LIFECORE BIOMEDICAL, INC. \DE\ - Quarter Report: 2018 February (Form 10-Q)

 

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		February 25, 2018				May 28, 2017
		(unaudited)
ASSETS
Current Assets:
Cash and cash equivalents		$	7,650			$	5,409
Accounts receivable, less allowance for doubtful accounts			50,438				47,083
Inventories			28,749				25,290
Prepaid expenses and other current assets			7,614				3,498
Total Current Assets			94,451				81,280
Investment in non-public company, fair value			65,800				63,600
Property and equipment, net			143,362				133,220
Goodwill			54,779				54,779
Trademarks/tradenames, net			16,028				16,028
Customer relationships, net			6,052				6,783
Other assets			5,364				2,918
Total Assets		$	385,836			$	358,608
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current Liabilities:
Accounts payable		$	35,240			$	25,868
Accrued compensation			6,732				8,211
Other accrued liabilities			10,369				9,125
Deferred revenue			1,906				310
Line of credit			12,000				3,000
Current portion of long-term debt			4,940				4,940
Total Current Liabilities			71,187				51,454
Long-term debt, net			38,595				42,299
Capital lease obligation, less current portion			3,665				3,731
Deferred taxes, net			15,822				24,581
Other non-current liabilities			6,417				8,391
Total Liabilities			135,686				130,456
Stockholders’ Equity:
Common stock, $0.001 par value; 50,000 shares authorized; 27,555 and 27,499 shares issued and outstanding at February 25, 2018 and May 28, 2017, respectively			28				27
Additional paid-in capital			144,498				141,680
Retained earnings			103,191				84,470
Accumulated other comprehensive income			915				432
Total Stockholders’ Equity			248,632				226,609
Non-controlling interest			1,518				1,543
Total Equity			250,150				228,152
Total Liabilities and Stockholders’ Equity		$	385,836			$	358,608

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		Three Months Ended								Nine Months Ended
		February 25, 2018				February 26, 2017				February 25, 2018				February 26, 2017
Product sales		$	149,323			$	136,568			$	409,137			$	404,827
Cost of product sales			129,195				113,136				353,971				341,298
Gross profit			20,128				23,432				55,166				63,529
Operating expenses:
Research and development			3,113				2,014				9,204				5,917
Selling, general and administrative			13,807				15,009				40,786				41,969
Legal settlement charge			—				2,080				—				2,580
Total operating costs and expenses			16,920				19,103				49,990				50,466
Operating income			3,208				4,329				5,176				13,063
Dividend income			413				413				1,238				1,238
Interest income			87				8				161				15
Interest expense			(531	)			(400	)			(1,415	)			(1,432	)
Loss on debt refinancing			—				—				—				(1,233	)
Other income			—				700				2,200				700
Net income before taxes			3,177				5,050				7,360				12,351
Income tax benefit (expense)			12,909				(1,556	)			11,451				(4,138	)
Consolidated net income			16,086				3,494				18,811				8,213
Non-controlling interest benefit (expense)			2				6				(90	)			(75	)
Net income applicable to common stockholders		$	16,088			$	3,500			$	18,721			$	8,138
Basic net income per share		$	0.58			$	0.13			$	0.68			$	0.30
Diluted net income per share		$	0.58			$	0.13			$	0.67			$	0.29
Shares used in per share computation
Basic			27,547				27,286				27,524				27,252
Diluted			27,918				27,682				27,884				27,608
Other comprehensive income, net of tax:
Change in net unrealized gains on interest rate swap (net of tax effect of $210, $59, $552, and $251)		$	347			$	103			$	483			$	430
Other comprehensive income, net of tax			347				103				483				430
Total comprehensive income		$	16,435			$	3,603			$	19,204			$	8,568

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		Common Stock								Additional Paid-in				Retained				Accumulated Other Comprehensive				Total Stockholders’				Non-controlling
		Shares				Amount				Capital				Earnings				Income				Equity				Interest
Balance at May 28, 2017			27,499			$	27			$	141,680			$	84,470			$	432			$	226,609			$	1,543
Issuance of common stock at $5.63 to $6.66 per share, net of taxes paid by Landec on behalf of employees			3				—				—				—				—				—				—
Issuance of common stock for vested restricted stock units (“RSUs”)			53				1				—				—				—				1				—
Taxes paid by Company for employee stock plans			—				—				(394	)			—				—				(394	)			—
Stock-based compensation			—				—				3,212				—				—				3,212				—
Payments to non-controlling interest			—				—				—				—				—				—				(115	)
Net income			—				—				—				18,721				—				18,721				90
Other comprehensive income, net of tax			—				—				—				—				483				483				—
Balance at February 25, 2018			27,555			$	28			$	144,498			$	103,191			$	915			$	248,632			$	1,518

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		Nine Months Ended
		February 25, 2018				February 26, 2017
Cash flows from operating activities:
Consolidated net income		$	18,811			$	8,213
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization			9,076				7,827
Stock-based compensation expense			3,212				2,842
Deferred taxes			(9,055	)			3,437
Loss on early debt extinguishment			—				1,233
Change in investment in non-public company, fair value			(2,200	)			(700	)
Net loss on disposal of property and equipment			93				264
Changes in current assets and current liabilities:
Accounts receivable, net			(3,355	)			488
Inventories			(3,459	)			2,262
Prepaid expenses and other current assets			(3,876	)			(137	)
Deposit for workers’ compensation collateral			—				(100	)
Accounts payable			9,373				(6,140	)
Accrued compensation			(1,548	)			676
Other accrued liabilities			(449	)			3,419
Deferred revenue			1,475				(403	)
Net cash provided by operating activities			18,098				23,181
Cash flows from investing activities:
Purchases of property and equipment			(18,533	)			(9,488	)
Issuance of note receivable			(2,099	)			—
Proceeds from sales of fixed assets			88				74
Net cash used in investing activities			(20,544	)			(9,414	)
Cash flows from financing activities:
Proceeds from sale of common stock			1				233
Taxes paid by Company for employee stock plans			(394	)			(385	)
Proceeds from long-term debt			—				50,000
Payments on long-term debt			(3,805	)			(55,966	)
Proceeds from lines of credit			18,000				1,500
Payments on lines of credit			(9,000	)			(5,000	)
Payments for debt issuance costs			—				(902	)
Payments for early debt extinguishment penalties			—				(233	)
Payments to non-controlling interest			(115	)			(166	)
Other, net			—				(8	)
Net cash provided by (used in) financing activities			4,687				(10,927	)
Net increase in cash and cash equivalents			2,241				2,840
Cash and cash equivalents at beginning of period			5,409				9,894
Cash and cash equivalents at end of period		$	7,650			$	12,734

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1.	Organization , Basis of Presentation, and Summary of Significant Accounting Policies

 

Organization

 

Landec Corporation and its subsidiaries (“Landec” or the “Company”) design, develop, manufacture, and sell differentiated products for food and biomaterials markets, and license technology applications to partners. The Company has two proprietary polymer technology platforms: 1) Intelimer® polymers, and 2) hyaluronan (“HA”) biopolymers. The Company sells specialty packaged branded Eat Smart® and GreenLine® and private label fresh-cut vegetables and whole produce to retailers, club stores, and foodservice operators, primarily in the United States, Canada, and Asia through its Apio, Inc. (“Apio”) subsidiary, and sells HA-based and non-HA biomaterials through its Lifecore Biomedical, Inc. (“Lifecore”) subsidiary. The Company’s HA biopolymers and non-HA materials are proprietary in that they are specially formulated for specific customers to meet strict regulatory requirements. Through its O Olive Oil and Vinegar (“O Olive”) division, which the Company acquired on March 1, 2017, the Company sells premier California specialty olive oils and wine vinegars under the O brand to natural food, conventional grocery and mass retail stores, primarily in the United States and Canada.

 

The Company’s technologies, along with its customer relationships and tradenames, are the foundation and key differentiating advantages upon which Landec has built its business.

 

Basis of Presentation

 

The accompanying unaudited consolidated financial statements of Landec have been prepared in accordance with United States generally accepted accounting principles (“GAAP”) for interim financial information and with the instructions for Form 10-Q and Article 10 of Regulation S-X. In the opinion of management, all adjustments (consisting of normal recurring accruals) have been made which are necessary to present fairly the financial position of the Company at February 25, 2018 and the results of operations and cash flows for all periods presented. Although Landec believes that the disclosures in these financial statements are adequate to make the information presented not misleading, certain information normally included in financial statements and related footnotes prepared in accordance with GAAP have been condensed or omitted in accordance with the rules and regulations of the Securities and Exchange Commission. The accompanying financial data should be reviewed in conjunction with the audited financial statements and accompanying notes included in Landec's Annual Report on Form 10-K for the fiscal year ended May 28, 2017.

 

The results of operations for the nine months ended February 25, 2018 are not necessarily indicative of the results that may be expected for an entire fiscal year because there is some seasonality in Apio’s food business, particularly, Apio’s export business, and the order patterns of Lifecore’s customers which may lead to significant fluctuations in Landec’s quarterly results of operations.

 

Basis of Consolidation

 

The consolidated financial statements are presented on the accrual basis of accounting in accordance with GAAP and include the accounts of Landec Corporation and its subsidiaries, Apio and Lifecore. All intercompany transactions and balances have been eliminated.

 

Arrangements that are not controlled through voting or similar rights are reviewed under the guidance for variable interest entities (“VIEs”). A company is required to consolidate the assets, liabilities, and operations of a VIE if it is determined to be the primary beneficiary of the VIE.

 

An entity is a VIE and subject to consolidation, if by design: a) the total equity investment at risk is not sufficient to permit the entity to finance its activities without additional subordinated financial support provided by any party, including equity holders, or b) as a group the holders of the equity investment at risk lack any one of the following three characteristics: (i) the power, through voting rights or similar rights to direct the activities of an entity that most significantly impact the entity’s economic performance, (ii) the obligation to absorb the expected losses of the entity, or (iii) the right to receive the expected residual returns of the entity. The Company reviewed the consolidation guidance and concluded that its partnership interest in Apio Cooling, LP and its equity investment in the non-public company are not VIEs.

 

 

Use of Estimates

 

The preparation of financial statements in conformity with GAAP requires management to make certain estimates and judgments that affect the amounts reported in the financial statements and accompanying notes. The accounting estimates that require management’s most significant and subjective judgments include revenue recognition; loss contingencies; sales returns and allowances; inventories; self-insurance liabilities; recognition and measurement of current and deferred income tax assets and liabilities; the assessment of recoverability of long-lived assets including intangible assets; the valuation of investments; and the valuation and recognition of stock-based compensation and contingent liabilities.

 

These estimates involve the consideration of complex factors and require management to make judgments. The analysis of historical and future trends can require extended periods of time to resolve and are subject to change from period to period. The actual results may differ from management’s estimates.

 

Cash and Cash Equivalents

 

The Company records all highly liquid securities with three months or less from date of purchase to maturity as cash equivalents. Cash equivalents consist mainly of money market funds. The market value of cash equivalents approximates their historical cost given their short-term nature.

 

Inventories

 

Inventories are stated at the lower of cost (first-in, first -out method) or net realizable value and consist of the following (in thousands):

 

 

If the cost of the inventories exceeds their net realizable value, provisions are recorded currently to reduce them to net realizable value. The Company also records a provision for slow moving and obsolete inventories based on the estimate of demand for its products.

 

Related Party Transactions

 

The Company sells products to and earns license fees from Windset Holdings 2010 Ltd. (“Windset”). During the three months ended February 25, 2018 and February 26, 2017, the Company recognized revenues of $104,000 and $72,000, respectively. During the nine months ended February 25, 2018 and February 26, 2017, the Company recognized revenues of $299,000 and $265,000, respectively. These amounts have been included in product sales in the accompanying Consolidated Statements of Comprehensive Income. The related receivable balances of $144,000 and $388,000 are included in accounts receivable in the accompanying Consolidated Balance Sheets as of February 25, 2018 and May 28, 2017, respectively.

 

All related party transactions are monitored quarterly by the Company and approved by the Audit Committee of the Board of Directors.

 

Debt Issuance Costs

 

The Company records its line of credit debt issuance costs as an asset, and as such, $120,000 and $308,000 were recorded as prepaid expenses and other current assets, and other assets, respectively, as of February 25, 2018, and $120,000 and $399,000, respectively, as of May 28, 2017. The Company records its term debt issuance costs as a contra-liability, and as such, $60,000 and $155,000 was recorded as current portion of long-term debt, and long-term debt, net, respectively, as of February 25, 2018 and $60,000 and $201,000, respectively, as of May 28, 2017. See Note 7 – Debt of the Notes to Consolidated Financial Statements for further information.

 

 

Financial Instruments

 

The Company’s financial instruments are primarily composed of commercial-term trade payables, grower advances, notes receivable, and debt instruments. For short-term instruments, the historical carrying amount approximates the fair value of the instrument. The fair value of long-term debt approximates its carrying value.

 

Cash Flow Hedges

 

The Company entered into an interest rate swap agreement to manage interest rate risk. This derivative instrument may offset a portion of the changes in interest expense. The Company designates this derivative instrument as a cash flow hedge. The Company accounts for its derivative instrument as either an asset or a liability and carries it at fair value in Other assets or Other non-current liabilities. The accounting for changes in the fair value of the derivative instrument depends on the intended use of the derivative instrument and the resulting designation.

 

For derivative instruments that hedge the exposure to variability in expected future cash flows that are designated as cash flow hedges, the effective portion of the gain or loss on the derivative instrument is reported as a component of Accumulated Other Comprehensive Income in Stockholders’ Equity and reclassified into earnings in the same period or periods during which the hedged transaction affects earnings. The ineffective portion of the gain or loss on the derivative instrument, if any, is recognized in earnings in the current period. To receive hedge accounting treatment, cash flow hedges must be highly effective in offsetting changes to expected future cash flows on hedged transactions.

 

Other Comprehensive Income

 

Comprehensive income consists of two components, net income and Other Comprehensive Income (“OCI”). OCI refers to revenue, expenses, and gains and losses that under GAAP are recorded as a component of stockholders’ equity but are excluded from net income. The Company’s OCI consists of net deferred gains on its interest rate swap derivative instrument accounted for as a cash flow hedge. The components of OCI and the changes in accumulated OCI, net of tax, are as follows (in thousands):

 

 

The Company does not expect any transactions or other events to occur that would result in the reclassification of any significant gains or losses into earnings in the next 12 months.

 

Investment in Non-Public Company

 

On February 15, 2011, the Company made its initial investment in Windset which is reported as an investment in non-public company, fair value, in the accompanying Consolidated Balance Sheets as of February 25, 2018 and May 28, 2017. The Company has elected to account for its investment in Windset under the fair value option. See Note 3 – Investment in Non-public Company for further information.

 

Intangible Assets

 

The Company’s intangible assets are comprised of customer relationships with a finite estimated useful life of eleven to thirteen years, and trademarks, tradenames and goodwill with indefinite useful lives.

 

Finite-lived intangible assets are reviewed for possible impairment whenever events or changes in circumstances occur that indicate that the carrying amount of an asset (or asset group) may not be recoverable. Indefinite lived intangible assets are reviewed for impairment at least annually. For goodwill and other indefinite-lived intangible assets, the Company performs a qualitative impairment analysis in accordance with Accounting Standards Codification (“ASC”) 350-30-35.

 

 

Partial Self-Insurance on Employee Health and Workers Compensation Plans

 

The Company provides health insurance benefits to eligible employees under self-insured plans whereby the Company pays actual medical claims subject to certain stop loss limits and self-insures its workers compensation claims. The Company records self-insurance liabilities based on actual claims filed and an estimate of those claims incurred but not reported. Any projection of losses concerning the Company's liability is subject to a high degree of variability. Among the causes of this variability are unpredictable external factors such as inflation rates, changes in severity, benefit level changes, medical costs, and claims settlement patterns. This self-insurance liability is included in Other accrued liabilities in the accompanying Consolidated Balance Sheets and represents management's best estimate of the amounts that have not been paid as of February 25, 2018 and May 28, 2017. It is reasonably possible that the expense the Company ultimately incurs could differ and adjustments to future reserves may be necessary.

 

Fair Value Measurements

 

The Company uses fair value measurement accounting for financial assets and liabilities and for financial instruments and certain other items measured at fair value. The Company has elected the fair value option for its investment in a non-public company. See Note 3 – Investment in Non-public Company for further information. The Company also measures its contingent consideration at fair value. See Note 2 – Acquisition of O Olive for further information. The Company has not elected the fair value option for any of its other eligible financial assets or liabilities.

 

The accounting guidance established a three-tier hierarchy for fair value measurements, which prioritizes the inputs used in measuring fair value as follows:

 

Level 1 – observable inputs such as quoted prices for identical instruments in active markets.

 

Level 2 – inputs other than quoted prices in active markets that are observable either directly or indirectly through corroboration with observable market data.

 

Level 3 – unobservable inputs in which there is little or no market data, which would require the Company to develop its own assumptions.

 

As of February 25, 2018 and May 28, 2017, the Company held certain assets that are required to be measured at fair value on a recurring basis, including its interest rate swap and its minority interest investment in Windset.

 

The fair value of the Company’s interest rate swap is determined based on model inputs that can be observed in a liquid market, including yield curves, and is categorized as a Level 2 measurement investment and is included in Other assets in the accompanying Consolidated Balance Sheets.

 

The fair value of the Company’s contingent consideration for the acquisition of O Olive utilizes significant unobservable inputs, including projected earnings before interest, taxes, depreciation and amortization (“EBITDA”) and discount rates. As a result, the Company’s contingent consideration associated with the O Olive acquisition is considered a Level 3 measurement liability. For the nine months ended February 25, 2018, the Company reduced its contingent consideration liability from $5.9 million at May 28, 2017 to $5.4 million at February 25, 2018 due to the change in projected EBITDA and discount rates during the three year earn out period ended May 31, 2020.

 

The Company has elected the fair value option of accounting for its investment in Windset. The calculation of fair value utilizes significant unobservable inputs, including projected cash flows, growth rates, and discount rates. As a result, the Company’s investment in Windset is considered to be a Level 3 measurement investment. The change in the fair value of the Company’s investment in Windset for the nine months ended February 25, 2018 was due to the Company’s 26.9% minority interest in the change in the fair market value of Windset during the period. In determining the fair value of the investment in Windset, the Company utilizes the following significant unobservable inputs in the discounted cash flow models:

 

 

 

The revenue growth, expense growth, and income tax rate assumptions are considered the Company's best estimate of the trends in those items over the discount period. The discount rate assumption takes into account the risk-free rate of return, the market equity risk premium, and the company’s specific risk premium and then applies an additional discount for lack of liquidity of the underlying securities. The discounted cash flow valuation model used by the Company has the following sensitivity to changes in inputs and assumptions (in thousands):

 

 

Imprecision in estimating unobservable market inputs can affect the amount of gain or loss recorded for a particular position. The use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different estimate of fair value at the reporting date.

 

The following table summarizes the fair value of the Company’s assets and liabilities that are measured at fair value on a recurring basis (in thousands):

 

 

	(1)	Included in Other assets in the accompanying consolidated balance sheets.
	(2)	Included in Other non-current liabilities in the accompanying consolidated balance sheets.

 

Revenue Recognition

 

See Note 9 – Business Segment Reporting, for a discussion about the Company’s four business segments; namely, Packaged Fresh Vegetables, Food Export, Biomaterials, and Other.

 

Revenue from product sales is recognized when there is persuasive evidence that an arrangement exists, title has transferred, the price is fixed and determinable, and collectability is reasonably assured. Allowances are established for estimated uncollectible amounts, product returns, and discounts based on specific identification and historical losses.

 

Apio’s Packaged Fresh Vegetables revenues generally consist of revenues generated from the sale of specialty packaged fresh-cut and whole value-added vegetable products that are generally washed and packaged in Apio’s proprietary packaging and sold under Apio’s Eat Smart and GreenLine brands and various private labels. Revenue is generally recognized upon shipment of these products to customers. The Company takes title to all produce it trades and/or packages, and therefore, records revenues and cost of sales at gross amounts in the accompanying Consolidated Statements of Comprehensive Income.

 

In addition, Packaged Fresh Vegetables revenues include the revenues generated from Apio Cooling, LP, a vegetable cooling operation in which Apio is the general partner with a 60% ownership position, and from the sale of BreatheWay® packaging to license partners. Revenue is recognized on the vegetable cooling operations as cooling and storage services are provided to Apio’s customers. Sales of BreatheWay packaging are recognized when shipped to Apio’s customers.

 

Apio’s Food Export revenues consist of revenues generated from the purchase and sale of primarily whole commodity fruit and vegetable products to Asia through its subsidiary, Cal-Ex Trading Company (“Cal-Ex”). As most Cal-Ex customers are in countries outside of the U.S., title transfers and revenue is generally recognized upon arrival of the shipment in the foreign port. Apio records revenue equal to the sale price to third parties because it takes title to the product while in transit. On February 28, 2018, the Company announced its plans to discontinue Cal-Ex by May 27, 2018.

 

Lifecore’s Biomaterials business principally generates revenue through the sale of products containing HA. Lifecore primarily sells products to customers in three medical areas: (1) Ophthalmic, which represented approximately 65% of Lifecore’s revenues in fiscal year 2017, (2) Orthopedic, which represented approximately 15% of Lifecore’s revenues in fiscal year 2017, and (3) Other/Non-HA products, which represented approximately 20% of Lifecore’s revenues in fiscal year 2017. The vast majority of Lifecore’s revenues are recognized upon shipment.

 

 

Lifecore’s business development revenues, a portion of which are included in all three medical areas, are related to contract research and development (“R&D”) services and multiple element arrangement services with customers where the Company provides products and/or services in a bundled arrangement.

  

O Olive’s business, which the Company acquired on March 1, 2017, sells premier California specialty olive oils and wine vinegars under the O brand to natural food, conventional grocery and mass retail stores, primarily in the United States and Canada. The revenues of O Olive are included in the Other segment. O Olive’s revenue is generally recognized upon shipment of its products to customers. The Company takes title to all products it trades and/or packages, and therefore, records revenues and cost of sales at gross amounts in the accompanying Consolidated Statements of Comprehensive Income.

 

Contract R&D revenue is recorded as earned, based on the performance requirements of the contract. Non-refundable contract fees for which no further performance obligations exist, and there is no continuing involvement by the Company, are recognized on the earlier of when the payment is received or collectability is reasonably assured.

 

For sales arrangements that contain multiple elements, the Company splits the arrangement into separate units of accounting if the individually delivered elements have value to the customer on a standalone basis. The Company also evaluates whether multiple transactions with the same customer or related party should be considered part of a multiple element arrangement, whereby the Company assesses, among other factors, whether the contracts or agreements are negotiated or executed within a short time frame of each other or if there are indicators that the contracts are negotiated in contemplation of each other. The Company then allocates revenue to each element based on a selling price hierarchy. The relative selling price for a deliverable is based on its vendor-specific objective evidence (“VSOE”), if available, third-party evidence (“TPE”), if VSOE is not available, or estimated selling price, if neither VSOE nor TPE is available. The Company then recognizes revenue on each deliverable in accordance with its policies for product and service revenue recognition. The Company is not typically able to determine VSOE or TPE, and; therefore, uses the estimated selling price to allocate revenue between the elements of an arrangement.

 

The Company limits the amount of revenue recognition for delivered elements to the amount that is not contingent on the future delivery of products or services or future performance obligations or subject to customer-specific cancellation rights. The Company evaluates each deliverable in an arrangement to determine whether it represents a separate unit of accounting. A deliverable constitutes a separate unit of accounting when it has stand-alone value, and for an arrangement that includes a general right of return relative to the delivered products or services, delivery or performance of the undelivered product or service is considered probable and is substantially controlled by the Company. The Company considers a deliverable to have stand-alone value if the product or service is sold separately by the Company or another vendor or could be resold by the customer. Further, the revenue arrangements generally do not include a general right of return relative to delivered products. Where the aforementioned criteria for a separate unit of accounting are not met, the deliverable is combined with the undelivered element(s) and treated as a single unit of accounting for the purposes of allocation of the arrangement consideration and revenue recognition. The Company allocates the total arrangement consideration to each separable element of an arrangement based upon the relative selling price of each element. Allocation of the consideration is determined at arrangement inception on the basis of each unit’s relative selling price. In instances where the Company has not established fair value for any undelivered element, revenue for all elements is deferred until delivery of the final element is completed and all recognition criteria are met.

 

For licensing revenue, the initial license fees are deferred and amortized to revenue over the period of the agreement when a contract exists, the fee is fixed and determinable, and collectability is reasonably assured. Noncancellable, nonrefundable license fees are recognized over the period of the agreement, including those governing R&D activities and any related supply agreement entered into concurrently with the license when the risk associated with commercialization of a product is non-substantive at the outset of the arrangement.

 

From time to time, the Company offers customers sales incentives, which include volume rebates and discounts. These amounts are estimated on a quarterly basis and recorded as a reduction of revenue.

 

A summary of revenues by type of arrangement as described above is as follows (in thousands):

  

 

Legal Contingencies

 

In the ordinary course of business, the Company is involved in various legal proceedings and claims.

 

The Company makes a provision for a liability relating to legal matters when it is both probable that a liability has been incurred and the amount of the loss can be reasonably estimated. These provisions are reviewed at least each fiscal quarter and adjusted to reflect the impacts of negotiations, estimate settlements, legal rulings, advice of legal counsel and other information and events pertaining to a particular matter. Legal fees are expensed in the period in which they are incurred.

 

Apio has been the target of a union organizing campaign which has included two unsuccessful attempts to unionize Apio's Guadalupe, California processing plant. The campaign involved a union and over 100 former and current employees of Pacific Harvest, Inc. and Rancho Harvest, Inc. (collectively "Pacific Harvest"), Apio's labor contractors at its Guadalupe, California processing facility, bringing legal actions before various state and federal agencies, the California Superior Court, and initiating over 100 individual arbitrations against Apio and Pacific Harvest.

 

The legal actions consisted of three main types of claims: (1) Unfair Labor Practice claims ("ULPs") before the National Labor Relations Board (“NLRB”), (2) discrimination/wrongful termination claims before state and federal agencies and in individual arbitrations, and (3) wage and hour claims as part of two Private Attorney General Act (“PAGA”) cases in state court and in over 100 individual arbitrations.

 

A settlement of the ULPs among the union, Apio, and Pacific Harvest that were pending before the NLRB was approved on December 27, 2016 for $310,000. Apio was responsible for half of this settlement, or $155,000. On May 5, 2017, the parties to the remaining actions executed a settlement agreement concerning the discrimination/wrongful termination claims and the wage and hour claims which covers all non-exempt employees of Pacific Harvest working at Apio's Guadalupe, California processing facility from September 2011 through the settlement date. Under the settlement agreement, the plaintiffs are to be paid $6.0 million in three installments: $2.4 million, which was paid on July 3, 2017, $1.8 million which was paid on November 22, 2017 and $1.8 million which is due in July 2018. The Company and Pacific Harvest have each agreed to pay one half of the settlement payments. The Company paid the entire first two installments of $4.2 million and will be reimbursed by Pacific Harvest for its $2.1 million portion which is included in Other assets in the accompanying Consolidated Balance Sheets. This receivable will be repaid through monthly payments until fully paid, which the Company expects to occur by December 2020. The Company and Pacific Harvest are each required to make one half of the third installment in July 2018. The Company’s recourse against non-payment by Pacific Harvest is its security interest in assets owned by Pacific Harvest.

 

As of February 25, 2018 and May 28, 2017, the Company had accrued $1.0 million and $3.2 million, respectively, related to these actions, which is included in Other accrued liabilities in the accompanying Consolidated Balance Sheets.

 

 

Recent Accounting Guidance Not Yet Adopted

 

Revenue Recognition

 

In May 2014, the FASB issued ASU 2014-09, which creates FASB ASC Topic 606, Revenue from Contracts with Customers and supersedes ASC Topic 605, Revenue Recognition (“ASU 2014-09”). The guidance replaces industry-specific guidance and establishes a single five-step model to identify and recognize revenue. The core principle of the guidance is that an entity should recognize revenue upon transfer of control of promised goods or services to customers in an amount that reflects the consideration to which an entity expects to be entitled in exchange for those goods or services. Additionally, the guidance requires the entity to disclose further quantitative and qualitative information regarding the nature and amount of revenues arising from contracts with customers, as well as other information about the significant judgments and estimates used in recognizing revenues from contracts with customers. Since its original issuance, the FASB has issued several additional related ASUs to address implementation concerns and to further clarify certain guidance within ASU 2014-09. The Company will adopt these updates beginning with the first quarter of its fiscal year 2019 and anticipates doing so using the modified retrospective method, which will be applied retrospectively only to the most current reporting period presented.

 

Currently, the Company is in the process of evaluating the impact of the adoption of ASU 2014-09. As a result, the Company has initially identified the following core revenue streams from its contracts with customers:

 

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Finished goods product sales (Packaged Fresh Vegetables and O Olive);

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Shipping and handling (Packaged Fresh Vegetables and O Olive);

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Product development and contract manufacturing arrangements (Biomaterials).

 

The Company’s assessment efforts to date have included reviewing current accounting policies, processes, and systems requirements, as well assigning internal resources and third-party consultants to assist in the process. Additionally, the Company has reviewed historical contracts and other arrangements to identify potential differences that could arise from the adoption of ASU 2014-09. Most notably, the Company is evaluating its current conclusions with respect to contract manufacturing arrangements for its Biomaterials business, as well as the timing of revenue recognition for its product development contract manufacturing arrangements in its Biomaterials business, to determine whether the application of ASU 2014-09 necessitates changes to such reporting. Beyond its core revenue streams, and the items listed above, the Company is also evaluating the impact of ASU 2014-09 on certain ancillary transactions and other arrangements.

 

Currently, the Company cannot reasonably estimate the impact the application of ASU 2014-09 will have upon its consolidated financial statements. The Company continues to assess the impact of ASU 2014-09, along with industry trends and additional interpretive guidance, on its core revenue streams, and as a result of the continued assessment, the Company may modify its plan of adoption accordingly.

 

Leases

 

In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842) (“ASU 2016-02”), which requires companies to generally recognize on the balance sheet operating and financing lease liabilities and corresponding right-of-use-assets. ASU 2016-02 also requires improved disclosures to help users of financial statements better understand the amount, timing and uncertainty of cash flows arising from leases. The Company will adopt ASU 2016-02 beginning in the first quarter of fiscal year 2020 on a modified retrospective basis.

 

The Company is currently in the process of evaluating the impact that ASU 2016-02 will have upon its consolidated financial statements and related disclosures. The Company’s assessment efforts to date have included:

 

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Reviewing the provisions of ASU 2016-02;

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Gathering information to evaluate its lease population and portfolio;

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Evaluating the nature of its real and personal property and other arrangements that may meet the definition of a lease; and

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Evaluating systems’ readiness.

 

As a result of these efforts, the Company currently anticipates that the adoption of ASU 2016-02 will have a significant impact to its long-term assets and liabilities, as, at a minimum, virtually all of its leases designated as operating leases are expected to be reported on the consolidated balance sheets. The pattern of recognition for operating leases within the consolidated statements of comprehensive income is not anticipated to significantly change.

 

Income Taxes

 

In February 2018, the FASB issued ASU 2018-02, Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income that permits a reclassification from accumulated other comprehensive income to retained earnings for stranded tax effects resulting from the Tax Cuts and Jobs Act enacted in December 2017. The standard is effective for fiscal years beginning after December 15, 2018. Early adoption is permitted. The Company is currently evaluating the impact that the adoption of this guidance will have on its consolidated financial statements.

 

 

 

2.	Acquisition of O Olive

 

On March 1, 2017, the Company purchased substantially all of the assets of O Olive for $2.5 million in cash plus contingent consideration of up to $7.5 million over the next three years based upon O Olive achieving certain EBITDA targets. All accounting for this acquisition is final.

 

The potential earn out payment up to $7.5 million is based on O Olive’s cumulative EBITDA over the Company’s fiscal years 2018 through 2020. At the end of each fiscal year, beginning in fiscal year 2018, the former owners of O Olive will earn the equivalent of the EBITDA achieved by O Olive for that fiscal year in an amount not to exceed $4.6 million over the three year period. The former owners can also earn an additional $2.9 million on a dollar for dollar basis for exceeding $6.0 million of cumulative EBITDA over the three year period. Each quarter the Company performs, with the assistance of a third party appraiser, an analysis of O Olive’s projected EBITDA over the earnout period. Based on this analysis the Company records a contingent consideration liability, included in Other non-current liabilities. As of February 25, 2018 and May 28, 2017 the contingent consideration liability was $5.4 million and $5.9 million, respectively, representing the present value of the expected earn out payments. The $500,000 reduction in the contingent consideration liability was recorded during the first nine months of fiscal year 2018 as a reduction to Selling, General and Administrative expenses in the accompanying Consolidated Statements of Comprehensive Income. For this analysis, the Company assumed that the maximum earn out of $7.5 million would be paid over the three year period with over half being earned in fiscal year 2020.

 

The operating results of O Olive are included in the Company’s financial statements beginning March 1, 2017, in the Other segment.

 

Intangible Assets

 

The Company identified two intangible assets in connection with the O Olive acquisition: trade names and trademarks valued at $1.6 million, which are considered to be indefinite lived intangible assets and therefore, will not be amortized; and customer relationships valued at $700,000 with an eleven year useful life. The Company recorded $17,000 and $67,000 of amortization expense from the amortization of the customer relationships intangible during the three and nine months ended February 25, 2018, respectively. The trade name/trademark intangible asset was valued using the relief from royalty valuation method and the customer relationship intangible asset was valued using the excess earnings method.

 

 

3.	Investment in Non-public Company

 

On February 15, 2011, Apio entered into a share purchase agreement (the “Windset Purchase Agreement”) with Windset. Pursuant to the Windset Purchase Agreement, Apio purchased from Windset 150,000 Senior A preferred shares for $15 million and 201 common shares for $201. On July 15, 2014, Apio increased its investment in Windset by purchasing from the Newell Capital Corporation an additional 68 common shares and 51,211 junior preferred shares of Windset for $11 million. After this purchase, the Company’s common shares represent a 26.9% ownership interest in Windset. The Senior A preferred shares yield a cash dividend of 7.5% annually. The dividend is payable within 90 days of each anniversary of the execution of the Windset Purchase Agreement. The non-voting junior preferred stock does not yield a dividend unless declared by the Board of Directors of Windset and no such dividend has been declared.

 

The Shareholders’ Agreement between Apio and Windset, as amended, includes a put and call option (the “Put and Call Option”), which can be exercised on or after March 31, 2022, whereby Apio can exercise the put to sell its common, Senior A preferred shares, and junior preferred shares to Windset, or Windset can exercise the call to purchase those shares from Apio, in either case, at a price equal to 26.9% of the fair market value of Windset’s common shares, plus the liquidation value of the preferred shares of $20.1 million ($15 million for the Senior A preferred shares and $5.1 million for the junior preferred shares). Under the terms of the arrangement with Windset, the Company is entitled to designate one of five members on the Board of Directors of Windset.

 

On October 29, 2014, Apio further increased its investment in Windset by purchasing 70,000 shares of Senior B preferred shares for $7 million. The Senior B preferred shares pay an annual dividend of 7.5% on the amount outstanding at each anniversary date of the Windset Purchase Agreement. The Senior B preferred shares purchased by Apio have a put feature whereby Apio can sell back to Windset $1.5 million of such shares on the first anniversary, an additional $2.75 million of such shares on the second anniversary, and the remaining $2.75 million on the third anniversary. After the third anniversary, Apio may at any time put any or all of the shares not previously sold back to Windset. At any time on or after February 15, 2017, Windset has the right to call any or all of the outstanding common shares, but at such time must also call the same proportion of Senior A preferred shares, Senior B preferred shares, and junior preferred shares owned by Apio. Windset’s partial call provision is restricted such that a partial call cannot result in Apio holding less than 10% of Windset’s common shares outstanding.

 

 

The investment in Windset does not qualify for equity method accounting as the investment does not meet the criteria of in-substance common stock due to returns through the annual dividend on the non-voting senior preferred shares that are not available to the common stock holders. As the put and call options require all of the various shares to be put or called in equal proportions, the Company has deemed that the investment, in substance, should be treated as a single security for purposes of accounting.

 

The fair value of the Company’s investment in Windset was determined utilizing the Windset Purchase Agreement’s put/call calculation for value and a discounted cash flow model based on projections developed by Windset, and considers the put and call conversion options. These features impact the duration of the cash flows utilized to derive the estimated fair values of the investment. These two discounted cash flow models’ estimate for fair value are then weighted. Assumptions included in these discounted cash flow models will be evaluated quarterly based on Windset’s actual and projected operating results to determine the change in fair value.

 

During each of the three month periods ended February 25, 2018 and February 26, 2017, the Company recorded $412,500 in dividend income. During each of the nine month periods ended February 25, 2018 and February 26, 2017, the Company recorded $1.2 million in dividend income. The increase in the fair market value of the Company’s investment in Windset for the nine month periods ended February 25, 2018 and February 26, 2017 was $2.2 million and $700,000, respectively, and is included in Other income in the accompanying Consolidated Statements of Comprehensive Income.

 

 

4.	Stock-Based Compensation

 

The Company’s stock-based awards include stock option grants and RSUs. The Company records compensation expense for stock-based awards issued to employees and directors in exchange for services provided based on the estimated fair value of the awards on their grant dates and is recognized over the required service periods, generally the vesting period.

 

The following table summarizes the stock-based compensation for options and RSUs (in thousands):

 

 

The following table summarizes the stock-based compensation by income statement line item (in thousands):

 

 

The estimated fair value for stock options, which determines the Company’s calculation of stock-based compensation expense, is based on the Black-Scholes option pricing model. RSUs are valued at the closing market price of the Company’s common stock on the date of grant. The Company uses the straight-line method to recognize the fair value of stock-based compensation arrangements.

 

As of February 25, 2018, there was $5.0 million of total unrecognized compensation expense related to unvested equity compensation awards granted under the Landec incentive stock plans. Total expense is expected to be recognized over the weighted-average period of 2.0 years for stock options and 1.9 years for restricted stock unit awards.

 

 

 

5.	Diluted Net Income Per Share

 

The following table sets forth the computation of diluted net income per share (in thousands, except per share amounts):

 

 

For the three and nine months ended February 25, 2018, the computation of the diluted net income per share excludes the impact of options to purchase 1.7 million and 1.5 million shares, respectively of Common Stock as such impacts would be antidilutive for this period.

 

 

6.	Income Taxes

 

The company’s effective tax rate for the nine months ended February 25, 2018 and February 26, 2017 was a benefit of 154% and expense of 36%, respectively. The income tax benefit was $11.5 million for the nine months ended February 25, 2018, and income tax expense was $4.1 million for the nine months ended February 26, 2017. The income tax benefit and discrete benefit for the nine months ended February 25, 2018 is primarily due to a $13.9 million discrete benefit that mainly reflects the impact of the re-measurement of net deferred tax liabilities resulting from the permanent reduction in the U.S. statutory corporate tax rate from 35% to 21%. The income tax provision for the nine months ended February 26, 2017 was primarily due to state income taxes and incentive stock option expense; partially offset by the domestic manufacturing deduction and research and development credits.

 

On December 22, 2017, the U.S. Government enacted the reconciled tax reform bill, commonly known as the Tax Cuts and Jobs Act of 2017 (the “TCJA”), which became effective on January 1, 2018. Among other tax related changes, the Company’s federal statutory tax rate has been reduced from 35 %, to an average rate of 29% for the fiscal year ended May 27, 2018, and then 21% for fiscal years thereafter. The TCJA also enhances and extends through 2026 the option to claim accelerated depreciation deductions on qualified property; however, the domestic manufacturing deduction, from which the Company has historically benefitted, has been eliminated. Under GAAP, the Company is required to recognize the effects of changes in tax laws and tax rates on deferred tax assets and liabilities in the period in which the new legislation is enacted. At February 25, 2018, the Company had not completed its accounting for the tax effects of enactment of the TCJA; however, the Company made a reasonable estimate of the effects on its existing deferred tax balances and the one-time transition tax.

 

The changes included in the TCJA are broad and complex and the Company does not have all the necessary information to analyze all income tax effects of the TCJA. The above income tax benefit amount is a provisional amount based on a reasonable estimate of the impact of the reduction in the corporate tax rate on our current and deferred tax liabilities. Changes in the estimate of the Company’s deferred tax asset and liability activity during fiscal year 2018 could impact the Company’s remeasurement of net deferred tax liabilities. The Company will continue to evaluate the TCJA and adjust the provisional amounts as additional information becomes available. The ultimate impact of the TCJA may differ from the provisional amounts due to changes in the Company’s interpretations and assumptions, as well as additional guidance on the interpretation of the TCJA. The Company will continue to assess its provision for income taxes as future guidance is issued. Although not anticipated, revisions to the Company’s provision for income taxes will be treated in accordance with the measurement period guidance outlined in Staff Accounting Bulletin No. 118.

 

As of February 25, 2018 and May 28, 2017, the Company had unrecognized tax benefits of approximately $472,000 and $537,000, respectively. Included in the balance of unrecognized tax benefits as of February 25, 2018 and May 28, 2017 is approximately $366,000 and $419,000, respectively, of tax benefits that, if recognized, would result in an adjustment to the Company’s effective tax rate. The Company does not expect its unrecognized tax benefits to change significantly within the next twelve months.

 

The Company has elected to classify interest and penalties related to uncertain tax positions as a component of its provision for income taxes. The Company has accrued an insignificant amount of interest and penalties relating to the income tax on the unrecognized tax benefits as of February 25, 2018 and May 28, 2017.

 

Due to tax attribute carryforwards, the Company is subject to examination for tax years 2015 forward for U.S. tax purposes. The Company is also subject to examination in various state jurisdictions for tax years 2012 forward, none of which were individually material.

 

Our estimated annual effective tax rate may be subject to further uncertainty due to the recent changes in U.S. tax rates and tax laws.

 

 

7.

Debt

 

Long-term debt, net consists of the following (in thousands):

 

 

On September 23, 2016, the Company entered into a Credit Agreement with JPMorgan, BMO, and City National Bank, as lenders (collectively, the “Lenders”), and JPMorgan as administrative agent, pursuant to which the Lenders provided the Company with a $100 million revolving line of credit (the “Revolver”) and a $50 million term loan facility (the “Term Loan”), guaranteed by each of the Company’s direct and indirect subsidiaries and secured by substantially all of the Company’s assets, with the exception of the Company’s investment in Windset.

 

Both the Revolver and the Term Loan mature in five years (on September 23, 2021), with the Term Loan providing for quarterly principal payments of $1.25 million commencing December 1, 2016, with the remainder due at maturity.

 

Interest on both the Revolver and the Term Loan is based on either the prime rate or Eurodollar rate, at the Company’s discretion, plus a spread based on the Company’s leverage ratio (generally defined as the ratio of the Company’s total indebtedness on such date to the Company’s consolidated EBITDA for the period of four consecutive fiscal quarters ended on or most recently prior to such date). The spread is at a per annum rate of (i) between 0.25% and 1.25% if the prime rate is elected or (ii) between 1.25% and 2.25% if the Eurodollar rate is elected.

 

The Credit Agreement provides the Company the right to increase the Revolver commitments and/or the Term Loan commitments by obtaining additional commitments either from one or more of the Lenders or another lending institution at an amount of up to $75 million.

 

The Credit Agreement contains customary financial covenants and events of default under which the obligation could be accelerated and/or the interest rate increased. The Company was in compliance with all financial covenants as of February 25, 2018.

 

On November 1, 2016, the Company entered into an interest rate swap agreement (“Swap”) with BMO at a notional amount of $50 million. The Swap has the effect of changing the Company’s Term Loan obligation from a variable interest rate to a fixed 30-day LIBOR rate of 1.22%. As of February 25, 2018, the interest rate on the Term Loan was 3.57%. For further discussion regarding the Company’s use of derivative instruments, see the Financial Instruments section of Note 1 – Organization, Basis of Presentation, and Summary of Significant Accounting Policies.

 

In connection with the Credit Agreement, the Company incurred lender and third-party debt issuance costs of $897,000, of which $598,000 and $299,000 was allocated to the Revolver and Term Loan, respectively.

 

As of February 25, 2018, $12 million was outstanding on the Revolver at an interest rate of 3.57% under the Libor option.

 

 

8.	Stockholders’ Equity

 

During the three months ended February 25, 2018, the Company did not grant any equity awards. During the nine months ended February 25, 2018, the Company granted options to purchase 498,000 shares of common stock and awarded 200,000 RSUs.

 

As of February 25, 2018, the Company has reserved 3.1 million shares of Common Stock for future issuance under its current and former equity plans.

 

On July 14, 2010, the Company announced that the Board of Directors of the Company had approved the establishment of a stock repurchase plan authorizing the repurchase of up to $10 million of the Company’s common stock. The Company may repurchase its common stock from time to time in open market purchases or in privately negotiated transactions. The timing and actual number of shares repurchased is at the discretion of management of the Company and will depend on a variety of factors, including stock price, corporate and regulatory requirements, market conditions, the relative attractiveness of other capital deployment opportunities and other corporate priorities. The stock repurchase program does not obligate Landec to acquire any amount of its common stock and the program may be modified, suspended or terminated at any time at the Company's discretion without prior notice. During the fiscal year ended May 28, 2017 and the nine months ended February 25, 2018, the Company did not purchase any shares on the open market.

 

 

9.	Business Segment Reporting

 

The Company manages its business operations through three strategic business units and an Other segment. Based upon the information reported to the chief operating decision maker, who is the Chief Executive Officer, the Company has the following reportable segments: the Packaged Fresh Vegetables segment, the Food Export segment and the Biomaterials segment.

 

The Packaged Fresh Vegetables segment markets and packs specialty packaged whole and fresh-cut fruit and vegetables, the majority of which incorporate the BreatheWay specialty packaging for the retail grocery, club store and food services industry. In addition, the Packaged Fresh Vegetables segment sells BreatheWay packaging to partners for fruit and vegetable products. The Food Export segment consists of revenues generated from the purchase and sale of primarily whole commodity fruit and vegetable products predominantly to Asia. The Biomaterials segment sells products utilizing hyaluronan, a naturally occurring polysaccharide that is widely distributed in the extracellular matrix of connective tissues in both animals and humans, and non-HA products for medical use primarily in the Ophthalmic, Orthopedic and other markets. Other includes licensing and R&D activities from Landec’s Intelimer polymers for agricultural products, personal care products and other industrial products and from the operations of the O Olive business which was acquired on March 1, 2017. The Other segment also includes corporate general and administrative expenses, non-Packaged Fresh Vegetables and non-Biomaterials interest income and income tax expenses. All of the assets of the Company are located within the United States of America.

  

The Company’s international sales by geography are based on the billing address of the customer and were as follows (in millions):

 

 

 

Operations by business segment consisted of the following (in thousands):

 

 

During the nine months ended February 25, 2018 and February 26, 2017, sales to the Company’s top five customers accounted for 46% and 43%, respectively, of sales. The Company’s top two customers, Costco Wholesale Corporation and Wal-Mart Stores, Inc., from the Packaged Fresh Vegetables segment, accounted for 18% and 17% of revenues, respectively, for the nine months ended February 25, 2018, and 17% and 14% respectively, for the nine months ended February 26, 2017. The Company expects that, for the foreseeable future, a limited number of customers may continue to account for a significant portion of its revenues.

 

 

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