible assets are not subject to amortization and are assessed for impairment at least as often as annually and as triggering events may occur. The impairment test for identifiable intangible assets not subject to amortization consists of a comparison of the fair value of the intangible asset's reporting unit with its carrying amount. If the carrying amount exceeds the fair value, then a second step of assessment is performed to measure the impairment loss, if any. Given the Company's internal reorganization in which the Company operates under one reporting unit, management primarily relies on the Company's market capitalization to determine fair value. Secondarily, the Company relies on a number of factors to discount anticipated future cash flows including operating results, business plans and present value techniques. Rates used to discount cash flows are dependent upon interest rates and the cost of capital at the relevant point in time. There are inherent uncertainties related to these factors and management's judgment in applying them to the analysis of intangible asset impairment. It is possible that assumptions underlying the impairment analysis will change in such a manner that impairment in value may occur in the future. Goodwill is not amortized but is subject to periodic assessments of impairment. At December 31, 2006, the Company had $13.2 million of goodwill on its books. Goodwill is assessed for impairment at least as often as annually and as triggering events may occur. The Company performs its annual review in the fourth quarter of each year. Recoverability of goodwill is evaluated using a comparison of the fair value of a reporting unit with its carrying value. 23 In evaluating the recoverability of goodwill, it is necessary to estimate the fair value of the reporting unit. In making this assessment, management relies on a number of factors to discount anticipated future cash flows including operating results, business plans and present value techniques. Rates used to discount cash flows are dependent upon interest rates and the cost of capital at the relevant point in time. There are inherent uncertainties related to these factors and management's judgment in applying them to the analysis of goodwill impairment. It is possible that assumptions underlying the impairment analysis will change in such a manner that impairment may occur in the future. Valuation of Plant and Equipment and finite-lived Intangible Assets In accordance with Statement of Financial Accounting Standards (SFAS) No. 144, Accounting for the Impairment or Disposal of Long-lived Assets ("SFAS 144"), management reviews finite-lived long-lived assets, primarily consisting of plant and equipment and amortized intangible assets such as acquired recipes, customer lists and non-compete agreements, whenever events or changes in circumstances indicate that the carrying amount of an asset group may not be recoverable. Intangible assets with finite useful lives continue to be amortized over their respective estimated useful lives. The estimated useful life of an identifiable intangible asset is based upon a number of factors, including the effects of demand, competition, and future cash flows. For these assets, if the total expected future undiscounted cash flows from the asset group are less than the carrying amount of the asset group, an impairment loss is recognized for the difference between the fair value of the carrying value of the asset group. The impairment tests require management to estimate the undiscounted cash flows and fair value of the asset groups. As of December 31, 2006, the net book value finite-lived intangible assets were $4.3 million. When analyzing finite, long-lived assets for potential impairment, significant assumptions are used in determining the undiscounted cash flows of the asset group, including the cash flows attributed to the asset group; future cash flows of the asset group, including estimates of future growth rates; and the period of time in which the assets will be held and used. The Company primarily determines fair values of the asset group using discounted cash flow models. In addition, to estimate fair value management is required to estimate the discount rate that incorporates the time value of money and risk inherent in future cash flows. Impairment of finite-lived and indefinite-lived Intangible Assets In the third quarter of 2006, it was determined that the identifiable intangible assets of Casual Gourmet Foods (including customer relationships, recipes and processes, non-competition agreements, and trade name) were impaired as their undiscounted cash flows were insufficient to recover the carrying value. Accordingly, the impairment charge was measured in accordance with SFAS 144 as the excess of the carrying value over the fair value of the respective assets. The Company's impairment evaluations were performed with the assistance of an independent valuation firm. The evaluations of both goodwill and other intangible assets included reasonable and supportable assumptions and projections and were based on estimates of projected future cash flows. Casual Gourmet Foods experienced lower than anticipated sales during the third quarter of 2006, due to a significant reduction in sales to its two largest customers. These estimates assume that Casual will be able to maintain its current, but reduced distribution. These estimates of future cash flows are based upon the Company's experience, historical trends, estimates of future profitability and economic conditions. Future estimates of profitability and economic conditions require estimating such factors as sales growth, employment rates and the overall economics of the retail food industry for five to ten years in the future, and are therefore subject to variability, are difficult to predict and in certain cases, beyond the Company's control. The assumptions utilized by management were consistent with those developed in conjunction with the Company's long-range planning process. If the assumptions and projections underlying these evaluations are not achieved, or should the Company ultimately adopt and pursue different long-range plans, the amount of the impairment could be adversely affected. Accordingly, there can be no assurance that there will not be additional impairment charges in the future based on future events and that the additional charges would not have a materially adverse impact on the Company's financial position or results of operations. The fair value of Casual Gourmet Foods for purposes of the intangible assets impairment test was estimated primarily using a discounted cash flow model based on the Company's internal plans related to the future cash flows of Casual Gourmet Foods' primary assets. The evaluation used a discount rate of 18.0% and future cash flows over the life of the related intangible asset. Upon completion of step two of the impairment test, the Company recorded an impairment loss of $3.2 million related to customer relationships, non-competition agreements, trade names, and recipes and processes, which was reflected in impairment of intangible assets on the Company's statement of operations. The decline in the fair value of Casual Gourmet Foods was principally due to reductions in sales to its two largest customers. As a result of this impairment charge to the intangible assets, when testing goodwill impairment for the reporting unit under SFAS 142, the fair value of the reporting unit exceeded the carrying value. Accordingly Step 1 of the goodwill impairment test passed and there was no goodwill impairment. 24 Accounting for Stock-Based Awards On January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123R, "Share-Based Payment." Prior to January 1, 2006, the Company had applied the intrinsic value method of accounting for stock options granted to our employees and directors under the provisions of Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees," and related interpretations, as permitted by SFAS No. 123, "Accounting for Stock-Based Compensation." Accordingly, employee and director compensation expense was recognized only for those options whose exercise price was less than the market value of our common stock at the measurement date. The Company adopted the fair value recognition provisions of SFAS No. 123R, using the modified prospective transition method. Under the modified prospective method, (i) compensation expense for share-based awards granted prior to January 1, 2006 are recognized over the remaining service period using the compensation cost calculated for pro forma disclosure purposes under SFAS No. 123 and (ii) compensation expense for all share-based awards granted subsequent to December 31, 2005 are based on the grant date fair value estimated in accordance with the provisions of SFAS No. 123R. Results for periods prior to January 1, 2006 have not been restated. As a result of adopting SFAS No. 123R, the Company recorded a pre-tax expense of $516,000 for stock-based compensation for the year ended December 31, 2006. The determination of fair value of share-based payment awards to employees and directors on the date of grant using the Black-Scholes model is affected by the Company's stock price as well as assumptions regarding a number of highly complex and subjective variables. These variables include, but are not limited to the expected stock price volatility over the term of the awards, and actual and projected employee stock option exercise behaviors. Prior to 2006, the Company estimated expected terms based on historical Company data and compared to a peer group of public companies. For new grants after December 31, 2005, management estimated expected term using the simplified method provided in SAB 107. Management has used historical data to estimate forfeitures. The risk-free rate is based on U.S. Treasury rates in effect during the corresponding period of grant. The expected volatility is based on the historical volatility of the Company's stock price. On June 23, 2005 the Company accelerated the vesting of all stock options outstanding under the Company's 2002 Stock Option Plan (formerly the 1993 Stock Option Plan) that have exercise prices per share higher than the closing price of the Company's common stock on June 23, 2005, which was $3.07. Options to purchase 422,600 shares of the Company's common stock became exercisable immediately. No other changes to these options were made. These options range in price from a low of $3.25 to a high of $4.99 with an average of $3.53. The primary purpose of the accelerated vesting was to eliminate future compensation expense the Company would otherwise recognize in its statement of operations with respect to these accelerated options upon the adoption of SFAS 123R "Share-Based Payment". The acceleration of the vesting of these options did not impact the Company's financial statements. Stock options issued prior to November 1, 2005 vested over a two year period while stock options issued after November 1, 2005 vest over a three year period. In addition, the Company has significantly reduced the number of employees who previously would have been eligible to receive stock options. The total compensation cost related to nonvested awards not yet recognized total $673,000 with a weighted average period over which it is expected to be recognized of one year. Recently Issued Accounting Standards In December 2006, the FASB issued FSP EITF 00-19-2, Accounting for Registration Payment Arrangements ("FSP 00-19-2") which addresses accounting for registration payment arrangements. FSP 00-19-2 specifies that the contingent obligation to make future payments or otherwise transfer consideration under a registration payment arrangement, whether issued as a separate agreement or included as a provision of a financial instrument or other agreement, should be separately recognized and measured in accordance with FASB Statement No. 5, Accounting for Contingencies. ESP 00-19-2 further clarifies that a financial instrument subject to a registration payment arrangement should be accounted for in accordance with other applicable generally accepted accounting principles without regard to the contingent obligation to transfer consideration pursuant to the registration payment arrangement. For registration payment arrangements and financial instruments subject to those arrangements that were entered into prior to the issuance of EITF 00-19-2, this guidance is effective for financial statement issued for fiscal years beginning after December 15, 2006 and interim period within those fiscal years. The Company is currently evaluating the impact that the adoption of ESP 00-19-2 may have on its financial statements. In September 2006, the FASB issued SFAS 157 "Fair Value Measurements", which provides enhanced guidance for using fair value to measure assets and liabilities and also expands information about the extent to which companies measure assets and liabilities at fair value, the information used to measure fair value, and the effect of fair value measurements on earnings. SFAS 157 25 applies whenever other accounting standards require or permit assets and liabilities to be measured at fair value and does not expand the use of fair value in any new circumstances. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. The Company is currently assessing the impact of SFAS 157. In September 2006, the Securities and Exchange Commission (SEC) issued SAB No. 108, Materiality. The interpretations in SAB 108 are being issued to address diversity in practice in quantifying financial statement misstatements and the potential under current practice for the build up of improper amounts on the balance sheet. SAB 108 is effective for the first interim period of the first fiscal year ending after November 15, 2006. The Company's adoption of the provisions of SAB 108 did not impact its financial condition or results of operations. In July 2006, the FASB issued Interpretation No. 48, ("FIN 48") "Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109." FIN 48 clarifies the accounting for uncertainty in income taxes recognized in a company's financial statements in accordance with SFAS 109, "Accounting for Income Taxes." FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measure of a tax position taken or expected to be taken in a tax return. It also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company is currently evaluating the impact that adoption of FIN 48 may have on its results of operations or financial position. In May 2005, the FASB issued SFAS No. 154, "Accounting Changes and Error Corrections." This new standard replaces APB Opinion No. 20, "Accounting Changes in Interim Financial Statements," and SFAS No. 3, "Reporting Accounting Changes in Interim Financial Statements," and represents another step in the FASB's goal to converge its standards with those issued by the International Accounting Standards Board ("IASB"). Among other changes, SFAS 154 requires that a voluntary change in accounting principle be applied retrospectively with all prior period financial statements presented on the new accounting principle, unless it is impractical to do so. SFAS 154 also provides that (1) a change in method of depreciating or amortizing a long-lived nonfinancial asset be accounted for as a change in estimate (prospectively) that was effected by a change in accounting principle, and (2) correction of errors in previously issued financial statements should be termed a "restatement." The new standard was effective for accounting changes and correction of errors made in fiscal years beginning after December 15, 2005. As of December 31, 2006 this pronouncement had no impact on the Company's consolidated financial statements. In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities ("SFAS 159"). SFAS 159 provides companies with an option to report selected financial assets and liabilities at fair value. SFAS 159 also establishes presentation and disclosure requirements designed to facilitate comparisons between companies that choose different measurement attributes for similar types of assets and liabilities and to provide additional information that will help investors and other financial statement users to more easily understand the effect of the company's choice to use fair value on its earnings. Finally, SFAS 159 requires entities to display the fair value of those assets and liabilities for which the company has chosen to use fair value on the face of the balance sheet. SFAS 159 is effective as of the beginning of an entity's first fiscal year beginning after November 15, 2007. Early adoption is permitted as of the beginning of the previous fiscal year provided that the entity makes that choice in the first 120 days of that fiscal year and also elects to apply the provisions of SFAS 157 (see above). The Company is currently assessing the impact of SFAS 159 which it will be required to adopt. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Market Risk Disclosure The Company does not hold market risk-sensitive trading instruments, nor does it use financial instruments for trading purposes. Except as disclosed below in this item, all sales, operating items and balance sheet data are denominated in U.S. dollars; therefore, the Company has no significant foreign currency exchange rate risk. In the ordinary course of its business the Company enters into commitments to purchase raw materials over a period of time, generally six months to one year, at contracted prices. At December 31, 2006 these future commitments were not at prices in excess of current market, or in quantities in excess of normal requirements. The Company does not utilize derivative contracts either to hedge existing risks or for speculative purposes. 26 Interest Rate Risk The Company invests excess cash in variable income investments consisting of cash equivalents. The magnitude of the interest income generated by these cash equivalents is affected by market interest rates. Management does not use marketable securities or derivative financial instruments in its investment portfolio. The interest payable on the Company's bank line of credit is based on variable interest rates and therefore affected by changes in market interest rates. During the second quarter of 2006, the Company repaid all of its loans with variable interest rates. Currency Risk During 2006, the Company sold $86,000 of product in currency other than US dollars. These sales have terms of net 30 days from shipment. The Company believes that its currency exposure is not material and has chosen not to hedge these sales. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The financial statements and supplementary data of the Company required by this item are set forth at the pages indicated at Item 15(a) and are incorporated here by reference. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None ITEM 9A. CONTROLS AND PROCEDURES Disclosure Controls and Procedures As required by Rule 13a-15(b) under the Exchange Act, we conducted an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer (together the "Certifying Officers"), of the effectiveness of the design and operation of our disclosure controls and procedures as of December 31, 2006, the end of the period covered by this report. Based upon that evaluation, the Certifying Officers concluded that our disclosure controls and procedures were effective as of December 31, 2006 to provide reasonable assurance that information required to be disclosed in our Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms and that such information is accumulated and communicated to our management, including our Certifying Officers, as appropriate, to allow for timely decisions regarding required disclosure. Inherent Limitations on Effectiveness of Controls Management is responsible for establishing and maintaining adequate internal control over financial reporting to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles. Internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of assets; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with U.S. generally accepted accounting principles, and that receipts and expenditures are being made only in accordance with authorizations of the management and the Board; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of Company assets that could have a material effect on the financial statements. Management personnel, including the Certifying Officers, recognize that our internal control over financial reporting cannot prevent or detect all error and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system's objectives will be met. The design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Further, because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that misstatements due to error or fraud will not occur or that all control issues and instances of fraud, if any, have been detected. The design of any 27 system of controls is based in part on certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Changes in Internal Control over Financial Reporting The Company reported a material weakness in conjunction with its 2005 audited financial statements. During 2006, the Company implemented the following remediation actions in order to conclude that the Company had effective internal controls as of December 31, 2006. All of the changes described below were implemented as of March 31, 2006 and remained through 2006. (a) Expanding accounting professionals. As of December 31, 2005, due to medical disability and unanticipated departure of personnel, the Company employed only two full-time and one part-time accountants. As of December 31, 2006, the Company had replaced or hired additional qualified accountants to bring its accounting staff to five full-time accountants and one part-time accountant. (b) Implementation of certain enhanced control processes over accounting for subsidiaries. (c) Enhanced internal reporting from its financial systems including general ledger reporting and consolidating entries. (d) Engagement of third party tax specialists to provide quality assurance and tax expertise outside of the firm that currently prepares the Company's tax return. (e) Engaging other specialists to provide support for reporting of technical areas. (f) Reviewing the process by which its tax provision is prepared. Other than these improvements, there has been no change during the company's fiscal quarter ended December 31, 2006 in the company's internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) that has materially affected, or is reasonably likely to materially affect, the company's internal control over financial reporting. ITEM 9B. OTHER INFORMATION None PART III ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE As of March 30, 2007, the directors, executive officers, and other significant employees of the Company are as follows: Directors and Executive Officers:
Name Age Position ---- --- -------- Charles B. Bonner (1) (4) (5) 64 Director F. Christopher Cruger (2) (3) (4) 72 Director Eric C. Eddings 46 Chief Executive Officer, President and Director Michael P. Schall (1) (4) 53 Director Van Tunstall (4) (5) 60 Chairman of the Board James Wong (2) (3) (4) (5) 59 Director Walter L Henning (2) (3) (4) 62 Vice Chairman of the Board John H. McGarvey (1) (4) 62 Director Scott Wheeler 52 Chief Financial Officer, Corporate Secretary and Director
(1) Member of Audit Committee (2) Member of Compensation Committee (3) Member of Nominating Committee (4) Independent Director (5) Member of the Governance Committee 28 Normally each director is elected for a period of one year and serves until the stockholders duly elect his or her successor. Directors may be elected by the Board to fill a vacancy between annual stockholder meeting elections. The principal occupations of each director and executive officer of the Company, for at least the past five years, are as follows: Charles B. Bonner. Mr. Bonner served as a Director of the Company from 1993 through January 1995, and was reappointed as a Director effective September 1995. Mr. Bonner is Principal and Founder of Pacific Resources, Inc., a mergers and acquisitions advisory firm, a position he has held since September 1989. From 1975 to 1988 he was president of Bonner Packing Co., an $80MM dried fruit processing and marketing company which was sold to Dole Food Company in 1988. Mr. Bonner also serves as a director for Everything Metal Imaginable, Inc., and Scrip Advantage, Inc. F. Christopher Cruger. Mr. Cruger was elected to the Board of Directors in December of 2001. He is a retired investor and former senior manager or executive of several consumer product companies. Mr. Cruger joined McCormick and Company, a maker of spices and seasonings, in 1995 and served until 1999 as Vice-President and General Manager of the Food Service Group and as Chairman of McCormick's Global Food Service Council. Mr. Cruger was president and CEO of Tone Brothers, Inc., a spice producer, from 1985 to 1995. He is a Director of Kemin Industries, Inc. Eric C. Eddings, Mr. Eddings was appointed by the Board of Directors as President and Chief Executive Officer of Monterey Gourmet Foods in September 2006. Prior to his appointment, he was the President of the Natural Foods Division of Monterey Gourmet Foods. Previously Mr. Eddings was the Chief Operating Officer and minority shareholder of CIBO Naturals, LLC which he and his associates purchased in June, 2002. CIBO Naturals was acquired by Monterey Gourmet Foods in January 2004 and later became part of the Natural Foods Division of Monterey Gourmet Foods. Prior to his employment with CIBO Naturals, Mr. Eddings was the Vice President of Wholesale/Plant Operations of Tully's Coffee Corporation in Seattle Washington. Mr. Eddings also has previously worked for Dreyers Grand Ice Cream, Haagen - Dazs Company and Frito Lay, Inc. Mr. Eddings has a Masters of Business Administration degree from the University of Redlands and a Bachelors of Arts degree in Business Administration from California State University at Fullerton. Michael P. Schall. Mr. Schall was elected to the Board of Directors in December of 2001. Mr. Schall is currently President of Strategic Marketing Methods, a consulting and advisory firm providing sales and marketing, business development advisory and new product expertise to the food and foodservice industries. Mr. Schall served as Senior Vice President of Sales, Marketing, and Direct Store Delivery for Wise Foods, a snack food company, from January 2002 until March 2003. From 2000 until January of 2002 he was President and CEO of the B. Manischewitz Company, one of the nation's largest kosher food companies. Prior to that Mr. Schall was President and CEO of Guiltless Gourmet, a food manufacturing company, from 1994 until it's acquisition by Manischewitz. Mr. Schall held executive or senior management positions with Carnation Company, now Nestle S.A., Lawry's Foods Inc., a division of Unilever U.S., and Prepared Products Co. Van Tunstall. Mr. Tunstall was elected to the Board of Directors in February 1997. Since 1997, he has served as President of the Central Coast Group, a strategic consulting and business services firm. Mr. Tunstall has been an independent consultant with a variety of companies since 1997. Mr. Tunstall was a senior executive with Gilroy Foods, Inc., an international manufacturer of various food product ingredients, from 1977 to 1995. He served as President and Chairman of the Board of Gilroy Foods, Inc. from 1991 through 1995. Previously, Mr. Tunstall held several executive positions with McCormick & Company, Inc. Mr. Tunstall has also served on the boards of other food companies such as Rudi's Organic Bakery, Inc., Wildwood Natural Foods, Inc, and Cascade Specialties, Inc. James Wong. Mr. Wong was elected to the Board of Directors in March 1997. Following a career in the U.S. Marine Corps, he worked as a turnaround manager and productivity consultant at General Motors and subsequently at PepsiCo, working in the U.S. and overseas. Since leaving employment with PepsiCo in 1988, Mr. Wong has worked on five continents as an entrepreneur and management consultant facilitating business turnarounds, strategic alliances and technology transfers for PepsiCo and other companies. Mr. Wong is currently Chairman and a Director of FRSI, Inc., a technology exploration, development and integration company. Walter L. Henning. Mr. Henning was elected to the Board of Directors in December 1999 and elected as Vice-Chairman in 2006. He has over 35 years experience in the production and distribution of a multitude of food products, including spices, extracts, seasoning mixes, and dehydrated onion, garlic and capsicums. He has been responsible for 12 plants in 5 different companies, including Rykoff- Sexton, Burns- Philp, ConAgra, and McCormick & Co, Inc., and has served as Vice- President Operations for each company. He was responsible for world- wide supply chain operations for Tone Spices in Des Moines, IA, and while there was instrumental in establishing a joint- venture manufacturing plant in Cochin, India. He also served as Chairman of the State of Iowa's Manufacturing Council from 1990 - 1995. His responsibilities with both McCormick and ConAgra included managing an extensive farming operation as well as the largest onion/garlic dehydration facilities in the world. Mr. Henning has B.S. and M.S. degrees in Food Science and Technology from the University of California, and currently holds an APICS Certification in Production and 29 Inventory Management. He retired from his daily activities at McCormick and Co. in January, 2007 after eight years in operations management and now devotes his primary effort to teaching at Cal State University- Monterey Bay. He is a faculty member in the School of Business where he teaches upper division courses in Operations Management. John H. McGarvey. Mr. McGarvey was elected to the Board of Directors in February 2006. He has served since 1990 as an associate and/or partner of Cybus Capital Markets, LLC, an investment bank specializing in capital placement and formation services for middle market companies in the food and agribusiness areas. Mr. McGarvey is an owner and director of McGarvey & Affiliates, a financial consulting firm. Currently, Mr. McGarvey serves on the boards of Cybus Capital Markets, LLC and Dominex LLC. Mr. McGarvey is a law graduate of Creighton University, received a Masters degree in Taxation from New York University, and has earned continuing education credit in finance from the Wharton Business School. Scott S. Wheeler. Mr. Wheeler joined the company in April 2003 as Corporate Controller, and was promoted to Chief Financial Officer, effective October 27, 2003 and was elected as a Board member in June 2004. His most recent position was Vice President and Financial Officer of KBC Edible Beans Division of ConAgra Foods, where he worked for three years. Prior to that he worked for Mallard's Food Products both when it was an independent company and after it was sold to Tyson Foods. He began his career at Mallard's Food Products in 1994 as Chief Financial Officer until 1999 when he was promoted to General Manager until joining KBC in April of 2000. Prior to joining Mallard's, Mr. Wheeler held a variety of positions with Basic American Foods over a thirteen-year period. He is a CPA with an MBA in finance from Golden Gate University in San Francisco, CA. Compliance with Section 16(a) of the Securities Exchange Act of 1934 Section 16(a) of the Securities Exchange Act of 1934, as amended, requires the Company's directors and executive officers, and persons who own more than 10% of a registered class of the Company's equity securities, to file with the SEC initial reports of ownership and reports of changes in ownership of Common Stock and other equity securities of the Company. Officers, directors and greater than 10% beneficial owners are required by SEC regulations to furnish the Company with copies of all reports they file under Section 16(a). To the Company's knowledge, based solely on its review of the copies of such reports furnished to the Company and written representations that no other reports were required, all Section 16(a) filing requirements applicable to its officers, directors and greater than 10% beneficial owners were complied with during the fiscal year ended December 31, 2006. Audit Committee Composition Among the committees identified above, the Company has a separately designated standing audit committee established in accordance with Section 3(a)(58)(A) of the Securities Exchange Act of 1934, as amended. Charles B. Bonner, Michael P. Schall and John H. McGarvey are members of the audit committee during the year 2006. The Company's Board of Directors has determined that all members of the Company's Audit Committee are "independent" as defined in NASD Marketplace Rule 4200(a)(15). Audit Committee Expert The Company's Board of Directors has determined that Mr. Charles B. Bonner and Mr. John H. McGarvey are the Board's designated financial experts. Code of Ethics The Company has adopted a Code of Ethics as defined in Item 406 of Regulation S-K that applies to its principal executive and financial officers and the persons performing similar functions. Monterey Gourmet Foods will provide a copy of its Code of Ethics, without charge, to any investor that requests it. Requests should be addressed in writing to Mr. Scott Wheeler, Corporate Secretary, 1528 Moffett Street, Salinas, CA 93905. ITEM 11. EXECUTIVE COMPENSATION Compensation Discussion and Analysis Overview of Compensation Policy The Company's Compensation Committee is empowered to review and approve, or in some cases recommend for the approval of the full Board of Directors the annual compensation for the executive officers of the Company. This Committee has the responsibility for establishing, implementing, and monitoring the Company's compensation strategy and policy. Among its principal duties, the Committee ensures that the total compensation of the executive officers is fair, reasonable and competitive. 30 Objectives and Philosophies of Compensation The primary objective of the Company's compensation policy, including the executive compensation policy, is to help attract and retain qualified, energetic managers who are enthusiastic about the Company's mission and products. The policy is designed to reward the achievement of specific annual and long-term strategic goals aligning executive performance with company growth and shareholder value. In addition, the Board of Directors strives to promote an ownership mentality among key leaders and the Board of Directors. The Corporate Governance Principles provide that it is the policy of the Board of Directors to encourage all directors to maintain an outright investment in the Company of a minimum of 5,000 shares of the company stock. Setting Executive Compensation The compensation policy is designed to reward performance. In measuring executive officers' contribution to the Company, the Compensation Committee considers numerous factors including the Company's growth and financial performance as measured by revenue, gross margin and net income before taxes among other key performance indicators. Regarding most compensation matters, including executive and director compensation, management provides recommendations to the Compensation Committee; however, the Compensation Committee does not delegate any of its functions to others in setting compensation. The Compensation Committee does not currently engage any consultant related to executive and/or director compensation matters. Stock price performance has not been a factor in determining annual compensation because the price of the Company's common stock is subject to a variety of factors outside of management's control. The Company does not subscribe to an exact formula for allocating cash and non-cash compensation. However, a significant percentage of total executive compensation is performance-based. Historically, the majority of the incentives to executives have been in the form of non-cash incentives in order to better align the goals of executives with the goals of stockholders. Elements of Company's Compensation Plan The principal components of compensation for the Company's executive officers are: o base salary o performance-based incentive cash compensation o right to purchase the company's stock at a preset price (stock options) o retirement and other benefits Base Salary The Company provides named executive officers and other employees with base salary to compensate them for services rendered during the fiscal year. Base salary ranges for named executive officers are determined for each executive based on his or her position and responsibility. During its review of base salaries for executives, the Committee primarily considers: o market data; o internal review of the executives' compensation, both individually and relative to other officers; and o individual performance of the executive. Salary levels are typically evaluated annually as part of the Company's performance review process as well as upon a promotion or other change in job responsibility. Performance-Based Incentive Compensation The management incentive plan gives the Committee the latitude to design cash and stock-based incentive compensation programs to promote high performance and achievement of corporate goals, encourage the growth of stockholder value and allow key employees to participate in the long-term growth and profitability of the Company. For stock-based programs, the Committee may grant participants stock options which are the only non-cash incentive currently approved by the stockholders of the Company. In granting these awards, the Committee establishes parameters such as vesting schedules and terms of the grants. 31 All awards of shares of the Company's stock options are made at the market price at the time of the award. Annual awards of stock options to executives are made at the Committee's regularly scheduled meeting while the stock options awarded to outside Board members are automatically granted at the regularly scheduled annual shareholders meeting. Newly hired or promoted executives receive their award of stock options on the first business day of their hire or promotion or at the time the Committee meets and approves such grants. Ownership Guidelines To directly align the interests of the Board of Directors with the interests of the stockholders, the Committee recommends that each Board member maintain a minimum ownership interest in the Company. Currently, the Compensation Committee recommends that each Board member own a minimum of 5,000 shares of the Company's common stock with such stock to be acquired within a reasonable time following election to the Board. Stock Option Program The Stock Option Program assists the Company to: o enhance the link between the creation of stockholder value and long-term executive incentive compensation; o provide an opportunity for increased equity ownership by executives; and o maintain competitive levels of total compensation. Stock option award levels are determined based on market data, vary among participants based on their positions within the Company and are granted at the Committee's regularly scheduled meeting. Options are awarded at the NASDAQ's closing price of the Company's Common Stock on the date of the grant. The Committee has never granted options with an exercise price that is less than the closing price of the Company's Common Stock on the grant date, nor has it granted options which are priced on a date other than the grant date. The majority of the options granted by the Committee vest at a rate of 33% per year over the first three years of the ten-year option term. Vesting and exercise rights cease upon termination of employment for executives and upon expiration of the vested options for independent Board members. Prior to the exercise of an option, the holder has no rights as a stockholder with respect to the shares subject to such option, including voting rights. Beginning on January 1, 2006, the Company began accounting for stock-based payments including its Stock Option Program and its Employee Stock Purchase Plan in accordance with the requirements of FASB Statement 123(R). Retirement and Other Benefits All employees in the United States are eligible to participate in the Company's 401-k Retirement Plan. In addition, employees are entitled to participate in the Company's Employee Stock Purchase Plan. 401-k Retirement Plan In 1996, the Company instituted a 401(k) Plan covering substantially all full-time employees with six months of service. Under the Plan, employees may elect to defer up to 15% of compensation (subject to certain limitations). Beginning in January 2003 the Company adopted a Safe Harbor Plan and currently matches employee contributions up to 4% of compensation. In addition, the Company may make an annual discretionary profit-sharing contribution. Employee contributions, Company matching contributions and related earnings are always 100% vested. Employee Stock Purchase Plan In October 1994, the Company's Board of Directors adopted a qualified employee stock purchase plan. Under the purchase plan, eligible employees (those who have completed one year of continuous employment with the Company) may purchase shares of the Company's common stock through payroll deductions not to exceed 10% of gross wages. The Company has reserved 200,000 shares of its common stock for issuance under the purchase plan, which remains in effect until terminated by the Company's Board of Directors, or until all of the shares reserved for under the purchase plan have been issued. Unless the Board has otherwise provided a higher amount prior to the commencement of an offering 32 period, the offering exercise price for each purchase period is 85% of the lesser of (a) the fair market value of the shares on the offering date of such offering period or (b) the fair market value of the shares on the given purchase date. Perquisites and Other Personal Benefits The Company provides some executive officers with perquisites and other personal benefits that the Company and the Committee believe are reasonable and consistent with its overall compensation program to better enable the Company to attract and retain superior employees for key positions. The Committee periodically reviews the levels of perquisites and other personal benefits provided to named executive officers. Some executive officers are provided use of company automobiles and all employees can participate in the plans and programs described above. Each employee of the Company is entitled to term life insurance, premiums for which are paid by the Company in the amount of one-times annual base salary. In addition, each employee is entitled to receive certain medical and dental benefits and part of the cost is funded by the employee. Accounting and Tax Considerations The Company's stock option grant policy has been impacted by the implementation of SFAS No. 123R, which was adopted in the first quarter of fiscal year 2006. Under this accounting pronouncement, the Company is required to value unvested stock options granted prior to the adoption of SFAS 123 under the fair value method and expense those amounts in the income statement over the stock option's remaining vesting period. Section 162(m) of the Internal Revenue Code restricts deductibility of executive compensation paid to Monterey Gourmet Foods' chief executive officer and each of the four other most highly compensated executive officers holding office at the end of any year to the extent such compensation exceeds $1,000,000 for any of such officers in any year and does not qualify for an exception under Section 162(m) or related regulations. The Committee's policy is to qualify its executive compensation for deductibility under applicable tax laws to the extent practicable. Income related to stock options granted under the Option Plan generally qualifies for an exemption from these restrictions imposed by Section 162(m). In the future, the Committee will continue to evaluate the advisability of qualifying its executive compensation for full deductibility. Summary Compensation Table (2006) The following table includes information concerning compensation for the one year period ended December 31, 2006 in reference to the five most highly compensated employees of the Company which includes required disclosure related to the CEO and CFO.
Change in Pension Value and Nonqualified Non-Equity Deferred Name and Stock Option Incentive Plan Compensation All Other Principal Position Year Salary $ (4) Bonus $ (5) Awards Awards (8) Compensation Earnings Compensation (9) Total ------------------ ---- ------------ ----------- ------ ---------- ------------ -------- ---------------- ----- James M. 2006 $ 335,000 $ 41,959 $ -- $ 193,515 $ -- $ -- $ 295,786 (6) $ 866,260 Williams (1) Former President and CEO Eric C. 2006 $ 227,950 $155,622 $ -- $ 74,631 $ -- $ -- $ 16,431 $ 474,634 Eddings (3) Current President and CEO Scott S. 2006 $ 177,308 $ 15,000 $ 24,549 $ -- $ -- $ 7,092 $ 223,949 Wheeler (2) Chief Financial Officer A. Martin Adams 2006 $ 181,125 $ 82,883 (7) $ -- $ -- $ -- $ 14,294 $ 278,302 Chief Executive Officer - Sonoma Foods, Inc. C. David Viviani 2006 $ 181,125 $ 82,883 (7) $ -- $ -- $ -- $ 14,294 $ 278,302 Chief Operating Officer - Sonoma Foods, Inc.
(1) Mr. Williams joined the Company in October 2002 as President. On December 28, 2002, Mr. Williams was promoted to President and Chief Executive Officer. On September 5, 2006 Mr. Williams resigned as an officer and Board member of the Company. (2) Mr. Wheeler joined the Company in April 2003 and was promoted to Chief financial Officer in October 2003. 33 (3) Mr. Eddings joined the Company in January 2004 as part of the acquisition of CIBO Naturals LLC. Mr. Eddings became President and Chief Executive Officer on September 5, 2006. (4) Includes amounts (if any) deferred at the named executive officer's option under the Company's 401(k) plan. (5) Bonuses were based on the Company's performance and other objectives obtained. (6) Represents payments made in accordance with the separation agreement between Mr. Williams and the Company. (7) Amount paid as part of the purchase agreement for Sonoma Foods, Inc. and deemed compensation according to GAAP. (8) Amounts calculated utilized the provisions of SFAS No. 123R "Share-based Payments" of the consolidated financial statements and reconciled to the amounts expensed in the Company's 2006 financial statements. Since the vesting of the option awards are over three years, this amount represents only a portion of the fair value of the options granted during 2005 and 2006. The fair value of the options granted in 2006 are: Mr. Williams $132,143; Mr. Eddings $317,085; Mr. Wheeler $0; Mr. Adams $0; and Mr. Viviani $0. (9) The Company matches 100% of the employee contributions to the Company's 401-k plan up to 4% of individual compensation. All of the participates contributed a minimum of 4% of base salary to the 401-k plan and the Company matched that contribution. Also, Mr. Williams, Mr. Eddings, Mr. Adams, and Mr. Viviani received a car allowance. Grants of Plan-Based Awards for 2006 The following table sets forth certain information with respect to the options granted during or for the calendar year ended December 31, 2006 to each of the executive officers listed in the summary Compensation Table as shown under the caption "Executive Compensation."
Estimated Future Estimated Future Payouts Under Non- Payouts Under Equity Incentive Equity Incentive Plan Awards Plan Awards Name and ------------------------------------- --------------------------------------- Principal Position Grant Date Threshold Target Maximum Threshold Target Maximum - -------------------------------------------- --------- ------ ------- --------- ------ -------- James M. Williams 9/5/2006 -- -- -- -- -- -- Former President and CEO Eric C. Eddings 9/13/2006 -- -- -- -- -- -- Current President and CEO Scott S. Wheeler -- -- -- -- -- -- Chief Financial Officer A. Martin Adams Chief Executive Officer - Sonoma Foods, Inc. -- -- -- -- -- -- C. David Viviani Chief Operating Officer - Sonoma Foods, Inc. -- -- -- -- -- -- All Other All Other Stock Option Awards: Awards: Grant Date Number of Number of Exercise or Fair Value Shares of Securities Base Price of Stock Name and Stock or Underlying of Option and Option Principal Position Units Options Awards Awards - -------------------------------------------- ---------- ----------- ---------- ----------- James M. Williams -- 150,000 3.72 $ 132,143 Former President and CEO Eric C. Eddings -- 150,000 3.89 $ 317,085 Current President and CEO Scott S. Wheeler -- -- -- -- Chief Financial Officer A. Martin Adams Chief Executive Officer - Sonoma Foods, Inc. -- -- -- -- C. David Viviani Chief Operating Officer - Sonoma Foods, Inc. -- -- -- --
Outstanding Equity Awards at December 31, 2006 The following table includes certain information with respect to the value at the calendar year end December 31, 2006 of all unexercised options previously awarded to the executive officers named above. 34
Option Awards -------------------------------------------------------------------------------- Equity Incentive Plan Number of Awards: Number of Securities Number of Securities Underlying Securities Underlying Unexercised Underlying Unexercised Options Unexercised Option Option Name and Principal Options Unexercisable Unearned Exercise Expiration Position Exercisable (1) Options Price Date - ---------------------------------------------------------------- -------------- -------------- --------------- --------------- James M. Williams 50,000 -- -- $ 3.76 9/5/2009 Former President and CEO 50,000 -- -- $ 3.44 9/5/2009 50,000 -- -- $ 3.95 9/5/2009 Eric C. Eddings 5,000 10,000 -- $ 3.95 12/9/2015 Current President and CEO -- 150,000 -- $ 3.89 9/13/2016 Scott S. Wheeler 10,000 -- -- $ 3.39 4/26/2013 Chief Financial Officer 15,000 -- -- $ 3.76 10/29/2013 15,000 -- -- $ 3.44 11/11/2014 6,667 13,333 -- $ 3.95 12/9/2015 A. Martin Adams -- -- -- -- -- Chief Executive Officer - Sonoma Foods, Inc. C. David Viviani -- -- -- -- -- Chief Operating Officer - Sonoma Foods, Inc. Stock Awards ---------------------------------------------------------------------- Equity Incentive Equity Plan Incentive Awards: Plan Market Awards: or Payout Number of Value of Market Unearned Unearned Number Value of Shares, Shares, of Shares Shares or Units or Units or or Units of Units of Other Other Stock That Stock That Rights Rights Name and Principal Have Not Have Not That Have That Have Position Vested Vested Not Vested Not Vested - ----------------------------------------------------------------- ---------------- ---------------- ------------------ James M. Williams -- -- -- -- Former President and CEO -- -- -- -- -- -- -- -- Eric C. Eddings -- -- -- -- Current President and CEO -- -- -- -- Scott S. Wheeler -- -- -- -- Chief Financial Officer -- -- -- -- -- -- -- -- -- -- -- -- A. Martin Adams -- -- -- -- Chief Executive Officer - Sonoma Foods, Inc. C. David Viviani -- -- -- -- Chief Operating Officer - Sonoma Foods, Inc.
Option Exercises and Stock Vested in 2006 The following table includes certain information with respect to the options exercised by the executive officers named above during the calendar year ended December 31, 2006.
Option Awards Stock Awards ----------------------------------- ---------------------------------- Number of Number of Shares Shares Acquired Value Realized Acquired Value Realized Name and Principal Position on Exercise on Exercise on Vesting on Vesting - ---------------------------------------------------------------------- ----------------- -------------- --------------- James M. Williams -- -- -- -- Former President and CEO Eric C. Eddings 15,000 $ 44,228 -- -- Current President and CEO 15,000 $ 36,855 -- -- Scott S. Wheeler -- -- -- -- Chief Financial Officer A. Martin Adams -- -- -- -- Chief Executive Officer - Sonoma Foods, Inc. C. David Viviani -- -- -- -- Chief Operating Officer - Sonoma Foods, Inc.
(1) All options listed above vest at a rate of 33% per year over the first three years of the ten-year option term. 35 Board of Directors Compensation Table for 2006 The following table provides compensation information for the one year period ended December 31, 2006 for each non-employee member of the Board of Directors.
Change in Pension Value and Fees Nonqualified Earned Non-Equity Deferred All Other or Paid in Stock Option Incentive Plan Compensation Compen- Name Cash (1) Awards Awards (2) Compensation Earnings sation Total - ------------------------------------- -------- ----------- --------------- --------------- ------------ -------- Charles B. Bonner $ 14,800 $ -- $ 24,327 -- -- -- $ 39,127 F. Christopher Cruger $ 12,000 $ -- $ 24,327 -- -- -- $ 36,327 Michael P. Schall $ 12,000 $ -- $ 24,327 -- -- -- $ 36,327 Van Tunstall $ 19,000 $ -- $ 33,774 -- -- -- $ 52,774 James Wong $ 14,000 $ -- $ 24,327 -- -- -- $ 38,327 Walter L Henning $ 12,000 $ -- $ 24,327 -- -- -- $ 36,327 John H. McGarvey $ 12,688 $ -- $ 18,488 -- -- -- $ 31,176
1. Independent directors are reimbursed for out-of-pocket travel expenses which are not included in this table. Each Board member receives a stipend of $3,000 for each Board meeting attended. The Board Chairman receives $4,500 for each Board meeting attended. The Audit Committee Chairperson receives a stipend of $700 for each Audit Committee meeting chaired, the Compensation Committee chairperson receives a stipend of $500 for each committee meeting chaired, and the Board Chairman receives a stipend of $1,000 for each meeting chaired. 2. Since the vesting of the option awards are over three years, this amount represents only a portion of the fair value of the options granted during 2006. The fair value of the options granted in 2006 is: Mr. Bonner $40,211; Mr. Cruger $40,211; Mr. Schall $40,211; Mr. Tunstall $60,933; Mr. Wong $40,211; Mr. Henning $40,211; Mr. McGarvey $50,263. Each Board member is granted 10,000 stock options each year with a grant date on the annual shareholder's meeting. The Board Chairman receives 15,000 stock options each year. Certain Relationships and Related Transactions The Compensation Committee is charged with monitoring and reviewing issues involving potential conflicts of interest, and reviewing and approving all related party transactions. As of December 31, 2006, there were no related party transactions. Employment Contracts and Termination of Employment and Change-in-Control Arrangements On September 4, 2006, the Board of Directors of the Company appointed Eric Eddings as President and Chief Executive Officer of Monterey Gourmet Foods effective September 5, 2006, pursuant to an employment contract which was signed on September 15, 2006 and filed on Form 8-K on September 21, 2006 and is incorporate here by reference. As part of the agreement, the Company will pay Mr. Eddings a base salary of $285,000 per year. Mr. Eddings will be eligible for an annual cash bonus based on performance and achieving certain goals. In addition, Mr. Eddings received an incentive stock option to purchase 150,000 shares of the Company's common stock vesting and exercisable in installments of 50,000 shares on each of the first, second, and third anniversaries of his employment agreement. As part of the agreement, if Mr. Eddings is terminated by the Board of Directors without cause, Mr. Eddings will be eligible for severance compensation equal to twelve months of his then applicable base annual salary. 36 Compensation Committee Interlocks and Insider Participation During the fiscal year ended December 31, 2006, executive compensation was administered by the Compensation Committee comprised of three independent members of the Board of Directors, James Wong, Walter L. Henning, and F. Christopher Cruger. Compensation Committee Report We have reviewed and discussed with management certain Compensation Discussion and Analysis provisions to be included in the Company's SEC Form 10-K and 2007 Shareholder Meeting Schedule 14A Proxy Statement. Based on the reviews and discussions referred to above, we recommend to the Board of Directors that the Compensation Discussion and Analysis referred to above be included in the Company's Annual Report on Form 10-K. Compensation Committee James Wong, Chairman Walter Henning F. Christopher Cruger ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS. The table below sets forth (except as noted in the footnotes to the table), certain information with respect to the beneficial ownership of the Company's Common Stock by (i) all persons known by the Company to be the beneficial owners of more than 5% of the outstanding Common Stock of the Company as of December 31, 2006, (ii) each director of the Company as of December 31, 2006, (iii) the executive officers named in the Summary Compensation Table in Item 11, and (iv) all such executive officers and directors of the Company as of December 31, 2006, as a group. No shares reported on this report are pledged.
Shares Owned -------------------------------------------- Name and Address of Beneficial Owner (1) Number of Shares Percentage of Class - ------------------------------------------------------- ---------------- ------------------- Gruber and McBaine Capital Management (2) 2,528,055 14.6% 50 Osgood Place, Penthouse San Francisco, CA 94133 T. Rowe Price Associates, Inc. (3) 1,267,400 7.3% 100 East Pratt Street Baltimore, MD 21202 Dimensional Fund Advisors (4) 1,410,462 8.1% 1299 Ocean Ave Santa Monica, CA 90401 AWM Investment Co., Inc. (5) 1,105,041 6.4% 153 East 53rd Street New York, NY 10022 F. Christopher Cruger (6) 61,317 * Van Tunstall (7) 135,807 * Michael P. Schall (8) 65,350 * James Wong (9) 86,000 * Charles B. Bonner (10) 181,906 1.0% Scott Wheeler (11) 50,667 * Walter L. Henning (12) 108,700 * Eric C. Eddings (13) 74,000 * John H. McGarvey (14) -- * James M. Williams (15) 156,650 * A. Martin Adams 6,215 * C. David Viviani 24,860 * All Executive Officers and Directors as a group (12 persons)(16) 951,472 5.1%
37 _____________________ * Represents less than 1% (1) Beneficial ownership is determined in accordance with the rules of the Securities and Exchange Commission. In computing the number of shares beneficially owned by a person and the percentage ownership of that person, shares of Common Stock subject to options or warrants held by that person that are currently exercisable or will become exercisable within sixty (60) days after December 31, 2006 are deemed outstanding, while such shares are not deemed outstanding for purposes of computing percentage ownership of any other person. Options granted under the Company's 2002 Stock Option Plan (the "2002 Stock Option Plan") generally become exercisable as the underlying shares vest. Unless otherwise indicated in the footnotes below, the persons and entities named in the table have sole voting and investment power with respect to all shares beneficially owned, subject to community property laws where applicable. Unless otherwise indicated, the address of each of the individuals listed in the table is: c/o Monterey Gourmet Foods, Inc., 1528 Moffett Street, Salinas, CA 93905. (2) Jon D. Gruber and J. Patterson McBaine are the only managers of, and hold all executive offices of, Gruber and McBaine Capital Management LLC ("GMCM"), an investment advisor. GMCM is the general partner of Lagunitas Partners, L.P. ("Lag"), a California investment limited partnership. As of December 31, 2006, GMCM had shared voting and investment power over 2,528,055 shares; Mr. Gruber had sole voting and investment power over 322,820 shares and shared voting and investment power over 2,528,055 shares; Mr. McBaine had sole voting and investment power over 351,750 shares and shared voting and investment power over 2,528,055 shares; Lag has shared voting and investment power over 1,249,885 shares. Neither Mr. Gruber nor Mr. McBaine participate in the Management of the Company, direct the policies of the company, or serve on the Board of Directors of the Company. (3) As of December 31, 2006, T. Rowe Price Associates, Inc ("Price Associates") had sole dispositive power for an entire holding of 1,267,400 shares and sole voting power over 267,400 shares. These securities are owned by various individual and institutional investors for whom Price Associates serves as investment advisor with power to direct investments and/or sole power to vote the securities. For purposes of the reporting requirements of the Securities Exchange Act of 1934, Price Associates expressly disclaims that it is, in fact, the beneficial owner of such securities. (4) As of December 31, 2006, Dimensional Fund Advisors Inc ("Dimensional") an investment advisor registered under Section 203 of the Investment Advisors Act of 1940 which furnishes investment advice to four investment companies registered under the Investment Company Act of 1940 and serves as investment manager to certain other commingled groups trusts and separate accounts directly or indirectly held 1,410,462 shares of Company stock. In its role as investment advisor or manager, Dimensional possesses investment and/or voting power over 1,410,462 shares. However, Dimensional disclaims beneficial ownership of these securities. In addition, no Dimensional officer serves as an executive officer or director of the Company. (5) As of December 31, 2006, AWM Investment Co., Inc. ("AWM"), in its capacity of investment advisor, may be deemed to have beneficial ownership of 1,105,041shares of the common stock of the Company. Mr. Austin W. Marxe and Mr. David M. Greenhouse are the controlling principals of AWM Investment Company, Inc. AWM had voting power and/or dispositive power over 1,105,041 shares. (6) Includes 56,250 shares subject to options granted under the 2002 Stock Option Plan which are exercisable within sixty (60) days of December 31, 2006. (7) Includes 111,667 shares subject to options granted under the 2002 Stock Option Plan which are exercisable within sixty (60) days of December 31, 2006. (8) Includes 56,250 shares subject to options granted under the 2002 Stock Option Plan which are exercisable within sixty (60) days of December 31, 2006. (9) Includes 80,000 shares subject to options granted under the 2002 Stock Option Plan which are exercisable within sixty (60) days of December 31, 2006. (10) Includes 103,750 shares subject to options granted under the 2002 Stock Option Plan which are exercisable within sixty (60) days of December 31, 2006. (11) Includes 46,667 shares subject to options granted under the 2002 Stock Option Plan which are exercisable within sixty (60) days of December 31, 2006. 38 (12) Includes 6,200 shares held in an IRA account in the name of Teresa A. Henning to which Mr. Henning claims beneficial ownership, and 80,000 shares subject to options granted under the 2002 Stock Option Plan which are exercisable within sixty (60) days of December 31, 2006. (13) Includes 5,000 shares subject to options granted under the 2002 Stock Option Plan which are exercisable within sixty (60) days of December 31, 2006. (14) Mr. McGarvey was elected to the Board of Directors in February 2006 and does not own any of the Company's stock and has not been issued any options under the 2002 Stock Option Plan which are exercisable within sixty (60) days of December 31, 2006. (15) Includes 150,000 shares subject to options granted under the 2002 Stock Option Plan which are exercisable within sixty (60) days of December 31, 2006. (16) Includes 689,584 shares subject to options granted under the 2002 Stock Option Plan which are exercisable within sixty (60) days of December 31, 2006. Additional information required by this item covering equity compensation plans offered by the Company is incorporated by reference from Note 10 to the consolidated financial statements contained in Item 15. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR INDEPENDENCE The Company's policy is to forbid all related party transactions; hence there is no separate policy to govern Board of Directors review or approval of such matters. During the year ended December 31, 2006, there were no related party transactions. ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES The Audit Committee of the Board of Directors of Monterey Gourmet Foods has selected BDO Seidman, LLP as independent registered public accounting firm to audit the consolidated financial statements of Monterey Gourmet Foods for the calendar year ending December 31, 2006. BDO Seidman, LLP has acted in such capacity since its appointment in fiscal year 1997. The following table sets forth the aggregate fees billed to Monterey Gourmet Foods for the years ended December 31, 2006 and December 31, 2005 by BDO Seidman, LLP: Fiscal 2006 Fiscal 2005 ----------- ----------- Audit Fees (1)........................... $318,000 $288,000 Audit-Related Fees (2)................... $30,000 $40,000 Tax Fees (3)............................. $56,000 $55,000 All Other Fees .......................... $0 $0 (1) Audit Fees consist of fees billed for professional services rendered for the audit of the Company's consolidated annual financial statements and review of the interim consolidated financial statements included in quarterly reports and services that are normally provided by BDO Seidman, LLP in connection with statutory and regulatory filings or engagements. Fiscal 2005 fees have been revised from the original 2005 filing to include additional fees billed in 2006 in relation to the 2005 audit. (2) Audit-Related Fees consist of fees billed for assurance and related services that are reasonably related to the performance of the audit or review of the Company's consolidated financial statements and are not reported under "Audit Fees." These services generally include fees for due diligence related to business acquisitions and equity awards. (3) Tax Fees consist of fees billed for professional services rendered for annual compliance filings, ongoing tax planning, and consultation regarding the tax implication of proposed or pending transactions. The Audit Committee must pre-approve audit and non-audit services provided to the Company by the independent registered public accounting firm (or subsequently approve non-audit services in those circumstances where a subsequent approval is necessary and permissible); in this regard, the Audit Committee has the sole authority to approve the hiring and firing of the independent registered public accounting firm, all audit engagement fees, terms and all non-audit engagements, as may be permissible, with the independent registered public accounting firm. Pre-approval was obtained from the audit committee for all fees incurred by the independent registered public accounting firm. 39 PART IV ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES
(a)(1) - (2) Consolidated Financial Statements of Monterey Gourmet Foods: Page Number (s) --------------- Report of Independent Registered Public Accounting Firm 41 Consolidated Balance Sheets: Year-End 2006 and 2005 42 Consolidated Statements of Operations: Years Ended 2006, 2005 and 2004 43 Consolidated Statements of Stockholders' Equity: Years Ended 2006, 2005 and 2004 44 Consolidated Statements of Cash Flows: Years Ended 2006, 2005 and 2004 45 Summary of Significant Accounting Policies 46-51 Notes to Consolidated Financial Statements 52-69 Schedule II - Valuation and Qualifying Accounts 70
All other schedules have been omitted since the required information is contained in the Consolidated Financial Statements or because such schedules are not required. (a)(3) Exhibits: See Index to Exhibits on page 72. The Exhibits listed in the accompanying Index of Exhibits are filed or incorporated by reference as part of this report. Exhibit Nos. 10.1, 10.2, and 10.7, are management contracts or compensatory plans or arrangements. 40 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Stockholders and Board of Directors of Monterey Gourmet Foods, Inc. We have audited the accompanying consolidated balance sheets of Monterey Gourmet Foods, Inc. as of December 31, 2006 and December 31, 2005 and the related consolidated statements of operations, stockholders' equity and cash flows for each of the three years in the period ended December 31, 2006. We have also audited the schedule listed in the accompanying index at Item 15(a). These consolidated financial statements and the schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and the schedule based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). These standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements and schedule are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements and schedule, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements and schedule. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Monterey Gourmet Foods, Inc. at December 31, 2006 and December 31, 2005, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2006, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the schedule presents fairly, in all material respects, the information set forth therein. As discussed in Note 9 to the Consolidated Financial Statements, effective January 1, 2006 the Company adopted the provisions of Statement of Financial Accounting No. 123 (Revised 2004), Share-Based Payment. BDO Seidman, LLP San Francisco, California March 21, 2007 41
MONTEREY GOURMET FOODS, INC. CONSOLIDATED BALANCE SHEETS (in thousands, except share amounts) December 31, 2006 December 31, 2005 ----------------- ----------------- ASSETS Current assets: Cash and cash equivalents $ 4,281 $ 330 Accounts receivable less allowances of $722 and $992 9,958 9,342 Inventories 7,574 6,949 Deferred tax assets-current 793 1,030 Prepaid expenses and other 807 866 ----------------- ----------------- Total current assets 23,413 18,517 Property and equipment, net 15,303 14,324 Deferred tax assets-long term 3,315 6,172 Deposits and other 174 148 Intangible assets, net 7,052 11,088 Goodwill 13,211 11,956 ----------------- ----------------- Total assets $ 62,468 $ 62,205 ================= ================= LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Bank overdraft $ -- $ 1,507 Line of credit -- 3,000 Accounts payable 7,835 4,171 Accrued payroll and related benefits 1,487 1,246 Accrued and other current liabilities 1,577 1,053 Current portion of notes, loans, and capital leases payable 1,018 2,521 ----------------- ----------------- Total current liabilities 11,917 13,498 Notes, loans, and capital leases payable, less current portion 129 6,626 Deferred tax liability-long term -- 2,812 Minority interest 159 159 Stockholders' equity: Preferred stock, $.001 par value, 1,000,000 shares authorized, none outstanding Common stock, $.001 par value, 50,000,000 shares authorized, 17,307,647 and 14,514,038 issued and outstanding 17 14 Additional paid-in capital 59,796 45,534 Accumulated deficit (9,550) (6,438) ----------------- ----------------- Total stockholders' equity 50,263 39,110 ----------------- ----------------- Total liabilities and stockholders' equity $ 62,468 $ 62,205 ================= =================
See accompanying summary of significant accounting policies and notes to consolidated financial statements. 42
MONTEREY GOURMET FOODS, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands, except share and per share amounts) Years Ended -------------------------------------------- 2006 2005 2004 ------------ ------------ ------------ Net revenues $ 94,297 $ 85,248 $ 62,491 Cost of sales 66,858 62,016 46,023 ------------ ------------ ------------ Gross profit 27,439 23,232 16,468 Selling, general and administrative expenses 26,754 23,590 18,224 Impairment of intangible assets 3,160 -- -- Gain (loss) on disposition of assets 13 -- (5) ------------ ------------ ------------ Operating loss (2,462) (358) (1,761) Other income, net -- 18 42 Interest expense, net (355) (628) (130) ------------ ------------ ------------ Loss before provision for income taxes (2,817) (968) (1,849) Income tax benefit (provision) (295) 431 505 ------------ ------------ ------------ Net loss $ (3,112) $ (537) $ (1,344) ============ ============ ============ Basic loss per common share ($ 0.19) ($ 0.04) ($ 0.09) Diluted loss per common share ($ 0.19) ($ 0.04) ($ 0.09) Weighted average basic shares outstanding 16,100,250 14,450,251 14,343,386 Weighted average diluted shares outstanding 16,100,250 14,450,251 14,343,386
See accompanying summary of significant accounting policies and notes to consolidated financial statements. 43
MONTEREY GOURMET FOODS, INC. CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY FOR THE YEARS ENDED 2004, 2005, and 2006 (in thousands, except share amounts) Common Stock --------------------------------- Additional Accumulated Shares Amount Paid-in Capital Deficit Total --------------- --------------- --------------- --------------- --------------- Balance, end of 2003 14,213,682 $ 14 $ 44,578 $ (4,557) $ 40,035 Issuance of common stock under Employee Stock Purchase Plan 14,964 -- 43 -- 43 Exercise of stock options for cash 163,928 -- 427 -- 427 Tax benefit of disqualifying dispositions -- -- 55 -- 55 Net loss for the year -- -- -- (1,344) (1,344) --------------- --------------- --------------- --------------- --------------- Balance, end of 2004 14,392,574 $ 14 $ 45,103 $ (5,901) $ 39,216 Issuance of common stock under Employee Stock Purchase Plan 8,198 -- 25 -- 25 Exercise of stock options for cash 51,116 -- 128 -- 128 Stock-based compensation -- -- 80 -- 80 Issuances of stock as part of an acquisition 62,150 -- 198 -- 198 Net loss for the year -- -- -- (537) (537) --------------- --------------- --------------- --------------- --------------- Balance, end of 2005 14,514,038 $ 14 $ 45,534 $ (6,438) $ 39,110 Issuance of common stock under Employee Stock Purchase Plan 10,900 -- 32 -- 32 Exercise of stock options for cash 308,709 -- 894 -- 894 Issuance of stock as part of an acquisition 300,000 -- 1,186 -- 1,186 Stock issued as part of PIPE Financing 2,174,000 3 11,632 -- 11,635 Tax benefit of disqualifying dispositions -- -- 2 -- 2 Stock-based compensation -- -- 516 -- 516 Net loss for the year -- -- -- (3,112) (3,112) --------------- --------------- --------------- --------------- --------------- Balance, end of 2006 17,307,647 $ 17 $ 59,796 $ (9,550) $ 50,263 =============== =============== =============== =============== ===============
See accompanying summary of significant accounting policies and notes to consolidated financial statements. 44
MONTEREY GOURMET FOODS, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands, except share amounts) Years Ended -------------------------------------------- 2006 2005 2004 ------------ ------------ ------------ Cash flows from operating activities: Net loss $ (3,112) $ (537) $ (1,344) Adjustments to reconcile net loss to net cash provided by (used in) operating activities net of acquisition: Deferred income taxes 282 (379) (557) Depreciation and amortization 2,926 3,033 2,510 Impairment of intangibles 3,160 -- -- Provisions for allowances for bad debts, returns, adjustments and spoils 4,876 4,792 3,646 Provisions for inventory allowances 629 499 550 Tax benefit of disqualifying dispositions -- -- 55 Stock-based compensation 516 80 -- (Gain) Loss on disposition of assets (13) -- 5 Changes in assets and liabilities: Accounts receivable (5,492) (6,554) (2,924) Inventories (1,254) (2,473) (267) Prepaid expenses and other 33 205 538 Accounts payable 3,664 972 (3) Accrued and other current liabilities 765 (742) (311) ------------ ------------ ------------ Net cash provided by (used in) operating activities 6,980 (1,104) 1,898 ------------ ------------ ------------ Cash flows from investing activities: Purchase of property and equipment (3,010) (1,071) (777) Proceeds from sale of fixed assets 13 -- -- Acquisition of business net of cash and minority interest (69) (9,062) (7,689) ------------ ------------ ------------ Net cash used in investing activities (3,066) (10,133) (8,466) ------------ ------------ ------------ Cash flows from financing activities: Proceeds from bank borrowing -- 7,500 2,000 Bank overdraft (1,507) 1,507 -- Line of credit (3,000) 3,000 -- Repayment of debt (7,992) (1,143) (610) Tax benefit of disqualifying dispositions 2 -- -- Repayment of capital lease obligations (27) (19) (8) Proceeds from issuance of common stock 12,561 153 470 ------------ ------------ ------------ Net cash provided by financing activities 37 10,998 1,852 ------------ ------------ ------------ Net increase (decrease) in cash and cash equivalents 3,951 (239) (4,716) Cash and cash equivalents, beginning of period 330 569 5,285 ------------ ------------ ------------ Cash and cash equivalents, end of period $ 4,281 $ 330 $ 569 ============ ============ ============ Cash payments: Interest $ 501 $ 634 $ 131 Income taxes 6 7 89 Non-cash investing and financing activities: Note issued to seller in acquisition of business $ -- $ -- $ 1,000 Capital lease obligations 19 86 5 Issuance of stock for acquisition of business 1,186 198 --
See accompanying summary of significant accounting policies and notes to consolidated financial statements. 45 MONTEREY GOURMET FOODS, INC NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Summary of Significant Accounting Policies Principles of Consolidation and Nature of Operations The consolidated financial statements include the accounts of Monterey Gourmet Foods, Inc. (a producer, distributor, and marketer of refrigerated gourmet food products), together with its wholly owned subsidiaries, Monterey Pasta Development Company (a franchiser of restaurants - inactive), CIBO Naturals, LLC (100% owned as of January 12, 2006), Casual Gourmet Foods, Inc. (100% owned as of September 29, 2006) and 80% owned Sonoma Foods, Inc. All significant intercompany accounts and transactions have been eliminated in consolidation. Collectively, Monterey Gourmet Foods, CIBO Naturals, LLC, Monterey Pasta Development Company, Casual Gourmet Foods, and Sonoma Foods are referred to as the "Company." The consolidated financial statements include the Company's accounts and the accounts of wholly- and majority-owned subsidiaries. The Company consolidates all of the majority-owned subsidiaries and reflects minority interest of Sonoma Foods on the consolidated balance sheet because of the uncertainty that Monterey will purchase the remaining shares from the minority shareholders. Monterey is the sole source of any financing needed by its majority-owned subsidiaries. The Company's production facilities and distribution center are located in Salinas (Monterey County), California, Seattle, Washington, and Eugene, Oregon. Its products are available throughout the United States as well as selected distribution areas in Canada, the Caribbean, Latin America, and Asia Pacific. The principal customers are retail grocery and club stores. The Company offers credit and payment terms to its customers in line with industry practices, generally calling for unsecured trade accounts receivable. The Company reported losses for the years 2004, 2005, and 2006 and at December 31, 2006 the company had an accumulated deficit of $9,550,000. The Company generated $7 million in cash from operating activities during 2006 and raised $11.6 million through a private equity transaction. Management believes that the Company's current cash balances and future operating projections will provide adequate liquidity to meet the Company's planned capital and operating requirements for normal operations and capital expenditures through the 2007 calendar year. See Note 7 for a description of the Company's credit facility. Accounting Periods The Company operates and reports results on a calendar year. The calendar year ended on December 31, 2006. Cash and Cash Equivalents The Company considers all highly liquid investments purchased with an original maturity of three months or less to be cash equivalents. The Company's cash consists primarily of cash in the Company's bank account. Accounts Receivable and Allowances The Company provides allowances for estimated credit losses, product returns, spoilage, and adjustments at a level deemed appropriate to adequately provide for known and inherent risks related to such amounts. The allowances are based on reviews of history of losses, returns, spoilages, adjustments, contractual relationships with customers, current economic conditions, and other factors that warrant consideration in estimating potential losses. The Company has a policy that estimates potential returns, spoilages, and adjustments to revenues; then management adjusts these amounts for known information specific to each customer. After all attempts to collect a receivable have failed, the receivable is written off against the allowance. While management uses the best information available in making its determination, the ultimate recovery of recorded accounts and other receivables is also dependent on future economic and other conditions that may be beyond management's control. Inventory Valuation Inventories are stated at the lower of cost (using the first-in, first-out method) or market and consist principally of component ingredients to the Company's refrigerated pasta and sauces, finished goods, and packaging materials. Many of the ingredients used in the Company's products are short shelf-lived products and if not used in a certain amount of time may spoil. Management estimates that the raw material will be used in a timely manner; however, management has established certain reserves for the potential of inventory obsolescence, especially for slow moving inventory. As of December 31, 2006 and December 31, 2005, the Company reduced the carrying value of its inventory by $273,000 and $123,000 respectively. This write-down was made to cover certain refrigerated raw material inventory that is nearing its shelf-life, certain packaging labels for products that may be rotated out of the Club Store accounts and for products that have already been rotated out of the Club Store accounts that may or may not be rotated back into the Club Store accounts. The allowance is established based on management's estimate of 46 alternative usage or salvage value of obsolete inventory. Management believes its estimates for spoiled and obsolete inventory are adequate given the current volume of business to current customers. Advertising Costs The Company expenses advertising costs as incurred or when the related campaign commences. The Company spent $107,000, $253,000 and $149,000 on advertising during, 2006, 2005, and 2004, respectively. Property and Equipment Property and equipment are recorded at cost. Depreciation is provided for on the straight-line method over the estimated useful lives of the assets (or lease term for leasehold improvements if shorter): Leasehold improvements 7 to 12 years Machinery and equipment 7 to 12 years Office furniture and equipment 5 to 15 years Computer and software 3 to 5 years Vehicles 5 to 7 years Long-lived assets, including plant and equipment, are assessed for possible impairment whenever events or changes in circumstances indicate that the carrying amounts may not be recoverable, or whenever management has committed to a plan to dispose of the assets. Assets to be held and used affected by such an impairment loss are depreciated or amortized at their new carrying amount over the remaining estimated life; assets to be sold or otherwise disposed of are not subject to further depreciation or amortization. Valuation of Goodwill/Indefinite-lived Intangible Assets Under SFAS 142, "Goodwill and Other Intangible Assets" goodwill and intangible assets with indefinite useful lives are to be tested for impairment at least annually. The primary identifiable intangible assets of the Company's reporting unit with indefinite lives are trademarks, tradenames and goodwill acquired in business acquisitions. As of December 31, 2006, the net book value of trademarks and other identifiable indefinite-lived intangible assets was $2.7 million. The Company defines a reporting unit as a unit one level below its operating segment. A reporting unit exists if the component constitutes a business for which discrete financial information is available and senior managers regularly review the operating results of the component. As of December 31, 2006, the Company determined that it had one reporting unit based on the Company's internal reorganization which integrated the Company's brands to a more functional reporting structure. Prior to the fourth quarter of 2006, the Company had four reporting units as its acquirees' operations were not integrated. Identifiable indefinite-lived intangible assets are not subject to amortization and are assessed for impairment at least as often as annually and as triggering events may occur. The impairment test for identifiable intangible assets not subject to amortization consists of a comparison of the fair value of the intangible asset's reporting unit with its carrying amount. If the carrying amount exceeds the fair value, then a second step of impairment is performed to measure the impairment loss, if any. Given the Company's internal reorganization in which the Company operates under one reporting unit, management primarily relies on the Company's market capitalization to determine fair value. Secondarily, the Company relies on a number of factors to discount anticipated future cash flows including operating results, business plans and present value techniques. Rates used to discount cash flows are dependent upon interest rates and the cost of capital at the relevant point in time. There are inherent uncertainties related to these factors and management's judgment in applying them to the analysis of intangible asset impairment. It is possible that assumptions underlying the impairment analysis will change in such a manner that impairment in value may occur in the future. Goodwill is not amortized but is subject to periodic assessments of impairment. At December 31, 2006, the Company had $13.2 million of goodwill on its books. Goodwill is assessed for impairment at least as often as annually and as triggering events may occur. The Company performs its annual review in the fourth quarter of each year. Recoverability of goodwill is evaluated using a comparison of the fair value of a reporting unit with its carrying value. In evaluating the recoverability of goodwill, it is necessary to estimate the fair value of the reporting unit. In making this assessment, management relies on a number of factors to discount anticipated future cash flows including operating results, business plans and present value techniques. Rates used to discount cash flows are dependent upon interest rates and the cost of capital at the relevant point in time. There are inherent uncertainties related to these factors and management's judgment in applying them to the analysis of goodwill impairment. It is possible that assumptions underlying the impairment analysis will change in such a manner that impairment may occur in the future. 47 Valuation of Plant and Equipment and finite-lived Intangible Assets In accordance with Statement of Financial Accounting Standards (SFAS) No. 144, Accounting for the Impairment or Disposal of Long-lived Assets ("SFAS 144"), management reviews finite-lived long-lived assets, primarily consisting of plant and equipment and amortized intangible assets such as acquired recipes, customer lists and non-compete agreements, whenever events or changes in circumstances indicate that the carrying amount of an asset group may not be recoverable. Intangible assets with finite useful lives continue to be amortized over their respective estimated useful lives. The estimated useful life of an identifiable intangible asset is based upon a number of factors, including the effects of demand, competition, and future cash flows. For these assets, if the total expected future undiscounted cash flows from the asset group is less than the carrying amount of the asset group, an impairment loss is recognized for the difference between the fair value of the carrying value of the asset group. The impairment tests require management to estimate the undiscounted cash flows and fair value of the asset groups. As of December 31, 2006, the net book value of finite-lived intangible assets was $4.3 million. When analyzing finite, long-lived assets for potential impairment, significant assumptions are used in determining the undiscounted cash flows of the asset group, including the cash flows attributed to the asset group; future cash flows of the asset group, including estimates of future growth rates; and the period of time in which the assets will be held and used. The Company primarily determines fair values of the asset group using discounted cash flow models. In addition, to estimate fair value management is required to estimate the discount rate that incorporates the time value of money and risk inherent in future cash flows. Impairment of finite-lived and indefinite-lived Intangible Assets In the third quarter of 2006, it was determined that the identifiable intangible assets of Casual Gourmet Foods (including customer relationships, recipes and processes, non-competition agreements, and trade name) were impaired as their undiscounted cash flows were insufficient to recover the carrying value. Accordingly, the impairment charge was measured in accordance with SFAS 144 as the excess of the carrying value over the fair value of the respective assets. The Company's impairment evaluations were performed with the assistance of an independent valuation firm. The evaluations of both goodwill and other intangible assets included reasonable and supportable assumptions and projections and were based on estimates of projected future cash flows. Casual Gourmet Foods experienced lower than anticipated sales during the third quarter of 2006, due to a significant reduction in sales to its two largest customers. These estimates assume that Casual will be able to maintain its current, but reduced distribution. These estimates of future cash flows are based upon the Company's experience, historical trends, estimates of future profitability and economic conditions. Future estimates of profitability and economic conditions require estimating such factors as sales growth, employment rates and the overall economics of the retail food industry for five to ten years in the future, and are therefore subject to variability, are difficult to predict and in certain cases, beyond the Company's control. The assumptions utilized by management were consistent with those developed in conjunction with the Company's long-range planning process. If the assumptions and projections underlying these evaluations are not achieved, or should the Company ultimately adopt and pursue different long-range plans, the amount of the impairment could be adversely affected. Accordingly, there can be no assurance that there will not be additional impairment charges in the future based on future events and that the additional charges would not have a materially adverse impact of the Company's financial position or results of operations. The fair value of Casual Gourmet Foods for purposes of the intangible assets impairment test was estimated primarily using a discounted cash flow model based on the Company's internal plans related to the future cash flows of Casual Gourmet Foods' primary assets. The evaluation used a discount rate of 18.0% and future cash flows over the life of the related intangible asset. Upon completion of step two of the impairment test, the Company recorded an impairment loss of $3.2 million related to customer relationships, non-competition agreements, trade names, and recipes and processes, which was reflected in impairment of intangible assets on the Company's statement of operations. The decline in the fair value of Casual Gourmet Foods was principally due to reductions in sales to its two largest customers. As a result of this impairment charge to the intangible assets, when testing goodwill impairment for the reporting unit under SFAS 142, the fair value of the reporting unit exceeded the carrying value. Accordingly Step 1 of the goodwill impairment test passed and there was no goodwill impairment. Income Taxes and Deferred Tax Asset Valuation Allowance The Company accounts for corporate income taxes in accordance with SFAS 109, "Accounting for Income Taxes" which requires an asset and liability approach. This approach results in the recognition of deferred tax assets (future tax benefits) and liabilities for the expected future tax consequences of temporary timing differences between the book carrying amounts and the tax 48 basis of assets and liabilities. Future tax benefits are subject to a valuation allowance to the extent of the likelihood that the deferred tax assets may not be realized. The Company's deferred tax assets include significant amounts of net operating losses (`NOLs"). During 2006, the valuation allowance was increased based on the management's judgment that it is not more-likely-than-not that all of its deferred tax assets could be realized due to the intangible asset impairment of the Casual Gourmet Foods which affected the Company's assessment of the realization of our NOLs. The amount of the valuation allowance is significantly dependant on management's assumptions regarding future taxable income and the availability of these NOLs to offset future taxable income. The effect on the Company's net income is significant whenever the estimate changes. The Company has a valuation allowance against deferred tax assets of $1.5 million as of December 31, 2006. Revenue Recognition The Company recognizes revenues through sales of its products primarily to grocery and club store chains. Revenues are recognized once there is evidence of an arrangement (such as a customer purchase order), product has been shipped to the customer or (in the case of Costco wholesales) when the product has been delivered to the customer, the price and terms are fixed, and collectibility is reasonably assured. Accordingly, sales are recorded when goods are shipped or delivered, at which time title and risk of loss have passed to the customer, consistent with the freight terms for the customer. Potential returns, adjustments and spoilage allowances which reduce net revenues are provided for in accounts receivable allowances and accruals. All pricing is quoted FOB shipping point to customers with freight included in the price for the convenience of the customer. The Company records shipping cost for product delivered to customers in selling general and administrative expense. These costs were approximately $5,764,000, $ 4,361,000 and $3,201,000 for 2006, 2005, and 2004 respectively. Any amounts charged to customers for freight and deliveries are included in revenues and approximate the amount recorded in SG&A. Certain incentives granted to customers such as promotions, trade ads, slotting fees, terms discounts, and coupons are recorded as offsets to revenues. Workers Compensation Reserve The Company's California and Oregon locations entered into a partially self-insured worker's compensation program for fiscal year 2003 and have continued the program through 2006 and into 2007. This program features a fixed annual payment, with a deductible on a per occurrence basis. The annual expense consists of a base fee paid to an insurance company to administer the program, direct cash expenses to pay for injuries, an estimate for potential injuries that may have occurred but have not been reported, an estimate by the insurance company of costs to close out each injury and an estimate for injury development. The Company has been on this partially self-insured program for four years and therefore has limited history of claim resolution available to support the Company's projected liabilities. Therefore the Company is using published industry actuarial data from an insurance carrier and reviewing each claim individually to determine the amount of reserves that should be established. Management believes that its current safety program and its safety record will provide the foundation to enable the Company to realize the premium savings partially self-insured programs are designed to achieve; however, estimated reserves may vary from future cash outlays. The remaining locations are on a fixed premium insurance contract that covers all costs including claims. Stock-based Compensation On January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123 (revised 2004), "Share-Based Payment," ("SFAS 123(R)") which requires the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors based on estimated fair values. SFAS 123(R) supersedes previous accounting under Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25") for periods beginning before calendar year 2006. In March 2005, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 107 ("SAB 107") relating to SFAS 123(R). The Company has applied the provisions of SAB 107 in its adoption of SFAS 123(R). The Company adopted SFAS 123(R) using the modified prospective transition method, which requires the application of the accounting standard as of January 1, 2006, the first day of the Company's fiscal year 2006. Consolidated financial statements as of December 31, 2006 reflect the impact of SFAS 123(R). In accordance with the modified prospective transition method, the consolidated financial statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS 123(R). There was no stock-based compensation expense related to employee or director stock options recognized during 2005. During 2006, the Company recognized $516,000 in stock-based compensation expense. On June 23, 2005 the Company accelerated the vesting of all stock options outstanding under the Company's 2002 Stock Option Plan (formerly the 1993 Stock Option Plan) that have exercise prices per share higher than the closing price of the Company's common stock on June 23, 2005, which was $3.07. Options to purchase 422,600 shares of the Company's common stock became exercisable immediately. No other changes to these options were made. These options range in price from a low of $3.25 to a high of $4.99 with an average of $3.53. The primary purpose of the accelerated vesting was to eliminate future 49 compensation expense the Company would otherwise recognize in its statement of operations with respect to these accelerated options upon the adoption of SFAS 123R "Share-Based Payment". The acceleration of the vesting of these options did not impact the Company's financial statements. Stock options issued prior to November 1, 2005 vested over a two year period while stock options issued after November 1, 2005 vest over a three year period. In addition, the Company has significantly reduced the number of employees who previously would have been eligible to receive stock options. Segment and Enterprise-Wide Reporting The Company discloses segment enterprise-wide information in accordance with SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information." Based upon definitions contained within SFAS No. 131, management has determined that the Company operates in one segment. In addition, virtually all revenues are in North America, and all of the long-lived assets are located within the United States. Use of Estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the period. Actual results could differ from those estimates. The most significant estimates made by the Company are those related to accounts receivable and deferred tax allowances, allocation of purchase price of acquired businesses, workers compensation reserves, assumptions regarding the expense of stock-based compensation, depreciation of fixed assets, amortization of acquired intangible assets, and impairment assessments made for intangible assets and goodwill. Indemnifications The Company follows FASB Interpretation No. ("FIN") 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others". FIN 45 requires a guarantor to recognize, at the inception of a qualified guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. Pursuant to its bylaws, the Company has agreed to indemnify its officers and directors for certain events or occurrences arising as a result of the officer or director serving in such capacity. The term of the indemnification period is for the officer's or director's lifetime. The Company has no liabilities recorded for these agreements as of December 31, 2006. The Company enters into indemnification provisions under (i) its agreements with other companies both in extraordinary transactions (such as acquisitions of a material amount of assets or other investment in other companies) and in its ordinary course of business, typically with business partners, contractors and customers, and its sublandlord and (ii) its agreements with investors. Under these provisions the Company has agreed to generally indemnify and hold harmless the indemnified party for losses suffered or incurred by the indemnified party as a result of the Company's activities or, in some cases, as a result of the indemnified party's activities under the agreement. These indemnification provisions often include indemnifications relating to representations made by the Company with regard to intellectual property and other rights. These indemnification provisions generally survive termination of the underlying agreement. The maximum potential amount of future payments the Company could be required to make under these indemnification provisions is unlimited. To date, the Company has not incurred any costs as there have been no lawsuits or claims related to these indemnification agreements. Accordingly, the Company has no liabilities recorded for these agreements as of December 31, 2006. New Accounting Pronouncements In December 2006, the FASB issued FSP EITF 00-19-2, Accounting for Registration Payment Arrangements ("FSP 00-19-2") which addresses accounting for registration payment arrangements. FSP 00-19-2 specifies that the contingent obligation to make future payments or otherwise transfer consideration under a registration payment arrangement, whether issued as a separate agreement or included as a provision of a financial instrument or other agreement, should be separately recognized and measured in accordance with FASB Statement No. 5, Accounting for Contingencies. ESP 00-19-2 further clarifies that a financial instrument subject to a registration payment arrangement should be accounted for in accordance with other applicable generally accepted accounting principles without regard to the contingent obligation to transfer consideration pursuant to the registration payment arrangement. For registration payment arrangements and financial instruments subject to those arrangements that were entered into prior to the issuance of EITF 00-19-2, this guidance is effective for financial statement issued for fiscal years beginning after December 15, 2006 and interim period within those fiscal years. The Company is currently evaluating the impact that the adoption of ESP 00-19-2 may have on its financial statements. In September 2006, the FASB issued SFAS 157 "Fair Value Measurements", which provides enhanced guidance for using fair value to measure assets and liabilities and also expands information about the extent to which companies 50 measure assets and liabilities at fair value, the information used to measure fair value, and the effect of fair value measurements on earnings. SFAS 157 applies whenever other accounting standards require or permit assets and liabilities to be measured at fair value and does not expand the use of fair value in any new circumstances. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. The Company is currently assessing the impact of SFAS 157. In September 2006, the Securities and Exchange Commission (SEC) issued SAB No. 108, Materiality. The interpretations in SAB 108 are being issued to address diversity in practice in quantifying financial statement misstatements and the potential under current practice for the build up of improper amounts on the balance sheet. SAB 108 is effective for the first interim period of the first fiscal year ending after November 15, 2006. The Company's adoption of the provisions of SAB 108 did not impact its financial condition or results of operations. In July 2006, the FASB issued Interpretation No. 48, ("FIN 48") "Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109." FIN 48 clarifies the accounting for uncertainty in income taxes recognized in a company's financial statements in accordance with SFAS 109, "Accounting for Income Taxes." FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measure of a tax position taken or expected to be taken in a tax return. It also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company is currently evaluating the impact that adoption of FIN 48 may have on its results of operations or financial position. In May 2005, the FASB issued SFAS No. 154, "Accounting Changes and Error Corrections." This new standard replaces APB Opinion No. 20, "Accounting Changes in Interim Financial Statements," and SFAS No. 3, "Reporting Accounting Changes in Interim Financial Statements," and represents another step in the FASB's goal to converge its standards with those issued by the International Accounting Standards Board ("IASB"). Among other changes, SFAS 154 requires that a voluntary change in accounting principle be applied retrospectively with all prior period financial statements presented on the new accounting principle, unless it is impractical to do so. SFAS 154 also provides that (1) a change in method of depreciating or amortizing a long-lived nonfinancial asset be accounted for as a change in estimate (prospectively) that was effected by a change in accounting principle, and (2) correction of errors in previously issued financial statements should be termed a "restatement." The new standard was effective for accounting changes and correction of errors made in fiscal years beginning after December 15, 2005. As of December 31, 2006 this pronouncement had no impact on the Company's consolidated financial statements. In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities ("SFAS 159"). SFAS 159 provides companies with an option to report selected financial assets and liabilities at fair value. SFAS 159 also establishes presentation and disclosure requirements designed to facilitate comparisons between companies that choose different measurement attributes for similar types of assets and liabilities and to provide additional information that will help investors and other financial statement users to more easily understand the effect of the company's choice to use fair value on its earnings. Finally, SFAS 159 requires entities to display the fair value of those assets and liabilities for which the company has chosen to use fair value on the face of the balance sheet. SFAS 159 is effective as of the beginning of an entity's first fiscal year beginning after November 15, 2007. Early adoption is permitted as of the beginning of the previous fiscal year provided that the entity makes that choice in the first 120 days of that fiscal year and also elects to apply the provisions of SFAS 157 (see above). The Company is currently assessing the impact of SFAS 159 which it will be required to adopt. Reclassifications Certain of the prior year financial statement amounts have been reclassified to conform to the current year presentation. These reclassifications had no impact on previously reported income or accumulated deficit. Earnings per Share Basic earnings per share is based on the weighted average number of common shares outstanding during the calendar period. Diluted earnings per share is based on the weighted average number of common shares outstanding plus, where applicable, the additional common shares that would have been outstanding as a result of the conversion of dilutive options and warrants. 51 2. Business Acquisitions 2006 Activities On January 12, 2006, the Company, Suekat LLC ("Suekat") and CIBO Naturals, LLC ("CIBO"), amended their previous agreement for the purchase and sale of limited liability company units: as a result, the Company acquired the remaining 15.5% of CIBO from Suekat in exchange for 300,000 unregistered shares of the Company's common stock with a market value of $1,186,000. The purchase price was all allocated to goodwill. The shares were later registered as part of the registration statement filed with the SEC on Form S-3 on July 19, 2006. On March 31, 2006, the Company purchased an additional 10% interest in Casual Gourmet Foods, Inc. ("Casual") pursuant to the Company's January 11, 2005 agreement with Casual and its shareholders. The purchase price for the additional 10% ownership was $1,600 which increased the Company's ownership of Casual to 70%. The purchase price was all allocated to goodwill. Casual, which produces branded gourmet sausages and other food products, is a Florida corporation. On September 29, 2006, the Company, Casual, and the shareholders of Casual entered into an agreement to amend the Purchase Agreement dated January 11, 2005, to accelerate the Third Closing and Final Closing to set the amount of the Third Payment and Final Payment, and to accelerate the purchase by the Company of the remaining 30% of Casual's outstanding shares for $23,000. A copy of the Amendment to the Stock Purchase Agreement was filed on Form 8-K filed with the SEC on October 5, 2006, and is incorporated here by reference. The Casual Gourmet Foods Purchase in 2005 On January 11, 2005, the Company entered into a definitive agreement with Casual Gourmet Foods, Inc. ("Casual"), and the shareholders of Casual ("Shareholders") for the purchase by the Company of 100% of Casual's outstanding shares. The acquisition was structured to provide that the Company acquired 60% of Casual's outstanding shares immediately and the remaining 40% over the next three years. Casual, which produces branded gourmet sausages and other food products, is a Florida corporation. Prior to entering into the Stock Purchase Agreement, there were no existing material relationships between or among the Company and Casual or its Shareholders. The Company acquired Casual in order to expand and diversify its product line in the specialty foods category in which it competes. For its initial acquisition, the Company paid $6.0 million in cash plus acquisition costs of $159,000. The Company purchased the remaining 40% of Casual Gourmet Foods, Inc. in 2006. The details of the 40% purchase is described in the 2006 activities above. Casual markets a wide range of refrigerated branded specialty items, including chicken sausages, chicken burgers, and gourmet soups. Their products are sold in club stores and retail food stores. Some of their most popular sausage items include red bell pepper with basil, and spinach with Asiago cheese. As part of the acquisition, Monterey Gourmet Foods commissioned a valuation study to determine the components that represent the intangible assets and goodwill purchased as part of the initial purchase price. Under the purchase method of accounting, the total purchase price is allocated to Casual's tangible and intangible assets based upon their estimated fair value as of the date of completion of the acquisition. Based upon the purchase price, the purchase price allocation is as follows (in thousands of dollars): 52
Cash paid directly to owners of Casual $ 6,000 Acquisition costs incurred 159 ---------- Total cost of acquisition 6,159 ---------- Liabilities assumed: Accounts payable 325 Income taxes payable 159 Other accrued liabilities 504 Long-term notes payable 266 Deferred tax liability created at time of acquisition 1,069 Tangible assets acquired: Cash on hand (524) Accounts receivable, net (524) Income tax refund recievable (264) Inventory (315) Prepaid expenses and other (30) Fixed assets (183) Computed interest on non-interest bearing notes 8 Intangible assets acquired: Customer Relations (2,500) Non Compete (800) Trademarks (840) Recipes (400) ---------- Goodwill acquired in transaction $ 2,110 ==========
As a result of a significant reduction in sales at Casual Gourmet Foods, the Company determined that indicators of impairment existed for the Casual Gourmet Foods intangible assets and potentially the reporting unit as a whole during the third quarter of 2006. Accordingly, in accordance with Statement of Financial Accounting Standard ("SFAS") No. 142, "Goodwill and Other Intangible Assets" and SFAS No. 144 "Accounting for the Impairment of Disposal of Long-Lived Assets," the Company applied impairment tests to its intangible assets, including goodwill. As a result of this testing and in accordance with SFAS No. 142, the Company recorded a pre-tax, non-cash charge of approximately $3.2 million in the third quarter of 2006 related to the impairment of intangible assets associated with the acquisition of Casual Gourmet Foods in January 2005. The values of the intangible assets and goodwill recorded as assets on the Company's balance sheet at December 31, 2006 are: Current values of intangible assets (in thousands) Customer Relations $ 67 Non Compete 128 Trademarks 440 Recipes 38 Goodwill 2,135 ---------- Total $ 2,808 ========== The Sonoma Foods Purchase in 2005 On April 7, 2005, the Company entered into a definitive agreement with Sonoma Foods, Inc. ("Sonoma") and the shareholders of Sonoma ("Shareholders") for the purchase by the Company of 80% of Sonoma's outstanding shares ("Stock Purchase Agreement"). The Stock Purchase Agreement provides options for Sonoma's two other shareholders to sell their remaining 20% interest after four years and, if that option is not exercised, there is an option for the Company to acquire the interest after seven years. This option has a $0 fair value since the option does not offer the holder any material economic advantage. Sonoma will continue to operate under its current management with its Board of Directors controlled by the Company. Sonoma markets a variety of refrigerated branded specialty cheese items, including its flagship products, Sonoma Jack Cheeses in a variety of flavors. Sonoma's products are sold in retail supermarkets, club stores, and specialty food stores across the US with the greatest penetration in the Western US markets. Some of the most popular cheese flavors include Hot Pepper Jack 53 Cheese, Garlic Jack Cheese, Mediterranean Jack Cheese and Pesto Jack Cheese. Sonoma maintains its headquarters in Sonoma, CA. The Company acquired Sonoma in order to expand and diversify its product line in the specialty foods category in which it competes. For its initial acquisition of 80% of Sonoma's outstanding shares, the Company paid $3.3 million in cash and issued 62,150 shares of the Company's common stock valued at $198,000 plus acquisition costs of $129,000. Purchase of the remaining shares will be at a price derived from a predetermined calculation based upon a percentage of earnings before taxes, interest, bonuses, depreciation and amortization during the interim periods. Sonoma will remain a separate entity and, under additional agreement between the Company, Sonoma and the Shareholders, Sonoma's day-to-day operations until the acquisition is completed are managed by Sonoma's existing management; The Company controls a majority of the Board of Directors and will be entitled to all future profits and is at risk for all future losses, if any. As part of the acquisition, the Company commissioned a valuation study to determine the components that represent the intangible assets and goodwill purchased as part of the initial purchase price. Under the purchase method of accounting, the total purchase price was allocated to Sonoma's tangible and intangible assets based upon their estimated fair value as of the date of completion of the acquisition. Based upon the purchase price, the purchase price allocation was as follows (in thousands of dollars): Cash paid directly to Sonoma for debt payment $ 3,000 Cash paid directly to owners of Sonoma 300 Value of 61,250 shares of Monterey Gourmet Foods common stock issued to owners of Sonoma 198 Acquisition costs incurred 129 ---------- Total cost of acquisition 3,627 ---------- Accounts payable assumed 577 Notes, loans, and capital leases payable 287 Minority interest 159 Cash acquired at time of acquisition -- Inventory valuation adjustment to market (8) Tangible assets acquired: Accounts receivable less allowances (580) Inventories (330) Deferred tax assets-current (1) Prepaid expenses and other (2) Property and equipment (529) Deposits and other (104) Intangible assets assumed: Non-compete agreements (56) Customers (762) Tradenames (574) ---------- Goodwill acquired in transaction $ 1,704 ========== The following unaudited pro forma financial information presents a summary of our consolidated results of operations for the year ended December 31, 2005 assuming Casual Gourmet Foods, Inc. (see the Company's current reports on Form 8-K and 8-K/A dated January 18 and March 28, 2005, respectively), and Sonoma Foods, Inc. (see the Company's current reports on Form 8-K and 8-K/A dated April 13 and June 22, 2005, respectively) acquisitions had taken place as of January 1, 2005 (in thousands except per share data). 54 December 31, 2005 ----------------- (unaudited) Net revenues $ 87,815 Net loss $ (660) ================= Net loss per common share: Basic loss per common share $ (0.05) ================= Diluted loss per common share $ (0.05) ================= Basic shares outstanding 14,450,251 Diluted shares outstanding 14,450,251 The unaudited condensed pro forma financial information has been prepared for comparative purposes only and reflects the historical audited results of Casual Gourmet Foods and Sonoma Foods. The pro forma financial information includes adjustments to reflect interest expense generated from cash that was used for the acquisition and related income tax adjustments. The pro forma information also includes an estimate of amortization of identifiable intangible assets. The pro forma information does not purport to be indicative of operating results that would have been achieved had the acquisition taken place on the dates indicated or the results that may be obtained in the future. 3. Concentration of Credit Risk Financial instruments, which potentially subject the Company to concentration of credit risk, include cash, cash equivalents, and accounts receivable. The Company maintains its cash accounts in Comerica Bank in Fresno, California. The bank cash balances are insured by the Federal Deposit Insurance Corporation up to $100,000. In addition, as of December 31, 2006, approximately 58% of the Company's accounts receivables are concentrated with two major customers (See Note 11). 4. Inventories Inventories consisted of the following:
2006 2005 ------------ ------------ (in thousands) Production - Ingredients $ 3,178 $ 2,510 Production - Finished goods 3,174 2,742 Paper goods and packaging materials 1,382 1,784 Operating supplies 113 36 ------------ ------------ 7,847 7,072 Allowances for spoils and obsolescence (273) (123) ------------ ------------ $ 7,574 $ 6,949 ============ ============
55 5. Property and Equipment Property and equipment consisted of the following:
2006 2005 ------------ ------------ (in thousands) Leasehold improvements $ 5,508 $ 5,142 Machinery and equipment 21,215 19,941 Computers, office furniture and equipment 1,393 1,240 Vehicles 454 454 ------------ ------------ 28,570 26,777 Less accumulated depreciation and amortization (14,754) (12,703) ------------ ------------ 13,816 14,074 Construction in progress 1,487 250 ------------ ------------ $ 15,303 $ 14,324 ============ ============ Construction in progress at December 31, 2006 includes deposits for equipment on order or yet to be installed. The Company believes it will cost approximately $200,000 to complete projects that have already been started. Depreciation expense for 2006, 2005, and 2004 was $2,052,000, $2,075,000, and $2,029,000 respectively. 6. Goodwill and Other Intangible Assets Goodwill and other intangible assets consisted of (in thousands of dollars): Gross goodwill and intangible assets ------------------------------------------ Net Year-end 2005 Impairments Accumulated Carrying 2004 Additions 2005 Year-end 2005 Amortization Amount ------------ ------------ ------------ ------------------------------------------ Trademarks and tradenames $ 220 $ -- $ -- $ 220 $ 215 $ 5 Customer lists 4,740 3,262 -- 8,002 1,361 6,641 Other intangibles 725 1,257 -- 1,982 644 1,338 ------------ ------------ ------------ ------------------------------------------ Total amortized intangible assets 5,685 4,519 -- 10,204 2,220 7,984 Intangible assets with indefinite lives 1,690 1,414 -- 3,104 -- 3,104 ------------ ------------ ------------ ------------------------------------------ Total intangible assets 7,375 5,933 -- 13,308 2,220 11,088 Goodwill 8,143 3,813 -- 11,956 -- 11,956 ------------ ------------ ------------ ------------------------------------------ Total goodwill and intangible assets $ 15,518 $ 9,746 $ -- $ 25,264 $ 2,220 $ 23,044 ============ ============ ============ ========================================== Gross goodwill and intangible assets ------------------------------------------ Net Year-end 2006 Impairments Accumulated Carrying 2005 Additions 2006 Year-end 2006 Amortization Amount ------------ ------------ ------------ ------------------------------------------ Trademarks and tradenames $ 220 $ -- $ -- $ 220 $ 220 $ -- Customer lists 8,002 -- (2,020) 5,982 2,031 3,951 Other intangibles 1,982 -- (740) 1,242 845 397 ------------ ------------ ------------ ------------------------------------------ Total amortized intangible assets 10,204 -- (2,760) 7,444 3,096 4,348 Intangible assets with indefinite lives 3,104 -- (400) 2,704 -- 2,704 ------------ ------------ ------------ ------------------------------------------ Total intangible assets 13,308 -- (3,160) 10,148 3,096 7,052 Goodwill 11,956 1,255 -- 13,211 -- 13,211 ------------ ------------ ------------ ------------------------------------------ Total goodwill and intangible assets $ 25,264 $ 1,255 $ (3,160) $ 23,359 $ 3,096 $ 20,263 ============ ============ ============ ==========================================
56 All of the Company's business combinations were accounted for using the purchase method. Amortization expense was $876,000, $958,000 and $481,000 for 2006, 2005 and 2004 respectively. As a result of a significant reduction in sales at Casual Gourmet Foods during the third quarter of 2006 the Company determined that indicators of impairment existed for the Casual Gourmet Foods intangible assets and potentially the reporting unit as a whole. Accordingly, in accordance with Statement of Financial Accounting Standard ("SFAS") No. 142, "Goodwill and Other Intangible Assets" and SFAS No. 144 "Accounting for the Impairment of Disposal of Long-Lived Assets," the Company applied impairment tests to its intangible assets, including goodwill. As a result of this testing and in accordance with SFAS No. 142, the Company recorded a pre-tax, non-cash charge of $3.2 million in the third quarter of 2006 related to the impairment of intangible assets associated with the acquisition of Casual Gourmet Foods in January 2005, which is reflected in the table above. The Company performed annual impairment testing as required by SFAS 142 during the fourth quarter of 2006 to determine if any additional writedowns were necessary, with no impairment adjustments needed. Following is table of estimated amortization expense for the next five years: Year Estimated Amortization ---- ---------------------- Expense ------- (In thousands) 2007 $ 597 2008 593 2009 591 2010 591 2011 591 2012 and thereafter 1,385 ------ Total $4,348 ====== 57 7. Notes, Loans, and Capitalized Leases Payable Notes, loans and capital leases payable consist of (in thousands):
2006 2005 ------------ ------------ Subordinated note payable to OBIC Inc.; assumed from CIBO Naturals stock purchase $ 944 $ 1,000 Monthly principal payments of $8,000 starting April 1, 2006 Matures in July 2007 Note payable to Comerica Bank to partially purchase CIBO Naturals -- 625 Variable rate interest at LIBOR plus 200 basis points Monthly principal payments of $62,500 plus interest of approximately 7% Matures in October 2006; Paid off in July 2006 Note payable to Comerica Bank to partially purchase Sonoma Foods -- 2,208 Variable rate interest at LIBOR plus 275 basis points Monthly principal payments of $41,667 plus interest of approximately 7% Matures in May 2010; Paid off in July 2006 Note payable to Comerica Bank to partially purchase Casual Gourmet Foods -- 5,000 Variable rate interest at LIBOR plus 275 basis points Monthly principal payments of $104,167 plus interest of approximately 7% Matures in February 2009; Paid off in July 2006 Notes assumed from Casual Gourmet stock purchase 92 180 Interest ranges from 0.0% to 9.35%; payable in monthly payments of $7,367 Maturing from January 2007 through March 2011 Note payable assumed from Sonoma Foods stock purchase 94 121 Payable in monthly payments of $3,857 including interest of 15.88% and 17.6% Matures in June 2009 Capital leases payable 17 13 ------------ ------------ Total notes, loans, and capital leases payable $ 1,147 $ 9,147 Less current portion of notes, loans, and capital leases payable (1,018) (2,521) ------------ ------------ Notes, loans, and capital leases payable, less current portion $ 129 $ 6,626 ============ ============
The weighted average interest rate on notes payable with outstanding balances at December 31, 2006 was 8%. Credit Facility The Company has a $5.0 million working capital line of credit which was not utilized as of December 31, 2006 and a letter of credit in the amount of $1,100,000 which is issued in favor of an insurance company to support a self-funded worker's compensation program and which was decreased to $800,000 on January 1, 2007. No additional loans are available to the Company without bank approval. The working capital commitment in place at December 31, 2006 expires June 1, 2007. The interest rate on this entire credit line will be calculated at the bank's prime lending rate or LIBOR plus 2.00%, which ever the Company chooses. The terms of the Credit Facility prohibit the payment of cash dividends (except with written approval) on the Company's capital stock and restrict payments for, among other things, repurchasing shares of Company's capital stock. Other terms of the Credit Facility limit the Company with respect to, among other things, (i) incurring additional indebtedness, (ii) adversely changing the capital structure, and (iii) acquiring assets other than in the normal course of business, and (iv) meeting certain financial covenants. As of December 31, 2006, the Company was not in violation of any bank covenant. Effective January 1, 2007, the Company initiated an $800,000 Letter of Credit in favor of Sentry Insurance as required collateral for a deductible worker's compensation program. The new letter of credit expires December 31, 2007. Future principal payments due under notes, loans, and capital leases payable are as follows (in thousands): 58 Year Principal Amount -------------------------- ---------------------- 2007 $ 1,018 2008 67 2009 47 2010 13 2011 2 ---------------------- $ 1,147 ====================== Employment Contracts On September 5, 2006, the Board of Directors of the Company appointed Eric Eddings as President and Chief Executive Officer of Monterey Gourmet Foods. As part of the employment contract with Mr. Eddings which was signed on September 15, 2006, the Company will pay Mr. Eddings a base salary of $285,000 per year. Mr. Eddings is eligible for an annual cash bonus based on performance and achieving certain goals. In addition, Mr. Eddings received an incentive stock option to purchase 150,000 shares of the Company's common stock vesting and exercisable in installments of 50,000 shares on each of the first, second, and third anniversaries of his employment agreement. As part of the agreement, if Mr. Eddings is terminated by the Board of Directors without cause, Mr. Eddings will be eligible for severance compensation equal to twelve months of his then applicable base annual salary. In addition, the management team of Casual Gourmet Foods has employment contracts that extend through the calendar year 2007 and the Sonoma Foods management team has employment contracts that extend through April 2009. Capitalized Leases The Company leases certain equipment under capitalized leases, including office equipment, and a forklift, with a liability of $68,000 and $75,000 in 2006 and 2005, respectively. 8. Operating Leases The Company currently leases production, warehouse and corporate office space as well as certain equipment in Monterey County, California under both month-to-month and non-cancelable operating lease agreements, expiring at various times through 2014. The terms of the leases generally require the Company to pay common area maintenance, taxes, insurance, and certain other costs. All building leases have renewal options (see Item 2 "Properties" on page 12) and all include cost of living adjustments. The Company records rent expense on a straight-line basis over the lease term. Future minimum annual lease payments due under non-cancelable operating leases with terms of more than one year are as follows (in thousands): Year Lease Amount ---- ------------ 2007 $ 1,773 2008 1,528 2009 1,430 2010 1,438 2011 1,449 2012 and Thereafter 3,088 -------------- $ 10,706 ============== Gross rent expense under the leases for 2006, 2005, and 2004 was $1,338,000, $1,286,000, and $1,080,000 respectively. The Company's four production facilities are leased. The Company leases approximately 133,000 square feet at two locations in Salinas, California. The current production facilities/headquarters lease expires in October 2014. The lease for the distribution center and storage facilities expires in May 2012. The Company acquired a lease for the 19,000 square foot production facility and offices in Eugene, Oregon, as part of its acquisition of Emerald Valley. The lease expires December 31, 2007, with three five-year renewal options. In 2004, in connection with its CIBO Naturals acquisition, the Company assumed an operating lease of 47,500 square feet in Seattle, Washington under a lease which expires in May 2008. 59 9. Stockholders' Equity Preferred Stock The Company has 1,000,000 Preferred Shares at $.001 par value authorized; however none are issued. Common Stock During 2006 employee and director options representing 308,709 shares of common stock were exercised for proceeds of $894,000 and 10,900 employee stock purchase plan shares were issued for proceeds of $32,000. On January 12, 2006, the Company, Suekat LLC ("Suekat") and CIBO Naturals, LLC ("CIBO"), amended their previous agreement for the purchase and sale of limited liability company units. As a result, the Company acquired the remaining 15.5% of CIBO from Suekat in exchange for 300,000 unregistered shares of the Company's common stock with a market value of $1,186,000. On June 28, 2006 the Company announced the completion of a private placement of 2,174,000 shares of Monterey Gourmet Foods common stock at a price of $5.75 per share for net proceeds of $11.6 million. In addition, the Company issued fully vested warrants to investors to purchase a total 652,200 shares of common stock of the Company at an exercise price of $7.50 per share. Part of the proceeds was used to pay down the Company's bank debt. Monterey Gourmet Foods filed a registration statement with the SEC to register the resale of the shares of common stock issued in the private placement, as well as the shares of common stock issuable upon the exercise of the warrants issued in the private placement. The registration statement was declared effective by the SEC on August 4, 2006. Stock offering costs of $868,000 have been reflected as a reduction of the gross proceeds received. During 2005 employee and director options representing 51,116 shares of common stock were exercised for proceeds of $128,000 and 8,198 employee stock purchase plan shares were issued for proceeds of $25,000. In addition, as part of the Sonoma Foods acquisition, 62,150 shares of common stock were issued with a value of $198,000. During 2004 employee and director options representing 163,928 shares of common stock were exercised for proceeds of $427,000 and 14,964 employee stock purchase plan shares were issued for proceeds of $43,000. Employee Stock Purchase Plan In October 1994, the Company's Board of Directors adopted a qualified employee stock purchase plan. Under the purchase plan, eligible employees (those who have completed one year of continuous employment with the Company) may purchase shares of the Company's common stock through payroll deductions not to exceed 10% of gross wages. The Company has reserved 200,000 shares of its common stock for issuance under the purchase plan, which remains in effect until terminated by the Company's Board of Directors, or until all of the shares reserved for under the purchase plan have been issued. Unless the Board has otherwise provided a higher amount prior to the commencement of an offering period, the offering exercise price for each purchase period is 85% of the lesser of (a) the fair market value of the shares on the offering date of such offering period or (b) the fair market value of the shares on the given purchase date. There were 10,900 shares, 8,198 shares, and 14,964 shares of common stock issued under the plan in 2006, 2005, and 2004 respectively. At December 31, 2006, there were 127,634 shares remaining available for purchase under the plan. Income per Share Calculation The Company has reported its earnings/ (loss) in accordance with Statement of Financial Accounting Standard ("SFAS") No. 128, "Earnings per Share." Basic net income/ (loss) per common share is based on the weighted average number of shares outstanding during the period. Diluted net income/ (loss) per common share is based on the weighted average number of shares outstanding during the period, including common stock equivalents. The reconciliation of the share denominator used in the basic and diluted net income per share computations is as follows: 60
2006 2005 2004 ------------ ------------ ------------ Weighted average common shares outstanding used in basic net income per share computation 16,100,250 14,450,251 14,343,386 Dilutive effect of common stock equivalents, using the treasury stock method -- -- -- ------------ ------------ ------------ Shares used in dilutive net income per share computation 16,100,250 14,450,251 14,343,386 ============ ============ ============
Basic earnings per share are based on earnings available to common stockholders divided by the weighted-average number of common shares actually outstanding during the period. Diluted earnings per share also include the incremental effect of any dilutive common stock equivalents assumed to be outstanding during the period. Because of equivalent shares includable in different periods or at different amounts, per-share amounts for the four quarters do not necessarily equal per-share amounts for the entire year. Options to purchase 1,687,435, 1,807,194, and 1,763,810, shares of common stock were outstanding at year-end 2006, 2005, and 2004, respectively and were excluded from the computation of diluted earnings per share because they were anti-dilutive due to the Company's net losses for those years. Stock-Based Compensation Expense On January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123 (revised 2004), "Share-Based Payment," ("SFAS 123(R)") which requires the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors based on estimated fair values. SFAS 123(R) supersedes previous accounting under Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25") for periods beginning before calendar year 2006. In March 2005, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 107 ("SAB 107") relating to SFAS 123(R). The Company has applied the provisions of SAB 107 in its adoption of SFAS 123(R). The Company adopted SFAS 123(R) using the modified prospective transition method, which requires the application of the accounting standard as of January 1, 2006, the first day of the Company's fiscal year 2006. Consolidated financial statements as of December 31, 2006 reflect the impact of SFAS 123(R). In accordance with the modified prospective transition method, the consolidated financial statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS 123(R). The Company recorded stock-based compensation in 2005 of $80,000, and no stock-based compensation expense related to employee or director stock options recognized during 2004. Stock-based compensation expense recognized under SFAS 123(R) for employee and directors for the year ended December 31, 2006 was $516,000. The Company recorded $55,000 in cost of sales and $461,000 in selling, general and administrative expenses. Included in the $461,000 stock based compensation expense is a stock compensation charge of $132,000 recorded in relation to the modification to extend the exercise period on 150,000 options as part of the separation agreement with the Company's former CEO. Basic and diluted loss per share for the year ended December 31, 2006 would have been ($0.16), if the Company had not adopted SFAS 123(R), compared to reported basic and diluted loss per share of ($0.19). The estimated fair value of option grants or modifications to employees and directors during the years 2006, 2005, and 2004 were $1,005,000, $436,000, and $534,000. The weighted average fair value per share of the stock options awarded in 2006, 2005 and 2004 of $2.14, $1.69 and $1.55 was based on the fair market value of the Company's common stock on the grant dates. The following table illustrates the effect on net loss and loss per share if the Company had applied the fair value recognition provisions of SFAS 123 to stock-based awards granted under the Company's stock option plans for 2005 and 2004. Proforma disclosures for 2006 are not presented because the amounts are recognized in the Consolidated Statement of Operations. For purposes of this pro-forma disclosure, the fair value of the options is estimated using the Black-Scholes-Merton option-pricing formula ("Black-Scholes model") and amortized to expense over the options' contractual term (in thousands except share data). 61
2005 2004 ------------ ------------ Net income (loss) as reported $ (537) $ (1,344) Add: stock-based employee compensaiton expense included in reported net loss, net of related tax effects 80 -- Deduct: total stock-based employee compensation determined under fair value method for all awards, net of related tax effects (619) (715) ------------ ------------ Proforma net loss, as adjusted (1,076) (2,059) ============ ============ Earnings per share: Basic, as reported $ (0.04) $ (0.09) Basic, as adjusted $ (0.07) $ (0.14) ============ ============ Diluted, as reported $ (0.04) $ (0.09) Diluted, as adjusted $ (0.07) $ (0.14) ============ ============
The fair value of stock option grants has been estimated at the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions: 2006 2005 2004 ---------- ---------- ---------- Dividend yield -- -- -- Volatility 52.3% 53.7% 54.9% Risk-free interest rates 4.75% 3.58% 3.69% Expected lives in years 6 6 4 Forfeiture rate 7% -- -- SFAS 123(R) requires companies to estimate the fair value of share-based payment awards to employees and directors on the date of grant using an option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in our Consolidated Statements of Operations. Prior to the adoption of SFAS 123(R), the Company accounted for stock-based awards to employees and directors using the intrinsic value method in accordance with APB 25 as allowed under Statements of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123"). Under the intrinsic value method, no stock-based compensation expense had been recognized in the Consolidated Statements of Operations for awards to employees and directors because the exercise price of stock options equaled the fair market value of the underlying stock at the date of grant. Stock-based compensation expense recognized during the period is based on the value of the portion of share-based payment awards that is ultimately expected to vest during the period. Stock-based compensation expense recognized in the Consolidated Statements of Operations for the year ended December 31, 2006 included compensation expense for share-based payment awards granted prior to, but not yet vested as of January 1, 2006 based on the grant date fair value estimated in accordance with the pro-forma provisions of SFAS 123 and compensation expense for the share-based payment awards granted subsequent to January 1, 2006 based on the grant date fair value estimated in accordance with the provisions of SFAS 123(R). For stock-based awards issued to employees and directors, stock-based compensation is expensed ratably over the vesting period, which is consistent with how the prior-period proformas were provided. As stock-based compensation expense recognized in the Consolidated Statements of Operations for the year ended December 31, 2006 is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. SFAS 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. For 2006, forfeitures of unvested stock options were estimated to be approximately 7%. In the pro-forma information required under SFAS 123 for the periods prior to fiscal 2006, the Company accounted for forfeitures as they occurred. 62 The determination of fair value of share-based payment awards to employees and directors on the date of grant using the Black-Scholes model is affected by the Company's stock price as well as assumptions regarding a number of highly complex and subjective variables. These variables include, but are not limited to the expected stock price volatility over the term of the awards, and actual and projected employee stock option exercise behaviors. Prior to 2006, the Company estimated expected terms based on historical Company data and compared to a peer group of public companies. For new grants after December 31, 2005, management estimated expected term using the simplified method provided in SAB 107. Management has used historical data to estimate forfeitures. The risk-free rate is based on U.S. Treasury rates in effect during the corresponding period of grant. The expected volatility is based on the historical volatility of the Company's stock price. Warrants On June 28, 2006 the Company announced the completion of a private placement of 2,174,000 shares of Monterey Gourmet Foods common stock. In connection with this private placement the Company also issued warrants for 652,200 shares of common stock with a conversion price of $7.50 per share. The warrants remain exercisable for a period of five years from June 28, 2006. The warrants are subject to call at the option of the Company after 18 months, if among other things, the registration statement filed by the Company to register the resale of the shares (including the warrant shares) issued in the June 28, 2006 private placement is effective and the volume weighted average trading price of the Company's common stock is $15 or higher for 20 consecutive trading days. The warrants meet the requirements of and are being accounted for as equity in accordance with EITF 00-19 "Accounting for Derivative Financial Instruments Indexed to or Potentially Settled in a Company's Own Stock." Stock Options The Company's 2002 Stock Option Plan, originally established in 1993 (the "Plan"), provides for the granting of incentive stock options or non-qualified stock options to eligible employees, consultants and outside directors. The Company initially reserved 1,200,000 shares of its common stock for issuance under the Plan and in subsequent years increased the total shares reserved to 3,240,000. The Plan provides that the option price shall not be less than the fair market value of the shares on the date of grant. Options generally vest over a period of one to three years and may be exercised for a period of up to ten years. During 2001, the Company issued additional options to purchase up to 155,200 shares outside of the Plan (the "Nonstatutory Plan"). The Plan expires April 30, 2012. As of December 31, 2006, the Company had 541,038 shares available for new grants under the Plan, and 33,800 shares available for new grants under the Nonstatutory Plan. In 2005, the Board of Directors amended the 2002 stock option plan and forms of option agreement (1) to allow retiring or deceased or disabled directors who satisfy the board's age and service requirements to exercise their vested options at any time prior to the end of their stated term and (2) to make certain necessary technical changes. Prior to this change a retiring director would have been required to exercise his options within 90 days of retirement. This requirement may have made it difficult or impossible for retiring directors to exercise their options in a manner which would not conflict with the Company's insider trading policy. The board also determined that the proposed changes would not adversely affect any outstanding option under the plan and therefore directed that each outstanding option granted to a current director shall be deemed to have been modified to permit extended exercise in accordance with the approved revised form of agreement for such option. This amendment caused the Company to incur a non-cash compensation expense in 2005 of $80,000 due to the death of its Chairman Mr. Lance Hewitt. The following table summarizes option activity: 63
2004 ------------------------------------ Weighted Weighted Average Aggregate Average Remaining Intrinsic Shares Exercise Price Contractual Life Value ---------------- ---------------- ---------------- ---------------- Outstanding at beginning of year 1,872,739 $ 4.63 Granted 344,000 3.46 Exercised (163,928) 2.61 Canceled or expired (289,001) 5.59 ---------------- ---------------- Outstanding at end of year 1,763,810 $ 4.44 ================ ================ 2005 ------------------------------------ Outstanding at beginning of year 1,763,810 $ 4.44 Granted 258,000 3.72 Exercised (51,116) 2.44 Canceled or expired (163,500) 6.30 ---------------- ---------------- Outstanding at end of year 1,807,194 $ 4.24 ================ ================ 2006 ------------------------------------ Outstanding at beginning of year 1,807,194 $ 4.24 Granted 470,000 4.42 Exercised (308,709) 2.90 Canceled or expired (281,050) 4.40 ---------------- ---------------- Outstanding at end of year 1,687,435 $ 4.51 6.34 $ 919,978 ================ ================ ================ ================ Vested/expected to vest at end of year 1,644,161 $ 4.51 6.34 $ 905,959 ================ ================ ================ ================ Options exercisable at year end 1,269,855 $ 4.51 5.31 $ 772,266 ================ ================ ================ ================ The following table shows information for options outstanding or exercisable as of December 31, 2006: OPTIONS OUTSTANDING OPTIONS EXERCISABLE ----------------------------------------------------------- -------------------------------------------- Weighted Average Weighted Aggregate Number Weighted Aggregate Number Remaining Average Intrinsic Value Exercisable Average Intrinsic Value Range of Outstanding Contractual Exercise Closing price at As of Exercise Closing price at Exercise Prices As of 12/31/06 Life Price 12/31/06 of $4.38 12/31/06 Price 12/31/06 of $4.38 -------------------- ----------------------------- --------- ----------------- ------------- --------- ----------------- $ 1.19 $ 3.34 246,235 3.80 Years $ 2.85 $ 375,705 244,735 $ 2.85 $ 373,943 $ 3.35 $ 3.44 232,500 6.88 Years $ 3.41 224,990 202,500 $ 3.42 194,390 $ 3.45 $ 3.76 193,200 6.35 Years $ 3.70 131,322 193,200 $ 3.70 131,322 $ 3.77 $ 3.89 196,500 8.94 Years $ 3.88 98,015 41,500 $ 3.85 21,865 $ 3.90 $ 3.95 178,500 6.45 Years $ 3.94 77,733 113,170 $ 3.94 49,641 $ 3.97 $ 5.85 190,500 7.55 Years $ 4.81 -- 99,750 $ 5.31 -- $ 5.94 $ 6.55 254,000 4.97 Years $ 6.31 -- 254,000 $ 6.31 -- $ 6.75 $ 7.92 177,500 6.92 Years $ 7.12 -- 102,500 $ 7.10 -- $ 8.08 $ 9.20 17,500 5.21 Years $ 8.17 -- 17,500 $ 8.17 -- $ 9.25 $ 9.25 1,000 5.28 Years $ 9.25 -- 1,000 $ 9.25 -- $ 1.19 $ 9.25 1,687,435 6.34 Years $ 4.51 $ 907,764 1,269,855 $ 4.51 $ 771,160
The aggregate intrinsic value in the preceding table represents the total intrinsic value based on the closing stock price of $4.38 as of December 29, 2006, which would have been received by the option holders had all option holders exercised as of that date. The aggregate intrinsic value of options exercised during the calendar year 2006 was $872,000. 64 The following table provides information about our common stock that may be issued upon the exercise of options, warrants or rights under all of our existing equity compensation plans as of December 31, 2006, including the Monterey Gourmet Foods 2002 Stock Option Plan and the Monterey Gourmet Foods 2001 Nonstatutory Stock Option Plan.
- -------------------------------------------------------------------------------------------------------------------- Number of securities to be Weighted-average exercise Number of securities issued upon exercise of price of outstanding remaining available for Plan category outstanding options, options, warrants and future issuance under warrants and rights rights equity compensation plans (excluding securities reflected in column (a)) (a) (b) (c) - -------------------------------------------------------------------------------------------------------------------- Equity compensation plans approved by security 1,636,735(1) $4.45 411,738 holders - -------------------------------------------------------------------------------------------------------------------- Equity compensation plans not approved by security 50,700(2) $6.55 129,300 holders - -------------------------------------------------------------------------------------------------------------------- Total 1,687,435 $4.51 541,038 - -------------------------------------------------------------------------------------------------------------------- (1) Issued under the Monterey Gourmet Foods 2002 Stock Option Plan. (2) Issued to Company employees under the Monterey Gourmet Foods 2001 Nonstatutory Stock Option Plan. 10. Income Taxes The Company's income tax benefit (provision) consists of (in thousands): 2006 2005 2004 ------------ ------------ ------------ Current: Federal $ (2) $ 25 $ (45) State (11) 27 (7) ------------ ------------ ------------ Total (13) 52 (52) ------------ ------------ ------------ Deferred: Federal (375) 334 404 State 93 45 153 ------------ ------------ ------------ Total (282) 379 557 ------------ ------------ ------------ Net tax benefit (expense) $ (295) $ 431 $ 505 ============ ============ ============
Reconciliation between the Company's effective tax rate and U.S. Federal income tax rate on loss from continuing operations follows: 65
2006 2005 2004 ---------- ---------- ---------- Federal statutory rate (34.0)% 34.0% 34.0% State income taxes, net of effect on federal income taxes (3.0)% 3.4% 5.6% Federal and State valuation allowances 44.0% 0.0% (10.7)% Manufacturing investment credits 0.0% 4.3% 2.3% Other 4.0% 2.8% (3.9)% ---------- ---------- ---------- Effective income tax rate 11.0% 44.5% 27.3% ========== ========== ========== The valuation allowance for 2006, 2005 and 2004 was increased (reduced) by $1,222,000, ($689,000) and $197,000 respectively. During 2006, the valuation allowance increased due to the Company's reassessment of the likelihood of utilization of its NOLs. This assessment was largely based upon the Company's ability to project future income, which was impacted negatively by the loss generated in 2006. Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of the Company's deferred tax assets are as follows: 2006 2005 ---------- ---------- (in thousands) -------------- Deferred tax assets: Federal NOLs and tax credit carryovers 6,385 6,211 State income and franchise taxes, net of effect on federal income taxes -- 28 Allowances against receivables and other 1,120 1,213 ---------- ---------- 7,505 7,452 Less valuation allowance (1,472) (250) ---------- ---------- Total deferred tax assets: 6,033 7,202 Deferred tax liabilities: Accumulated depreciation and amortization (1,925) (2,812) ---------- ---------- Net deferred tax assets 4,108 4,390 ========== ==========
We have elected to track the portion of our federal and state net operating loss carryforwards attributable to stock option benefits, in a separate memo account pursuant to SFAS No. 123(R). Therefore, these amounts are no longer included in our gross or net deferred tax assets. Pursuant to SFAS No. 123(R), footnote 82, the benefit of these net operating loss carryforwards will only be recorded to equity when they reduce cash taxes payable. The amounts removed from the memo account relating to deductions for stock option benefits as of December 31, 2006 are $150,000 for federal and $20,000 for state tax purposes, respectively. While we do not expect any impact to the effective tax rate for US non-qualified stock option or restricted stock expense due to the adoption of SFAS No. 123(R), the effective tax rate may be negatively impacted by incentive stock option expense that may not be deductible for tax. Also, SFAS No. 123(R) requires that the tax benefit of stock option deductions relating to Incentive Stock Options (ISO's) be recorded in the period of disqualifying disposition. This could result in fluctuations in our effective tax rate between accounting periods. On November 10, 2005, the Financial Accounting Standards Board (FASB) issued FASB Staff Position No. FAS 123(R)-3 "Transition Election Related to Accounting for Tax Effects of Share-Based Payment Awards." The Company has elected to adopt the alternative transition method provided in the FASB Staff Position for calculating the tax effects of stock-based compensation pursuant to 66 SFAS 123(R). The alternative transition method includes simplified methods to establish the beginning balance of the additional paid-in capital pool ("APIC pool") related to the tax effects of employee stock-based compensation and to determine the subsequent impact on the APIC pool and Consolidated Statements of Cash Flows of the tax effects of employee stock-based compensation awards that are outstanding upon adoption of SFAS 123(R). As of December 31, 2006, the Company had federal NOLs totaling $17.0 million, which expire in varying amounts through 2012. Should more than a 50% change in Company ownership occur within a three-year period, utilization of these losses to reduce future taxable income would be further limited. Federal deferred tax credits include a minimum tax credit of $252,000 and a targeted jobs credit of $21,000. The targeted jobs credit will expire in 2020 and the minimum tax credit will not expire. State deferred tax assets include approximately $350,000 in California Manufacturing Tax Credits available to offset future California income taxes, expiring in varying amounts through 2012. As of December 31, 2006, the deferred tax assets available to offset future cash tax liabilities are $793,000 short-term and $5,240,000 long-term offset by $1,925,000 of long-term deferred tax liabilities. The Company realizes tax benefits as a result of non-qualified stock options and the exercise and subsequent early resale of certain incentive stock options (disqualifying disposition). For financial reporting purposes, any reduction in income tax obligations as a result of these tax benefits is credited to additional paid in capital. For the years, 2006, 2005 and 2004, tax benefits of disqualifying dispositions totaling $2,000, $0, and $55,000 were credited to stockholders' equity. 11. Significant Customers Costco and Sam's Club (including Wal-Mart Supercenters) stores each accounted for percentages of total net revenues as follows: 2006 2005 2004 ------ ------ ------ Costco 48% 45% 36% Sam's Club Stores 17% 17% 24% At December 31, 2006 and December 31, 2005, Costco and Sam's Club stores accounted for the following concentration of accounts receivable: 2006 2005 ------ ------ Costco 38% 42% Sam's Club Stores 20% 15% The Company currently sells its products to eight separate US Costco regions, Mexico and Canada which make purchasing decisions independently of one another. On a regular basis, these regions re-evaluate the products carried in their stores. There can be no assurance that these Costco regions will continue to offer the Company's products in the future or continue to allocate the Company the same amount of shelf space. Purchasing decisions for Sam's Club stores, the Company's second largest customer, are made at their respective head offices with input from the stores. The Company is in the ninth year of its relationship with Sam's Club. There can be no assurance that Sam's Club will continue to carry the Company's products. Currently, the loss of either Costco or Sam's Club or the significant reduction in sales to either of these customers would materially adversely affect the Company's business operations. No other single customer accounted for more than 10% of revenues or accounts receivable during 2006 and 2005. The Company operates in the refrigerated specialty foods segment. During 2006, 2005 and 2004 net revenues to foreign customers represented 1.4%, 2.2% and 3.4% of total net revenues, with Canada and Mexico accounting for over 90% of those sales, and the remainder going to Asia Pacific. Most of the foreign sales are invoiced in US dollars. The Company discloses segment enterprise-wide information in accordance with SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information." Based upon definitions contained within SFAS No. 131, management has determined that the Company operates in one segment. In addition, virtually all revenues are in North America, and all of the long-lived assets are located within the United States. 67 12. Litigation and Contingencies There are no material legal proceedings pending to which the Company is a party or to which any of its property is subject. The Company is a party to ordinary routine litigation incidental to the Company's business. 13. Employee Benefit Plan In 1996, the Company instituted a 401(k) Plan covering substantially all full-time employees with six months of service. Under the Plan, employees may elect to defer up to 15% of compensation (subject to certain limitations). Beginning in January 2003 the Company adopted a Safe Harbor Plan and currently matches employee contributions up to 4% of compensation. In addition, the Company may make an annual discretionary profit-sharing contribution. Employee contributions, Company matching contributions and related earnings are always 100% vested. The Company offers its employees multiple investment options with varying degrees of risk. The Company also provides its employees with outside investment advice annually. Company profit-sharing contributions and related earnings vest 20% a year, with 100% vesting after five years of service. During 2006, 2005, and 2004 the Company's expense for matching contributions was $270,000, $228,000 and $201,000 respectively; there were no discretionary profit-sharing contributions for 2006, 2005, or 2004. 68 14. Quarterly Information (unaudited) The summarized quarterly financial data presented below reflect all adjustments which, in the opinion of management, are of a normal and recurring nature necessary to present fairly the results of operations for the periods presented (in thousands of dollars).
Year Ended 2005 First Second Third Fourth Quarter Quarter Quarter Quarter 2005 ---------- ---------- ---------- ---------- ---------- Net revenue $ 17,663 $ 21,155 $ 22,772 $ 23,658 $ 85,248 Gross profit 4,948 5,744 6,591 5,949 23,232 Operating income (loss) 102 194 306 (960) (358) Net income (loss) 17 11 132 (697) (537) Primary earnings per common share $ -- $ -- $ 0.01 $ (0.05) $ (0.04) Diluted earnings per common share $ -- $ -- $ 0.01 $ (0.05) $ (0.04) Year Ended 2006 First Second Third Fourth Quarter Quarter Quarter Quarter 2005 ---------- ---------- ---------- ---------- ---------- Net revenue $ 22,478 $ 23,081 $ 22,090 $ 26,648 $ 94,297 Gross profit 6,780 6,963 6,379 7,317 27,439 Operating income (loss) 404 400 (3,955) 689 (2,462) Net income (loss) 100 146 (3,872) 514 (3,112) Primary earnings per common share $ 0.01 $ 0.01 $ (0.22) $ 0.03 $ (0.19) Diluted earnings per common share $ 0.01 $ 0.01 $ (0.22) $ 0.03 $ (0.19)
69 SCHEDULE II MONTEREY PASTA COMPANY VALUATION AND QUALIFYING ACCOUNTS (in '000s)
Additions - Deductions - Balance, Charged to Write-offs Balance, Beginning Costs and Charged to End of of 2004 Expense Reserves 2004 ------------ ------------ ------------ ------------ Allowances against receivables -- Spoils, returns, adjustments and bad debts $ 441 $ 3,646 $ 3,847 $ 240 Inventory reserves -- $ 51 $ 550 $ 388 $ 213 Spoils and obsolescence Additions - Deductions - Balance, Charged to Write-offs Balance, Beginning Costs and Charged to End of of 2005 Expense Reserves 2005 ------------ ------------ ------------ ------------ Allowances against receivables -- Spoils, returns, adjustments and bad debts $ 240 $ 4,792 $ 4,040 $ 992 Inventory reserves -- $ 213 $ 499 $ 589 $ 123 Spoils and obsolescence Additions - Deductions - Balance, Charged to Write-offs Balance, Beginning Costs and Charged to End of of 2006 Expense Reserves 2006 ------------ ------------ ------------ ------------ Allowances against receivables -- Spoils, returns, adjustments and bad debts $ 992 $ 4,876 $ 5,146 $ 722 Inventory reserves -- $ 123 $ 629 $ 479 $ 273 Spoils and obsolescence
70 SIGNATURES Pursuant to the requirements of Section 13 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, in the city of San Francisco, State of California, on the 14th day of March, 2006 MONTEREY GOURMET FOODS By: /s/ ERIC C. EDDINGS -------------------------------------- Eric C. Eddings President and Chief Executive Officer By: /s/ SCOTT S. WHEELER -------------------------------------- Scott S. Wheeler Chief Financial Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons in the capacities indicated and on the dates indicated.
Name Title Date ---- ----- ---- /s/ ERIC C. EDDINGS Chief Executive Officer, March 21, 2007 ------------------------------ President, and Director Eric C. Eddings /s/ CHARLES B. BONNER Director March 21, 2007 ------------------------------ Charles B. Bonner /s/ F. CHRISTOPHER CRUGER Director March 21, 2007 ------------------------------ F. Christopher Cruger /s/ MICHAEL P. SCHALL Director March 21, 2007 ------------------------------ Michael P. Schall /s/ VAN TUNSTALL Chairman of the Board March 21, 2007 ------------------------------ Van Tunstall /s/ JAMES WONG Director March 21, 2007 ------------------------------ James Wong /s/ JOHN H. McGARVEY Director March 21, 2007 ------------------------------ John H. McGarvey /s/ WALTER L. HENNING Director March 21, 2007 ------------------------------ Walter L. Henning /s/ SCOTT S. WHEELER Chief Financial Officer March 21, 2007 ------------------------------ Corporate Secretary and Director Scott S. Wheeler
71 Index to Exhibits (Unless otherwise indicated, all exhibits incorporated by reference are filed under SEC file number 001-11177.) 3.1 Certificate of Incorporation dated August 1, 1996 (incorporated by reference from Exhibit B to the Company's Definitive Proxy Statement for its August 1, 1996 Special Meeting of Shareholders filed June 27, 1996 ) 3.2 Amendments of Articles I and IV of Delaware Certificate of Incorporation (incorporated by reference from Exhibits 3 and 4 to the Company's Definitive Proxy Statement for its 2004 Annual Meeting of Shareholders filed June 21, 2004) 3.3 Bylaws of the Company, as amended. Incorporated by reference from Exhibit 3.3 filed with the Company's Form 10-Q for the quarter ended June 30, 2005 filed with the Commission. 4.1 Form of Investor Warrant, issued by Monterey Gourmet Foods, Inc. to the investors in connection with the June 28, 2006 private offering. (incorporated by reference from Exhibit 10.31 filed with the Company's Form 8-K on June 13, 2006) 4.2 Registration Rights Agreement (incorporated by reference from Exhibit 10.29 filed with the Company's Form 8-K on June 13, 2006) 10.1* 2002 Stock Option Plan, as amended on March 3, 2006. Incorporated by reference from Exhibit 10.1 to the Company's Form 10-Q for the quarter ended March 31, 2006 10.2* 1995 Employee Stock Purchase Plan (incorporated by reference from Exhibit 10.15 to the Company's Form 10-K for the fiscal year ended January 1, 1995 10.3 Monterey County Production Facility Lease of the Company, as amended (incorporated by reference from Exhibit 10.03 to the Company's Registration Statement on Form SB-2 filed with the Commission (the "SB-2)) on August 29, 1993 10.4 Amendment No. 1 dated February 1, 1995 and Amendment No. 2 dated March 1, 1995 to Monterey County Production Facility Lease of the Company (incorporated by reference from Exhibit 10.6 filed with the Company's Form 10-K for the fiscal year ended December 31, 1995) filed April 1, 1996(the "1995 Form 10-K") 10.5 Amendment No. 3 dated September 12, 1997, and Amendment No. 4 dated February 6, 1998 to Monterey County Production Facility Lease of the Company (incorporated by reference from Exhibit 10.5 filed with the Company's September 27, 1998 Quarterly Report on Form 10-Q filed November 4, 1998 ("1998 Q3 10-Q")) 10.6 Trademark Registration--MONTEREY PASTA COMPANY and Design, under Registration No. 1,953,489, registered on January 30, 1996 with the U.S. Patent and Trademark Office (incorporated by reference from Exhibit 10.27 to the 1995 Form 10-K) 10.7* Employment letter dated September 15, 2006 to Chief Executive Officer Eric C. Eddings (incorporated by reference from Exhibit 10.1 filed with the Company's Form 8-K filed September 20, 2006) 10.8 Agreement for Handling and Storage Services between the Company and CS Integrated LLC dated February 5, 1999 (incorporated by reference to Exhibit 10.21 to the Company's 1998 Form 10-K for the fiscal year ended December 27, 1998, filed March 17, 1999 10.9 Royalty agreement dated July 12, 1999 between Company and Chet's Gourmet Foods, Inc. (incorporated by reference to Exhibit 10.25, in the Company's September 26, 1999 Quarterly Report on Form 10-Q filed November 9, 1999 ("1999 Q3 10-Q")) 10.10 Storage Agreement Manufactured Products dated August 3, 1999 between the Company and Salinas Valley Public Warehouse (incorporated by reference to Exhibit 10.26, filed with the Company's 1999 Q3 10-Q) 10.11 Commercial Lease dated August 10, 1999 between Company and Salinas Valley Public Warehouse (incorporated by reference to Exhibit 10.27, filed with the Company's 1999 Q3 10-Q) 10.12 Commercial lease dated January 1, 2000 between the Company and PTF for Operating Engineers, LLC (incorporated by reference to Exhibit 10.32, in the Company's June 25, 2000 Quarterly Report on Form 10-Q filed on August 4, 2000) 10.13 Lease Extension and Modification Agreement between the Company and Marco Warehouse d.b.a. Salinas Valley Public Warehouse dated September 1, 2001 (incorporated by reference to Exhibit 10.40 in the Company's September 30, 2001 Quarterly Report on Form 10-Q filed on November 7, 2001) 10.14 Commercial lease dated August 23, 2002 between the Company and Mel Bankoff (incorporated by reference from Exhibit 10.43 filed with the Company's Report on Form 8-K on August 30, 2002) 72 10.15 Commercial lease dated January 3, 2003 between the Company and Conrad Family Trust (incorporated by reference from Exhibit 10.44 filed with the Company's Form 10-K for the fiscal year ended December 29, 2002, filed on February 14, 2003) 10.16** Third Lease modification to Commercial lease dated August 8, 2006 between the Company and PTF for Operating Engineers, LLC for storage space in Monterey County, California 10.17 Lease Extension and Modification Agreement between the Company and Kenneth Salma and Pattie Salma dated August 24, 2005 (incorporated by reference from Exhibit 10.18 filed with the Company's September 30, 2005 Quarterly Report of Form 10-Q filed on November 14, 2005.) 10.18 Second Amendment of Agreement for the Purchase and Sales of Limited Liability Company Units dated January 12, 2006. (Incorporated by reference from Exhibit 2.1 filed with the Company's current report on Form 8-K dated January 12, 2006 filed with the Commission.) 10.19 Stock Purchase Agreement by and among Monterey Gourmet Foods, Inc., Casual Gourmet Foods, Inc., and Certain Shareholders dated January 11, 2005 (incorporated by reference from Exhibit 2.01 filed with the Company's Report on Form 8-K on January 18, 2005) 10.20 Amendment to the Stock Purchase Agreement by and among Monterey Gourmet Foods, Inc. Casual Gourmet Foods, Inc. and Certain Shareholders dated September 29, 2006 (incorporated by reference from Exhibit 2 filed with the Company's Report on Form 8-K on October 5, 2006) 10.21 Stock Purchase Agreement by and among Monterey Gourmet Foods, Inc., Sonoma Foods, Inc., and Its Shareholders dated April 7, 2005 (incorporated by reference from Exhibit 2.01 filed with the Company's 8-K on April 13, 2005) 10.22 Third Modification to Business Loan Agreement between the Company and Comerica Bank dated January 5, 2005.(incorporated by reference to Exhibit 10.33 filed with the Company's Form 10-K for the fiscal year ended December 26, 2004, filed on March 25, 2005 10.23 Fourth Modification to Business Loan Agreement between the Company and Comerica Bank dated April 11, 2005 (incorporated by reference from Exhibit 10.24 to the Company's Form 10-Q for the quarter ended June 30, 2005 filed with the Commission). 10.24 Securities Purchase Agreement, dated as of June 12, 2006, (incorporated by reference from Exhibit 10.28 filed with the Company's 8-K on June 13, 2006) 10.25 Engagement letter between Roth Capital Partners, LLC and Monterey Gourmet Foods, Inc. dated May 26, 2006(incorporated by reference from Exhibit 10.30 filed with the Company's 8-K on June 13, 2006) 23.1** Consent of Independent Registered Public Accounting Firm 31.1** Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 31.2** Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 32.1** Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 32.2** Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 * Management contract or compensatory plan or arrangement covering executive officers or directors of the Company and its former subsidiary, Upscale Food Outlets, Inc. ** filed herewith 73
EX-10.16 2 ex10_16.htm EXHIBIT 10.16

Exhibit 10.16


Message


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I have reviewed this Form 10-K of Monterey Gourmet Foods Inc.; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: (a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; (b) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and (c) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): (a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: March 21, 2007 /s/ ERIC C. EDDINGS - ------------------------------------- Eric C. Eddings President and Chief Executive Officer 75 EX-31.2 7 ex31_2.txt EXHIBIT 31.2 EXHIBIT 31.2 CERTIFICATION I, Scott Wheeler, certify that: 1. I have reviewed this Form 10-K of Monterey Gourmet Foods Inc.; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: (a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; (b) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and (c) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): (a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: March 21, 2007 /s/ SCOTT S. WHEELER - ------------------------ Scott S, Wheeler Chief Financial Officer 76 EX-32.1 8 ex32_1.txt EXHIBIT 32.1 EXHIBIT 32.1 CERTIFICATION OF CHIEF EXECUTIVE OFFICER Certification pursuant to 18 U.S.C. Section 1350, as adopted ------------------------------------------------------------ pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 --------------------------------------------------------- In connection with the Annual Report of Monterey Gourmet Foods, Inc. (the "Registrant") on Form 10-K for the fiscal year ended December 31, 2006 (the "Report"), I, Eric Eddings, Chief Executive Officer of the Registrant, do hereby certify in accordance with 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that, based on my knowledge: (1) The Report fully complies with the requirements of Section 13(a) of the Securities Exchange Act of 1934 (15 U.S.C. 78m); and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Registrant. Dated: March 21, 2007 /s/ ERIC C. EDDINGS -------------------------- Eric C. Eddings Chief Executive Officer 77 EX-32.2 9 ex32_2.txt EXHIBIT 32.2 EXHIBIT 32.2 CERTIFICATION OF CHIEF FINANCIAL OFFICER Certification pursuant to 18 U.S.C. Section 1350, as adopted ------------------------------------------------------------ pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 --------------------------------------------------------- In connection with the Annual Report of Monterey Gourmet Foods, Inc. (the "Registrant") on Form 10-K for the fiscal year ended December 31, 2006 (the "Report"), I, Scott Wheeler, Chief Financial Officer of the Registrant, do hereby certify in accordance with 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that, based on my knowledge: (1) The Report fully complies with the requirements of Section 13(a) of the Securities Exchange Act of 1934 (15 U.S.C. 78m); and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Registrant. Dated: March 21, 2007 /s/ SCOTT S. WHEELER ------------------------- Scott S. Wheeler Chief Financial Officer 78
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