DAR-2011.7.2-10Q


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC  20549
 
FORM 10-Q
 
 (Mark One)      
/X/  QUARTERLY REPORT PURSUANT TO SECTION 13 or 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
 For the quarterly period ended July 2, 2011
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   001-13323

DARLING INTERNATIONAL INC.
(Exact name of registrant as specified in its charter)
 
 Delaware
 
 36-2495346
 (State or other jurisdiction     
 
(I.R.S. Employer
of incorporation or organization)   
 
Identification Number)
 
 
 
 251 O'Connor Ridge Blvd., Suite 300
 
 
 Irving, Texas
 
 75038
(Address of principal executive offices)  
 
(Zip Code)
 
Registrant's telephone number, including area code:  (972) 717-0300
 
    Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.       Yes    X         No ____
 
    Indicate by check mark whether the Registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the Registrant was required to submit and post such files).        Yes    X        No ___

 Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer     
X
 
Accelerated filer    
 
 
Non-accelerated filer 
 
 
Smaller reporting company       
 
 
 
 
 
 
 
(Do not check if a smaller reporting company)
 
 
 
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).     Yes            No  X  
 
There were 117,046,206 shares of common stock, $0.01 par value, outstanding at August 4, 2011.

1



DARLING INTERNATIONAL INC. AND SUBSIDIARIES
FORM 10-Q FOR THE QUARTERLY PERIOD ENDED JULY 2, 2011
 
 
TABLE OF CONTENTS   

 
 
 
 
Page No.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 43
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 


2






DARLING INTERNATIONAL INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS
July 2, 2011 and January 1, 2011
(in thousands, except shares)

 
July 2,
2011
 
January 1,
2011
ASSETS
(unaudited)
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
12,444

 
$
19,202

Restricted cash
376

 
373

Accounts receivable, net
109,257

 
87,455

Escrow receivable

 
16,267

Inventories
63,137

 
45,606

Income taxes refundable
9,383

 
1,474

Other current assets
12,353

 
8,833

Deferred income taxes
5,356

 
6,376

Total current assets
212,306

 
185,586

Property, plant and equipment, less accumulated depreciation of
   $257,567 at July 2, 2011 and $238,265 at January 1, 2011
396,004

 
393,420

Intangible assets, less accumulated amortization of
   $70,290 at July 2, 2011 and $56,689 at January 1, 2011
376,881

 
390,954

Goodwill
378,050

 
376,263

Investment in unconsolidated subsidiary
9,567

 

Other assets
31,014

 
36,035

 
$
1,403,822

 
$
1,382,258

LIABILITIES AND STOCKHOLDERS’ EQUITY
 

 
 

Current liabilities:
 

 
 

Current portion of long-term debt
$
161

 
$
3,009

Accounts payable, principally trade
88,021

 
70,123

Accrued expenses
63,371

 
81,698

Total current liabilities
151,553

 
154,830

Long-term debt, net of current portion
329,873

 
707,030

Other non-current liabilities
46,512

 
50,760

Deferred income taxes
15,154

 
5,342

Total liabilities
543,092

 
917,962

Commitments and contingencies


 


Stockholders’ equity:
 

 
 

     Common stock, $0.01 par value; 150,000,000 shares authorized;
        117,579,944 and 93,014,691 shares issued at July 2, 2011
        and at January 1, 2011, respectively
1,176

 
930

Additional paid-in capital
587,500

 
290,106

     Treasury stock, at cost;  533,738 and 455,020 shares at
       July 2, 2011 and at January 1, 2011, respectively
(5,464
)
 
(4,340
)
Accumulated other comprehensive loss
(19,859
)
 
(20,988
)
Retained earnings
297,377

 
198,588

Total stockholders’ equity
860,730

 
464,296

 
$
1,403,822

 
$
1,382,258


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

3



DARLING INTERNATIONAL INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS
Three months and six months ended July 2, 2011 and July 3, 2010
(in thousands, except per share data)
(unaudited)


 
 
Three Months Ended
 
Six Months Ended
 
July 2,
2011
 
July 3,
2010
 
July 2,
2011
 
July 3,
2010
Net sales
$
470,610

 
$
166,210

 
$
910,508

 
$
328,992

Costs and expenses:
 

 
 

 
 
 
 
Cost of sales and operating expenses
325,228

 
123,853

 
626,619

 
244,263

Selling, general and administrative expenses
34,092

 
16,237

 
64,785

 
32,002

Depreciation and amortization
19,055

 
7,206

 
38,736

 
14,230

Total costs and expenses
378,375

 
147,296

 
730,140

 
290,495

Operating income
92,235

 
18,914

 
180,368

 
38,497

 
 
 
 
 
 
 
 
Other income/(expense):
 

 
 

 
 
 
 
Interest expense
(7,745
)
 
(889
)
 
(21,973
)
 
(1,799
)
Other, net
(830
)
 
(448
)
 
(1,396
)
 
(982
)
Total other income/(expense)
(8,575
)
 
(1,337
)
 
(23,369
)
 
(2,781
)
 
 
 
 
 
 
 
 
Equity in net loss of unconsolidated subsidiary
(1,174
)
 

 
(1,174
)
 

Income from operations before income taxes
82,486

 
17,577

 
155,825

 
35,716

Income taxes
30,259

 
6,206

 
57,036

 
12,867

Net income
$
52,227

 
$
11,371

 
$
98,789

 
$
22,849

 
 
 
 
 
 
 
 
Basic income per share
$
0.45

 
$
0.14

 
$
0.88

 
$
0.28

Diluted income per share
$
0.44

 
$
0.14

 
$
0.87

 
$
0.28



 



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

4



DARLING INTERNATIONAL INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS
Six months ended July 2, 2011 and July 3, 2010
(in thousands)
(unaudited)

 
July 2,
2011
 
July 3,
2010
Cash flows from operating activities:
 
 
 
Net income
$
98,789

 
$
22,849

Adjustments to reconcile net income to net cash provided by
         operating activities:
 
 
 
Depreciation and amortization
38,736

 
14,230

Gain on disposal of property, plant, equipment and other assets
(64
)
 
(28
)
Deferred taxes
10,832

 
(309
)
Increase in long-term pension liability
415

 
877

Stock-based compensation expense
2,204

 
842

Write-off deferred loan costs
4,184

 

Deferred loan cost amortization
1,697

 
296

Equity in net loss of unconsolidated subsidiary
1,174

 

Changes in operating assets and liabilities, net of effects
    from acquisitions:
 
 
 
Restricted cash
(3
)
 
22

Accounts receivable
(23,536
)
 
(641
)
Escrow receivable
16,267

 

Income taxes refundable/payable
(7,909
)
 
(2,769
)
Inventories and prepaid expenses
(21,037
)
 
(7,990
)
Accounts payable and accrued expenses
(1,957
)
 
(2,412
)
Other
(1,288
)
 
1,623

Net cash provided by operating activities
118,504

 
26,590

Cash flows from investing activities:
 
 
 
Capital expenditures
(27,870
)
 
(9,400
)
       Acquisition
(164
)
 
(15,284
)
       Investment in unconsolidated subsidiary
(10,741
)
 

Gross proceeds from disposal of property, plant and equipment
        and other assets
665

 
144

Payments related to routes and other intangibles

 
(991
)
Net cash used by investing activities
(38,110
)
 
(25,531
)
Cash flows from financing activities:
 
 
 
Payments on long-term debt
(240,005
)
 
(2,504
)
Net payments on revolver
(140,000
)
 

Deferred loan costs
(267
)
 

Issuance of common stock
293,189

 
7

Minimum withholding taxes paid on stock awards
(1,205
)
 
(442
)
Excess tax benefits from stock-based compensation
1,136

 
184

Net cash used by financing activities
(87,152
)
 
(2,755
)
Net decrease in cash and cash equivalents
(6,758
)
 
(1,696
)
Cash and cash equivalents at beginning of period
19,202

 
68,182

Cash and cash equivalents at end of period
$
12,444

 
$
66,486

Supplemental disclosure of cash flow information:
 
 
 
Cash paid during the period for:
 
 
 
Interest
$
16,023

 
$
1,512

Income taxes, net of refunds
$
53,780

 
$
16,379


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

5



DARLING INTERNATIONAL INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements
July 2, 2011
(unaudited)

(1)
General

Darling International Inc., a Delaware corporation (“Darling”, and together with its subsidiaries, the “Company”), is a leading provider of rendering, cooking oil and bakery waste recycling and recovery solutions to the nation's food industry. The Company collects and recycles animal by-products, bakery waste and used cooking oil from poultry and meat processors, commercial bakeries, grocery stores, butcher shops, and food service establishments and provides grease trap cleaning services to many of the same establishments. As further discussed in Note 3, on December 17, 2010, Darling completed its acquisition of Griffin Industries, Inc. (which was subsequently converted to a limited liability company) and its subsidiaries (“Griffin”) pursuant to the Agreement and Plan of Merger, dated as of November 9, 2010 (the “Merger Agreement”), by and among Darling, DG Acquisition Corp., a wholly-owned subsidiary of Darling (“Merger Sub”), Griffin and Robert A. Griffin, as the Griffin shareholders' representative. Merger Sub was merged with and into Griffin (the “Merger”), and Griffin survived the Merger as a wholly-owned subsidiary of Darling (the “Griffin Transaction”). The Company operates over 125 processing and transfer facilities located throughout the United States to process raw materials into finished products such as protein (primarily meat and bone meal (“MBM”) and poultry meal (“PM”)), hides, fats (primarily bleachable fancy tallow (“BFT”), poultry grease (“PG”) and yellow grease (“YG”)) and bakery by-products (“BBP”) as well as a range of branded and value-added products. The Company sells these products nationally and internationally, primarily to producers of animal feed, pet food, fertilizer, bio-fuels and other consumer and industrial ingredients including oleo-chemicals, soaps and leather goods for use as ingredients in their products or for further processing. Effective January 2, 2011, as a result of the acquisition of Griffin, the Company's business operations were reorganized into two new segments, Rendering and Bakery, in order to better align its business with the underlying markets and customers that the Company serves. All historical periods have been restated for the changes to the segment reporting structure. Comparative segment revenues and related financial information are presented in Note 6 to the consolidated financial statements.

The accompanying consolidated financial statements for the three and six month periods ended July 2, 2011 and July 3, 2010, have been prepared in accordance with generally accepted accounting principles in the United States by the Company without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”).  The information furnished herein reflects all adjustments (consisting only of normal recurring accruals) that are, in the opinion of management, necessary to present a fair statement of the financial position and operating results of the Company as of and for the respective periods. However, these operating results are not necessarily indicative of the results expected for a full fiscal year. Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with generally accepted accounting principles have been omitted pursuant to such rules and regulations.  However, management of the Company believes, to the best of their knowledge, that the disclosures herein are adequate to make the information presented not misleading.  The Company has determined that there were no subsequent events that would require disclosure or adjustments to the accompanying consolidated financial statements through the date the financial statements were issued.  The accompanying consolidated financial statements should be read in conjunction with the audited consolidated financial statements contained in the Company’s Form 10-K for the fiscal year ended January 1, 2011, as amended by Form 8-K filed on June 15, 2011

(2)
Summary of Significant Accounting Policies

(a)
Basis of Presentation

The consolidated financial statements include the accounts of Darling and its subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.

(b)
Fiscal Periods

The Company has a 52/53 week fiscal year ending on the Saturday nearest December 31.  Fiscal periods for the consolidated financial statements included herein are as of July 2, 2011, and include the 13 and 26 weeks ended July 2, 2011, and the 13 and 26 weeks ended July 3, 2010.



6



(c)
Reclassifications

Certain prior year immaterial amounts have been reclassified to conform to the current year presentation.

(d)
Earnings Per Share

Basic income per common share is computed by dividing net income by the weighted average number of common shares including non-vested and restricted shares outstanding during the period.  Diluted income per common share is computed by dividing net income by the weighted average number of common shares including non-vested and restricted shares outstanding during the period increased by dilutive common equivalent shares determined using the treasury stock method. As a result of the use of weighted average number of shares the full effect of the issuance of 24,193,548 shares as discussed in Note 9 are not in the below earnings per share calculation in fiscal 2011.

 
Net Income per Common Share (in thousands, except per share data)
 
Three Months Ended
 
 
 
July 2, 2011
 
 
 
 
 
July 3, 2010
 
 
 
Income
 
Shares
 
Per Share
 
Income
 
Shares
 
Per Share
Basic:
 
 
 
 
 
 
 
 
 
 
 
Net Income
$
52,227

 
117,064

 
$
0.45

 
$
11,371

 
82,444

 
$
0.14

Diluted:
 

 
 

 
 

 
 

 
 

 
 

Effect of dilutive securities:
 

 
 

 
 

 
 

 
 

 
 

Add: Option shares in the money and dilutive effect of non-vested stock
 

 
973

 
 

 
 

 
784

 
 

Less: Pro forma treasury shares
 

 
(365
)
 
 

 
 

 
(401
)
 
 

Diluted:
 

 
 

 
 

 
 

 
 

 
 

Net income
$
52,227

 
117,672

 
$
0.44

 
$
11,371

 
82,827

 
$
0.14


 
Six Months Ended
 
 
 
July 2, 2011
 
 
 
 
 
July 3, 2010
 
 
 
Income
 
Shares
 
Per Share
 
Income
 
Shares
 
Per Share
Basic:
 
 
 
 
 
 
 
 
 
 
 
Net Income
$
98,789

 
112,795

 
$
0.88

 
$
22,849

 
82,366

 
$
0.28

Diluted:
 

 
 

 
 

 
 

 
 

 
 

Effect of dilutive securities:
 

 
 

 
 

 
 

 
 

 
 

Add: Option shares in the money and dilutive effect of non-vested stock
 

 
986

 
 

 
 

 
785

 
 

Less: Pro forma treasury shares
 

 
(381
)
 
 

 
 

 
(403
)
 
 

Diluted:
 

 
 

 
 

 
 

 
 

 
 

Net income
$
98,789

 
113,400

 
$
0.87

 
$
22,849

 
82,748

 
$
0.28


For the three months ended July 2, 2011 and July 3, 2010, respectively, 72,157 and 101,722 outstanding stock options were excluded from diluted income per common share as the effect was antidilutive. For the three months ended July 2, 2011 and July 3, 2010, respectively, 326,526 and zero shares of non-vested stock were excluded from diluted income per common share as the effect was antidilutive.

For the six months ended July 2, 2011 and July 3, 2010, respectively, 50,387 and 73,964 outstanding stock options were excluded from diluted income per common share as the effect was antidilutive. For the six months ended July 2, 2011 and July 3, 2010, respectively, 350,125 and zero shares of non-vested stock were excluded from diluted income per common share as the effect was antidilutive.



7



(3)
Acquisitions

On December 17, 2010, Darling completed its acquisition of all of the shares of Griffin pursuant to the Merger Agreement. The Griffin Transaction will increase Darling's capabilities by growing volumes, diversifying the raw material supplies, increasing the ability to better serve the Company's customers and suppliers and providing new opportunities for business growth on a national platform.

As a result of the Griffin Transaction, effective December 17, 2010, the Company began including the operations of Griffin into the Company's consolidated financial statements. The following table presents selected pro forma information, for comparative purposes, assuming the Griffin Transaction had occurred on January 3, 2010 for the periods presented (unaudited) (in thousands, except per share data):


 
 
Three Months Ended
 
Six Months Ended
 
 
July 3, 2010
 
July 3, 2010
Net sales
 
$
322,295

 
$
627,633

Income from continuing operations
 
37,719

 
71,725

Net income
 
24,356

 
45,883

Earnings per share
 
 
 
 
Basic
 
$
0.26

 
$
0.50

Diluted
 
$
0.26

 
$
0.49


The selected unaudited pro forma information is not necessarily indicative of the consolidated results of operations for future periods or the results of operations that would have been realized had the Griffin Transaction actually occurred on January 3, 2010.

Total consideration paid in the Griffin Transaction was approximately $872.2 million and comprises $740.5 million in cash (including $33.6 million in escrow), the issuance of approximately 10.0 million shares of Darling common stock (valued at the fair market value at the closing of $13.06 or approximately $130.6 million), a $16.3 million escrow receivable for certain over funding of working capital, a $13.6 million accrued expense for the Company's and the Griffin shareholders' election to step up the tax basis of the assets acquired in the Griffin Transaction and a long-term liability of approximately $3.8 million of contingent consideration for the true-up adjustment as further described below. The purchase price is subject to customary adjustments relating to representations and warranties. During the first quarter of fiscal 2011 a working capital adjustment was made between bakery goodwill and accounts receivable of approximately $1.7 million. In second quarter of fiscal 2011, the Company received approximately $16.4 million from escrow representing the $16.3 million escrow receivable recorded for certain over funding of working capital and other final working capital adjustments. Additionally, in the second quarter of fiscal 2011, the Company paid approximately $13.8 million for the Company's election under Section 338(h)(10) of the Internal Revenue Code an increase of approximately $0.2 million from the original $13.6 million accrual. The tax benefit from the step up in the tax basis of the Griffin assets is expected to occur over a period of approximately 15 years. However, there can be no assurance that the Company will generate sufficient income to take advantage of these possible tax deductions. Further, there could be changes in the tax law that could erode the value of the increased tax basis of the Griffin assets. The tax benefits that may be received by the Company as a result of the Section 338(h)(10) election will have no impact on the Company's earnings and will impact cash flows only to the extent that the Company has taxable income that is offset by depreciation and amortization deductions on the Griffin assets. The cash consideration was funded primarily through borrowings under the Company's credit agreement and the sale of senior notes as further discussed in Note 8. The shares issued in the Griffin Transaction were issued on terms set forth in the rollover agreement, dated as of November 9, 2010, by and among Darling, certain of Griffin's shareholders who qualify as “accredited investors” (the “Rollover Shareholders”) pursuant to Rule 501(a) of Regulation D promulgated under the Securities Act of 1933, as amended (the “Securities Act”), and Robert A. Griffin, as such shareholders' representative (the “Rollover Agreement”), to the Rollover Shareholders.

The Rollover Agreement provides for a true-up adjustment in which additional cash of up to $15 million could be paid by Darling if on the True-Up Date (the last day of the 13th full consecutive month following the closing of the Merger), the True-up Market Price (as defined in the Rollover Agreement) is less than $10.002. If the True-Up Market Price exceeds $10.002 per share, no additional consideration will be paid. The Company initially valued this contingent consideration at fair value of approximately $3.8 million based on the probability that the Company's True-up Market

8



Price as defined above will be less than $10.002 per share. At July 2, 2011 the additional contingent consideration was revalued to an estimated liability of approximately $0.3 million resulting in a reduction of approximately $3.5 million, which has been recorded as a reduction to selling, general and administrative expenses. The Company is required to revalue the contingent consideration on a quarterly basis until the True-up Market Price is determined.

On May 28, 2010, the Company acquired certain rendering business assets from Nebraska By-Products, Inc. for approximately $15.3 million.  The purchase was accounted for as an asset purchase pursuant to the terms of the asset purchase agreement between the Company and Nebraska By-Products, Inc. and affiliated companies (the “Nebraska Transaction”).  The assets acquired in the Nebraska Transaction will increase the Company’s rendering portfolio and better serve the Company’s customers within the rendering segment.
 
Effective May 28, 2010, the Company began including the operations of the Nebraska Transaction into the Company’s consolidated financial statements.  The Company paid approximately $15.3 million in cash for assets and assumed liabilities consisting of property, plant and equipment of $9.6 million, intangible assets of $2.8 million, goodwill of $2.8 million and other of $0.1 million on the closing date.  The goodwill from the Nebraska Transaction was assigned to the rendering segment and is expected to be deductible for tax purposes.  The identifiable intangibles have a weighted average life of eleven years.

The Company notes that the Nebraska Transaction is not considered a related business, therefore pro forma results of operations for this acquisition have not been presented because the effect is not deemed material to revenues and net income of the Company for any fiscal period presented.

(4)    Investment in Unconsolidated Subsidiary

The Company announced on January 21, 2011 that a wholly-owned subsidiary of Darling entered into a limited liability company agreement with a wholly-owned subsidiary of Valero Energy Corporation (“Valero”) to form Diamond Green Diesel Holdings LLC (the “Joint Venture”). The Joint Venture will be owned 50% / 50% with Valero and was formed to design, engineer, construct and operate a renewable diesel plant (the “Facility”), which will be capable of producing approximately 9,300 barrels per day of renewable diesel fuel and certain other co-products, to be located adjacent to Valero's refinery in Norco, Louisiana. The Joint Venture intends to construct the Facility under an engineering, procurement and construction contract that is intended to fix the Company's maximum economic exposure for the cost of the Facility.

On May 31, 2011, the Joint Venture and Diamond Green Diesel LLC, a wholly-owned subsidiary of the Joint Venture (“Opco”), entered into (i) a facility agreement (the “Facility Agreement”) with Diamond Alternative Energy, LLC, a wholly-owned subsidiary of Valero (the “Lender”), and (ii) a loan agreement (the “Loan Agreement”) with the Lender, which will provide the Joint Venture with a 14 year multiple advance term loan facility of approximately $221,300,000 (the “JV Loan”) to support the design, engineering and construction of the Facility, which is now under construction. In connection with the Facility Agreement and the Loan Agreement, the Joint Venture terminated discussions with the U.S. Department of Energy (“DOE”) regarding the DOE's offer to the Joint Venture of a conditional commitment to issue a loan guarantee under the Energy Policy Act of 2005. The Facility Agreement and the Loan Agreement prohibit the Lender from assigning all or any portion of the Facility Agreement or the Loan Agreement to unaffiliated third parties. Opco has also pledged substantially all of its assets to the Lender, and the Joint Venture has pledged all of Opco's equity interests to the Lender, until the JV Loan has been paid in full and the JV Loan has terminated in accordance with its terms.

Pursuant to sponsor support agreements executed in connection with the Facility Agreement and the Loan Agreement, each of the Company and Valero are committed to contributing approximately $93.2 million of the estimated aggregate costs of approximately $407.7 million for the completion of the Facility. The Company is also required to pay for 50% of any cost overruns incurred in connection with the construction of the Facility. The ultimate cost of the Joint Venture to the Company cannot be determined until, among other things, further detailed engineering reports and studies have been completed. As of July 2, 2011 under the equity method of accounting, the Company has an investment in the Joint Venture of approximately $9.6 million on the consolidated balance sheet and has recorded approximately $1.2 million in losses in the unconsolidated subsidiary for the six months ended July 2, 2011.

(5)
Contingencies 

The Company is a party to lawsuits, claims and loss contingencies arising in the ordinary course of its business, including assertions by certain regulatory and governmental agencies related to permitting requirements and air, wastewater and storm water discharges from the Company’s processing facilities.

9




The Company’s workers compensation, auto and general liability policies contain significant deductibles or self-insured retentions.  The Company estimates and accrues its expected ultimate claim costs related to accidents occurring during each fiscal year and carries this accrual as a reserve until these claims are paid by the Company.

As a result of the matters discussed above, the Company has established loss reserves for insurance, environmental and litigation matters.  At July 2, 2011 and January 1, 2011, the reserves for insurance, environmental and litigation contingencies reflected on the balance sheet in accrued expenses and other non-current liabilities for which there are no potential insurance recoveries were approximately $30.0 million and $28.2 million, respectively.  The Company's management believes these reserves for contingencies are reasonable and sufficient based upon present governmental regulations and information currently available to management; however, there can be no assurance that final costs related to these matters will not exceed current estimates. The Company believes that the likelihood is remote that any additional liability from these lawsuits and claims that may not be covered by insurance would have a material effect on the financial statements.

Lower Passaic River Area. The Company has been named as a third party defendant in a lawsuit pending in the Superior Court of New Jersey, Essex County, styled New Jersey Department of Environmental Protection, The Commissioner of the New Jersey Department of Environmental Protection Agency and the Administrator of the New Jersey Spill Compensation Fund, as Plaintiffs, vs. Occidental Chemical Corporation, Tierra Solutions, Inc., Maxus Energy Corporation, Repsol YPF, S.A., YPF, S.A., YPF Holdings, Inc., and CLH Holdings, as Defendants (Docket No. L-009868-05) (the “Tierra/Maxus Litigation”). In the Tierra/Maxus Litigation, which was filed on December 13, 2005, the plaintiffs seek to recover from the defendants past and future cleanup and removal costs, as well as unspecified economic damages, punitive damages, penalties and a variety of other forms of relief, purportedly arising from the alleged discharges into the Passaic River of a particular type of dioxin and other unspecified hazardous substances. The damages being sought by the plaintiffs from the defendants are likely to be substantial. On February 4, 2009, two of the defendants, Tierra Solutions, Inc. (“Tierra”) and Maxus Energy Corporation (“Maxus”), filed a third party complaint against over 300 entities, including the Company, seeking to recover all or a proportionate share of cleanup and removal costs, damages or other loss or harm, if any, for which Tierra or Maxus may be held liable in the Tierra/Maxus Litigation. Tierra and Maxus allege that Standard Tallow Company, an entity that the Company acquired in 1996, contributed to the discharge of the hazardous substances that are the subject of this case while operating a former plant site located in Newark, New Jersey. The Company is investigating these allegations, has entered into a joint defense agreement with many of the other third-party defendants and intends to defend itself vigorously. Additionally, in December 2009, the Company, along with numerous other entities, received notice from the United States Environmental Protection Agency (EPA) that the Company (as successor-in-interest to Standard Tallow Company) is considered a potentially responsible party with respect to alleged contamination in the lower Passaic River area which is part of the Diamond Alkali Superfund Site located in Newark, New Jersey. In the letter, EPA requested that the Company join a group of other parties in funding a remedial investigation and feasibility study at the site. As of the date of this report, the Company has not agreed to participate in the funding group. The Company's ultimate liability for investigatory costs, remedial costs and/or natural resource damages in connection with the lower Passaic River area cannot be determined at this time; however, as of the date of this report, there is nothing that leads the Company to believe that these matters will have a material effect on the Company's financial position or results of operation.

(6)    Business Segments

Effective January 2, 2011, as a result of the acquisition of Griffin, the Company's business operations were reorganized into two new segments, Rendering and Bakery, in order to better align its business with the underlying markets and customers that the Company serves. All historical periods have been restated for the changes to the segment reporting structure. The Company sells its products domestically and internationally. The measure of segment profit (loss) includes all revenues, operating expenses (excluding certain amortization of intangibles), and selling, general and administrative expenses incurred at all operating locations and excludes general corporate expenses.

Included in corporate activities are general corporate expenses and the amortization of intangibles. Assets of corporate activities include cash, unallocated prepaid expenses, deferred tax assets, prepaid pension, and miscellaneous other assets.

Rendering
Rendering operations process poultry, animal by-products and used cooking oil into fats (primarily BFT, PG and YG), protein (primarily MBM and PM (feed grade and pet food grade)) and hides. Fat was approximately $245.5 million and $92.6 million of net sales for the three months ended July 2, 2011 and July 3, 2010, respectively and approximately $481.7 million and $175.7 million of net sales for the six months ended July 2, 2011 and July 3, 2010, respectively.

10



Protein was approximately $120.4 million and $55.4 million of net sales for the three months ended July 2, 2011 and July 3, 2010, respectively and $230.5 million and $116.8 million of net sales for the six months ended July 2, 2011 and July 3, 2010, respectively. Rendering also provides grease trap servicing. Included in Rendering is the National Service Center (“NSC”). The NSC schedules services such as fat and bone and used cooking oil collection and trap cleaning for contracted customers using the Company's resources or third party providers.

Bakery
Bakery products are collected from large commercial bakeries that produce a variety of products, including cookies, crackers, cereal, bread, dough, potato chips, pretzels, sweet goods and biscuits, among others. The Company processes the raw materials into BBP, including Cookie Meal®, an animal feed ingredient primarily used in poultry rations.

Business Segment Net Sales (in thousands):

 
 
Three Months Ended
Six Months Ended
 
July 2,
2011
July 3,
2010
July 2,
2011
July 3,
2010
Rendering
$
392,675

$
166,210

$
764,245

$
328,992

Bakery
77,935


146,263


Total
$
470,610

$
166,210

$
910,508

$
328,992


Business Segment Profit/(Loss) (in thousands):

 
 
Three Months Ended
Six Months Ended
 
July 2, 2011
July 3, 2010
July 2, 2011
July 3, 2010
Rendering
$
93,398

$
28,647

$
182,354

$
57,950

Bakery
18,541


33,509


Corporate Activities
(51,967
)
(16,387
)
(95,101
)
(33,302
)
Interest expense
(7,745
)
(889
)
(21,973
)
(1,799
)
Net Income
$
52,227

$
11,371

$
98,789

$
22,849


 Business Segment Assets (in thousands):

 
 
July 2,
2011
January 1,
2011
Rendering
$
1,117,568

$
1,102,719

Bakery
169,205

166,658

Corporate Activities
117,049

112,881

Total
$
1,403,822

$
1,382,258

 
(7)    Income Taxes
 
The Company has provided income taxes for the three-month periods ended July 2, 2011 and July 3, 2010, based on its estimate of the effective tax rate for the entire 2011 and 2010 fiscal years.
 
The Company accounts for income taxes using the asset and liability method.  Under the asset and liability method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases.  Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled.  The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.

The Company periodically assesses whether it is more likely than not that it will generate sufficient taxable income to realize its deferred income tax assets.  In making this determination, the Company considers all available positive and

11



negative evidence and makes certain assumptions.  The Company considers, among other things, its deferred tax liabilities, the overall business environment, its historical earnings and losses, current industry trends and its outlook for future years.  Although the Company is unable to carryback any of its net operating losses, based upon recent favorable operating results and future projections, the Company believes it is more likely than not that certain net operating losses can be carried forward and utilized and other deferred tax assets will be realized.

The Company’s major taxing jurisdiction is the U.S. (federal and state).  The Company is no longer subject to federal examinations on years prior to fiscal 2007.  The number of years open for state tax audits varies, depending on the tax jurisdiction, but are generally from three to five years. Currently, several state examinations are in progress.  The Company does not anticipate that any state or federal audits will have a significant impact on the Company’s results of operations or financial position.  In addition, the Company does not reasonably expect any significant changes to the estimated amount of liability associated with the Company’s unrecognized tax positions in the next twelve months.

(8)    Debt

Credit Facilities

Senior Secured Credit Facilities. On December 17, 2010, the Company entered into a credit agreement (the “Credit Agreement”) in connection with the Griffin Transaction, consisting of a five-year senior secured revolving loan facility and a six-year senior secured term loan facility. On March 25, 2011, the Company amended its Credit Agreement to increase the aggregate available principal amount under the revolving loan facility from $325.0 million to $415.0 million (approximately $75.0 million of which will be available for a letter of credit sub-facility and $15.0 million of which will be available for a swingline sub-facility) and to add additional stepdowns to the pricing grid providing lower spread margins to the applicable base or Libor rate under the Credit Agreement based on defined leverage ratio levels. As of July 2, 2011, the Company had availability of $371.6 million under the revolving loan facility, taking into account outstanding borrowings of $20.0 million and letters of credit issued of $23.4 million. As of July 2, 2011, the Company had repaid approximately $240.0 million of the original $300.0 million term loan issued under the Credit Agreement, and had an outstanding remaining balance of approximately $60 million on its term loan facility. The amounts that have been repaid on the term loan may not be reborrowed. Quarterly amortization payments on the term loan of $0.15 million will begin on June 30, 2012, with the final installment due December 17, 2016. As a result of the term loan payments, the Company incurred a write-off of a portion of the senior term loan facilities deferred loan costs of approximately $4.2 million in the three month period ending April 2, 2011, which is included in interest expense. The revolving credit facility has a five-year term ending December 17, 2015. The Company used the proceeds of the term loan facility and a portion of the revolving loan facility to pay a portion of the consideration of its acquisition of Griffin, to pay related fees and expenses and to provide for working capital needs and general corporate purposes.

The Credit Agreement allows for borrowings at per annum rates based on the following loan types. With respect to any revolving facility loan, i) an alternate base rate means a rate per annum equal to the greatest of (a) the prime rate (b) the federal funds effective rate (as defined in the Credit Agreement) plus ½ to 1% and (c) the adjusted London Inter-Bank Offer Rate (“LIBOR”) for a month interest period plus 1%, plus in each case, a margin determined by reference to a pricing grid under the Credit Agreement and adjusted according to the Company's adjusted leverage ratio, and, ii) Eurodollar rate loans bear interest at a rate per annum based on the then applicable LIBOR multiplied by the statutory reserve rate plus a margin determined by reference to a pricing grid and adjusted according to the Company's adjusted leverage ratio. With respect to an alternate base rate loan that is a term loan, at no time will the alternate base rate be less than 2.50% per annum, plus the term loan alternate base rate margin of 2.50%. With respect to a LIBOR loan that is a term loan, at no time will the LIBOR rate applicable to the term loans (before giving effect to any adjustment for reserve requirements) be less than 1.50% per annum, plus the term loan LIBOR margin of 3.50%. At July 2, 2011 under the Credit Agreement, the interest rate for the $60.0 million of the term loan that was outstanding was based on LIBOR plus a margin of 3.5% per annum for a total of 5.0% per annum. The interest rate for $20.0 million of the revolver loan amount outstanding was based on base rate plus a margin of 2.25% per annum for a total of 5.50% per annum.


12



The Credit Agreement contains various customary representations and warranties by the Company, which include customary use of materiality, material adverse effect and knowledge qualifiers. The Credit Agreement also contains (a) certain affirmative covenants that impose certain reporting and/or performance obligations on the Company, (b) certain negative covenants that generally prohibit, subject to various exceptions, the Company from taking certain actions, including, without limitation, incurring indebtedness, making investments, incurring liens, paying dividends, and engaging in mergers and consolidations, sale leasebacks and sales of assets, (c) financial covenants such as maximum total leverage ratio and a minimum fixed charge coverage ratio and (d) customary events of default (including a change of control). Obligations under the Credit Agreement may be declared due and payable upon the occurrence of such customary events of default.

Senior Notes. On December 17, 2010, Darling issued $250.0 million aggregate principal amount of its 8.5% Senior Notes due 2018 (the “Restricted Notes”) under an indenture with U.S. Bank National Association, as trustee. Darling used the net proceeds from the sale of the Restricted Notes to finance in part the cash portion of the purchase price paid in connection with Darling's acquisition of Griffin. The Company will pay 8.5% annual cash interest on the Restricted Notes on June 15 and December 15 of each year, commencing June 15, 2011. Other than for extraordinary events such as change of control and defined assets sales, the Company is not required to make any mandatory redemption or sinking fund payments on the Restricted Notes.

Holders of the Restricted Notes have the benefit of registration rights. In connection with the issuance of the Restricted Notes, Darling and the subsidiary guarantors entered into a registration rights agreement (the “Notes Registration Rights Agreement”) with the representative of the initial purchasers. In accordance with the terms of the Notes Registration Rights Agreement, on June 15, 2011, the Company filed a registration statement on Form S-4 to offer to exchange all outstanding Restricted Notes for $250.0 million 8.5% Senior Notes due 2018 (the “Exchange Notes” and collectively with the Restricted Notes, the “Notes”). The exchange offer was made effective June 27, 2011 and expired July 27, 2011 with the Company offering to exchange all outstanding Restricted Notes that are validly tendered and not withdrawn prior to the expiration or termination of the exchange offer for an equal principal amount of the applicable Exchange Notes. As of July 27, 2011 all of the Notes have been exchanged. The terms of the Exchange Notes are substantially identical in all material respects to those of the applicable outstanding Restricted Notes, except that transfer restrictions, registration rights and additional interest provisions relating to the Restricted Notes do not apply to the Exchange Notes. The Exchange Notes will be issued under the same indenture as the Restricted Notes. The Company did not receive any proceeds from the exchange offer. The Exchange Notes may be sold in the over-the-counter market, in negotiated transactions or through a combination of such methods. The Company does not plan to list the Notes on a national market.

The Company may at any time and from time to time purchase Notes in the open market or otherwise. The Notes are redeemable, in whole or in part, at any time on or after December 15, 2014 at the redemption prices specified in the indenture. Prior to December 15, 2014, the Company may redeem some or all of the Notes at a redemption price of 100% of the principal amount of the Notes redeemed, plus accrued and unpaid interest to the redemption date and an applicable premium as specified in the indenture.

The indenture contains covenants limiting Darling's ability and the ability of its restricted subsidiaries to, among other things; incur additional indebtedness or issue preferred stock; pay dividends on or make other distributions or repurchase of Darling's capital stock or make other restricted payments; create restrictions on the payment of dividends or other amounts from Darling's restricted subsidiaries to Darling or Darling's other restricted subsidiaries; make loans or investments; enter into certain transactions with affiliates; create liens; designate Darling's subsidiaries as unrestricted subsidiaries; and sell certain assets or merge with or into other companies or otherwise dispose of all or substantially all of Darling's assets.

The indenture also provides for customary events of default, including, without limitation, payment defaults, covenant defaults, cross acceleration defaults to certain other indebtedness in excess of specified amounts, certain events of bankruptcy and insolvency and judgment defaults in excess of specified amounts. If any such event of default occurs and is continuing under the indenture, the Trustee or the holders of at least 25% in principal amount of the total outstanding Notes may declare the principal, premium, if any, interest and any other monetary obligations on all the then outstanding Notes issued under the indenture to be due and payable immediately.

The Credit Agreement and the Notes consisted of the following elements at July 2, 2011 and January 1, 2011, respectively (in thousands):


13



 
 
July 2,
2011
January 1,
2011
Senior Notes:
 
 
8.5% Senior Notes due 2018
$
250,000

$
250,000

Senior Secured Credit Facilities:
 
 
Term Loan
$
60,000

$
300,000

Revolving Credit Facility:
 

 

Maximum availability
$
415,000

$
325,000

Borrowings outstanding
20,000

160,000

Letters of credit issued
23,383

23,383

Availability
$
371,617

$
141,617


The obligations under the Credit Agreement are guaranteed by Darling National, Griffin, and its subsidiary, Craig Protein Division, Inc (“Craig Protein”) and are secured by substantially all of the property of the Company, including a pledge of 100% of the stock of all material domestic subsidiaries and 65% of the capital stock of certain foreign subsidiaries. The Notes are guaranteed on an unsecured basis by Darling's existing restricted subsidiaries, including Darling National, Griffin and all of its subsidiaries, other than Darling's foreign subsidiaries, its captive insurance subsidiary and any inactive subsidiary with nominal assets. The Notes rank equally in right of payment to any existing and future senior debt of Darling. The Notes will be effectively junior to existing and future secured debt of Darling and the guarantors, including debt under the Credit Agreement, to the extent of the value of assets securing such debt. The Notes will be structurally subordinated to all of the existing and future liabilities (including trade payables) of each of the subsidiaries of Darling that do not guarantee the Notes. The guarantees by the guarantors (the “Guarantees”) rank equally in right of payment to any existing and future senior indebtedness of the guarantors. The Guarantees will be effectively junior to existing and future secured debt of the guarantors including debt under the Credit Agreement, to the extent the value of the assets securing such debt. The Guarantees will be structurally subordinated to all of the existing and future liabilities (including trade payables) of each of the subsidiaries of each guarantor that do not guarantee the Notes.

As of July 2, 2011, the Company believes it is in compliance with all of the financial covenants, as well as all of the other covenants contained in the Credit Agreement and the Notes Indenture. 

(9)    Stockholders' Equity

On January 27, 2011, the Company entered into an underwritten public offering for 24,193,548 shares of its common stock, at a price to the public of $12.70 per share, pursuant to an effective shelf registration statement. The offering closed on February 2, 2011. In addition, certain former stockholders of Griffin Industries, Inc. (pursuant to such stockholders' contractual registration rights) granted the underwriters a 30-day option, which the underwriters subsequently exercised in full, to purchase from them up to an additional 3,629,032 shares of Darling common stock to cover over-allotments. The Company used the net proceeds of approximately $292.7 million from the offering to repay all of its then outstanding revolver balance and a portion of its term loan facility under the Company's Credit Agreement. Darling did not receive any proceeds from the sale of shares by the former stockholders of Griffin.

(10)    Derivatives

The Company’s operations are exposed to market risks relating to commodity prices that affect the Company’s cost of raw materials, finished product prices and energy costs and the risk of changes in interest rates.

The Company makes limited use of derivative instruments to manage cash flow risks related to interest expense, natural gas usage, diesel fuel usage and inventory. The Company does not use derivative instruments for trading purposes. Interest rate swaps are entered into with the intent of managing overall borrowing costs by reducing the potential impact of increases in interest rates on floating-rate long-term debt. Natural gas swaps and options are entered into with the intent of managing the overall cost of natural gas usage by reducing the potential impact of seasonal weather demands on natural gas that increases natural gas prices. Heating oil swaps are entered into with the intent of managing the overall cost of diesel fuel usage by reducing the potential impact of seasonal weather demands on diesel fuel that increases diesel fuel prices. Inventory swaps and options are entered into with the intent of managing seasonally high concentrations of MBM, PM, BFT, PG, YG and BBP inventories by reducing the potential impact of decreasing prices. At July 2, 2011, the Company had natural gas swaps outstanding that qualified and were designated for hedge accounting as well as heating oil swaps and natural gas swaps and options that did not qualify and were not designated for hedge accounting.

14




Entities are required to report all derivative instruments in the statement of financial position at fair value. The accounting for changes in the fair value (i.e., gains or losses) of a derivative instrument depends on whether it has been designated and qualifies as part of a hedging relationship and, if so, on the reason for holding the instrument. If certain conditions are met, entities may elect to designate a derivative instrument as a hedge of exposures to changes in fair value, cash flows or foreign currencies. If the hedged exposure is a cash flow exposure, the effective portion of the gain or loss on the derivative instrument is reported initially as a component of other comprehensive income (outside of earnings) and is subsequently reclassified into earnings when the forecasted transaction affects earnings. Any amounts excluded from the assessment of hedge effectiveness as well as the ineffective portion of the gain or loss are reported in earnings immediately. If the derivative instrument is not designated as a hedge, the gain or loss is recognized in earnings in the period of change.

Cash Flow Hedges

On May 19, 2006, the Company entered into two interest rate swap agreements that were considered cash flow hedges according to FASB authoritative guidance. In December 2010, as a result of the Merger and entry into a new Credit Agreement the term loan that specifically related to these interest swap transactions was repaid. As such, the Company discontinued and paid approximately $2.0 million representing the fair value of these two interest swap transactions at the discontinuance date with the effective portion in accumulated other comprehensive loss to be reclassified to income over the remaining original term of the interest swaps which ends April 7, 2012.

In fiscal 2010, the Company entered into natural gas swap contracts that are considered cash flow hedges. Under the terms of the natural gas swap contracts the Company fixed the expected purchase cost of a portion of its plants expected natural gas usage through the second quarter of fiscal 2011. As of July 2, 2011, all of the contracts have expired and settled according to the contracts.

In the first six months of fiscal 2011, the Company entered into natural gas swap contracts that are considered cash flow hedges. Under the terms of the natural gas swap contracts the Company fixed the expected purchase cost of a portion of its plants expected natural gas usage for the third and fourth quarters of fiscal 2011. As of July 2, 2011, some of the contracts have expired and settled according to the contracts while the remaining contract positions and activity are disclosed below.

The Company estimates the amount that will be reclassified from accumulated other comprehensive loss at July 2, 2011 into earnings over the next 12 months will be approximately $0.9 million. As of July 2, 2011, approximately $0.6 million of losses have been reclassified into earnings as a result of the discontinuance of cash flow hedges.

The following table presents the fair value of the Company’s derivative instruments under FASB authoritative guidance as of July 2, 2011 and January 1, 2011 (in thousands):

Derivatives Designated
Balance Sheet
Asset Derivatives Fair Value
as Hedges
Location
July 2, 2011
January 1, 2011
Natural gas swaps
Other current assets
$
10

$
135

 
 
 
 
Total asset derivatives designated as hedges
$
10

$
135

 
 
 
 
Derivatives not
Designated as
Hedges
 
 

 

Natural gas swaps and options
Other current assets
$
27

$
212

Heating oil swaps
Other current assets
51

81

 
 
 
 
Total asset derivatives not designated as hedges
$
78

$
293

 
 
 
 
Total asset derivatives
 
$
88

$
428



15



Derivatives Designated
Balance Sheet
Liability Derivatives Fair Value
as Hedges
Location
July 2, 2011
January 1, 2011
Natural gas swaps
Accrued expenses
$
77

$
16

 
 
 
 
Total liability derivatives designated as hedges
$
77

$
16

 
 
 
 
Derivatives not
Designated as
Hedges
 
 

 

Natural gas swaps
Accrued expenses
$
13

$

Heating oil swaps
Accrued expenses
113


 
 
 
 
Total liability derivatives not designated as hedges
$
126

$

 
 
 
 
Total liability derivatives
$
203

$
16



The effect of the Company’s derivative instruments on the consolidated financial statements as of and for the three months ended July 2, 2011 and July 3, 2010 is as follows (in thousands):

 
 
 
Derivatives
Designated as
Cash Flow Hedges
 
Gain or (Loss)
Recognized in OCI
on Derivatives
(Effective Portion) (a)
Gain or (Loss)
Reclassified From
Accumulated OCI
into Income
(Effective Portion) (b)
Gain or (Loss)
Recognized in Income
on Derivatives
(Ineffective Portion and
Amount Excluded from
Effectiveness Testing) (c)
 
2011
2010
2011
2010
2011
2010
Interest rate swaps
$

$
(196
)
$
(303
)
$
(407
)
$

$
24

Natural gas swaps
18

150

105

27

(9
)
92

 
 
 
 
 
 
 
Total
$
18

$
(46
)
$
(198
)
$
(380
)
$
(9
)
$
116


(a)
Amount recognized in accumulated OCI (effective portion) is reported as accumulated other comprehensive gain/(loss) of less than $0.1 million recorded net of taxes of less than $0.1 million as of July 2, 2011 and July 3, 2010, respectively.
(b)
Gains and (losses) reclassified from accumulated OCI into income (effective portion) for interest rate swaps and natural gas swaps is included in interest expense and cost of sales, respectively, in the Company’s consolidated statements of operations.
(c)
Gains and (losses) recognized in income on derivatives (ineffective portion) for interest rate swaps and natural gas swaps is included in other, net in the Company’s consolidated statements of operations.

The effect of the Company’s derivative instruments on the consolidated financial statements as of and for the six months ended July 2, 2011 and July 3, 2010 is as follows (in thousands):


16



 
 
 
Derivatives
Designated as
Cash Flow Hedges
 
Gain or (Loss)
Recognized in OCI
on Derivatives
(Effective Portion) (a)
Gain or (Loss)
Reclassified From
Accumulated OCI
into Income
(Effective Portion) (b)
Gain or (Loss)
Recognized in Income
on Derivatives
(Ineffective Portion and
Amount Excluded from
Effectiveness Testing) (c)
 
2011
2010
2011
2010
2011
2010
Interest rate swaps
$

$
(516
)
$
(622
)
$
(827
)
$

$
26

Natural gas swaps
231

67

(45
)
248

(1
)
87

 
 
 
 
 
 
 
Total
$
231

$
(449
)
$
(667
)
$
(579
)
$
(1
)
$
113


(a)
Amount recognized in accumulated OCI (effective portion) is reported as accumulated other comprehensive gain/(loss) of approximately $0.2 million and approximately $0.4 million recorded net of taxes of approximately $0.1 million and $0.2 million as of July 2, 2011 and July 3, 2010, respectively.
(b)
Gains and (losses) reclassified from accumulated OCI into income (effective portion) for interest rate swaps and natural gas swaps is included in interest expense and cost of sales, respectively, in the Company’s consolidated statements of operations.
(c)
Gains and (losses) recognized in income on derivatives (ineffective portion) for interest rate swaps and natural gas swaps is included in other, net in the Company’s consolidated statements of operations.

At July 2, 2011, the Company had forward purchase agreements in place for purchases of approximately $4.7 million of natural gas and diesel fuel.  These forward purchase agreements have no net settlement provisions and the Company intends to take physical delivery of the underlying product.  Accordingly, the forward purchase agreements are not subject to the requirements of fair value accounting because they qualify as normal purchases as defined in the FASB authoritative guidance.

(11)      Comprehensive Income

The Company follows FASB authoritative guidance for reporting and presentation of comprehensive income or loss and its components.  For the three months ended July 2, 2011 and July 3, 2010, total comprehensive income was $52.8 million and $12.1 million, respectively. For the six months ended July 2, 2011 and July 3, 2010, total comprehensive income was $99.9 million and $23.9 million, respectively.  

(12)    Revenue Recognition

The Company recognizes revenue on sales when products are shipped and the customer takes ownership and assumes risk of loss.  Certain customers may be required to prepay prior to shipment in order to maintain payment protection against certain foreign and domestic sales.  These amounts are recorded as unearned revenue and recognized when the products have shipped and the customer takes ownership and assumes risk of loss.  The Company has formula arrangements with certain suppliers whereby the charge or credit for raw materials is tied to published finished product commodity prices after deducting a fixed processing fee incorporated into the formula and is recorded as a cost of sale by line of business.  The Company recognizes revenue related to grease trap servicing in the month the trap service occurs.

(13)    Employee Benefit Plans

The Company has retirement and pension plans covering substantially all of its employees.  Most retirement benefits are provided by the Company under separate final-pay noncontributory and contributory defined benefit and defined contribution plans for all salaried and hourly employees (excluding those covered by union-sponsored plans) who meet service and age requirements. Defined benefits are based principally on length of service and earnings patterns during the five years preceding retirement.

Net pension cost for the three and six months ended July 2, 2011 and July 3, 2010 includes the following components (in thousands):

17



 
Three Months Ended
Six Months Ended
 
July 2,
2011
July 3,
2010
July 2,
2011
July 3,
2010
Service cost
$
295

$
264

$
590

$
528

Interest cost
1,513

1,489

3,026

2,978

Expected return on plan assets
(1,722
)
(1,597
)
(3,444
)
(3,194
)
Amortization of prior service cost
22

28

44

56

Amortization of net loss
681

783

1,362

1,566

Net pension cost
$
789

$
967

$
1,578

$
1,934

  
The Company's funding policy for employee benefit pension plans is to contribute annually not less than the minimum amount required nor more than the maximum amount that can be deducted for federal income tax purposes.  Contributions are intended to provide not only for benefits attributed to service to date, but also for those expected to be earned in the future. Based on actuarial estimates at July 2, 2011, the Company expects to contribute approximately $2.3 million to its pension plans to meet funding requirements during the next twelve months.  

The Company participates in several multi-employer pension plans which provide defined benefits to certain employees covered by labor contracts. The Company knows that three of these multi-employer plans were under-funded as of the latest available information, some of which is over a year old.  The Company has no ability to compel the plan trustees to provide more current information to the extent it has not already been prepared for and is available to the plan trustees. In June 2009, the Company received a notice of a mass withdrawal termination and a notice of initial withdrawal liability from a multi-employer plan in which it participates. The Company had anticipated this event and as a result had accrued approximately $3.2 million as of January 3, 2009 based on the most recent information that was probable and estimable for this plan. The plan had given a notice of redetermination liability in December 2009. In fiscal 2010, the Company received further third party information confirming the future payout related to this multi-employer plan. As a result, the Company reduced its liability to approximately $1.2 million. In fiscal 2010, another underfunded multi-employer plan in which the Company participates gave notification of partial withdrawal liability. As of July 2, 2011, the Company has an accrued liability of approximately $1.1 million representing the present value of scheduled withdrawal liability payments under this multi-employer plan. While the Company has no ability to calculate a possible current liability for under-funded multi-employer plans that could terminate or could require additional funding under the Pension Protection Act of 2006, the amounts could be material.

(14)    Fair Value Measurements

FASB authoritative guidance defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements.  The following table presents the Company’s financial instruments that are measured at fair value on a recurring basis as of July 2, 2011 and are categorized using the fair value hierarchy under FASB authoritative guidance.  The fair value hierarchy has three levels based on the reliability of the inputs used to determine the fair value.
 
 
 
Fair Value Measurements at July 2, 2011 Using
 
 
Quoted Prices in
Active Markets for
Identical Assets
Significant Other
Observable
Inputs
Significant
Unobservable
Inputs
(In thousands of dollars)
Total
(Level 1)
(Level 2)
(Level 3)
Assets:
 
 
 
 
Derivative instruments
$
88

$

$
88

$

Total Assets
$
88

$

$
88

$

 
 
 
 
 
Liabilities:
 
 
 
 
Derivative instruments
$
203

$

$
203

$

Total Liabilities
$
203

$

$
203

$


Derivative assets consist of the Company’s natural gas swap, natural gas option and heating oil swap contracts, which represents the difference between observable market rates of commonly quoted intervals for similar assets and liabilities in active markets and the fixed swap rate considering the instruments term, notional amount and credit risk.  See Note 10 Derivatives for breakdown by instrument type.

18




The carrying amount of cash and cash equivalents, accounts receivable, accounts payable and accrued expenses approximates fair value due to the short maturity of these instruments.  Based upon quoted market price the Company's Notes described in Note 8 have a fair value of approximately $273.1 million and $260.6 million compared to a carrying amount of $250.0 million at July 2, 2011 and January 1, 2011, respectively. The Company's term loans and revolver as described in Note 8 have a fair value based on rates the Company believes it would pay for debt of the same remaining maturity. The Company's term loan had a fair value of approximately $59.4 million and $300.0 million compared to a carrying amount of $60.0 million and $300.0 million at July 2, 2011 and January 1, 2011, respectively. The Company's revolver loan had a fair value of approximately $21.7 million and $160.0 million compared to a carrying amount of $20.0 million and $160.0 million at July 2, 2011 and January 1, 2011, respectively. The carrying amount for the Company's other debt is not deemed to be significantly different than the amount recorded and all other financial instruments have been recorded at fair value.

(15)     New Accounting Pronouncements

In January 2010, the FASB issued ASU No. 2010-06, Improving Disclosures about Fair Value Measurements.  The ASU amends ASC Topic 820, Fair Value Measurements and Disclosures.  The new standard provides for additional disclosures requiring the Company to disclose separately the amounts of significant transfers in and out of Level 1 and Level 2 fair value measurements, describe the reasons for the transfers and present separately information about purchases, sales, issuances and settlements in the reconciliation of Level 3 fair value measurements.  The update also provides clarification of existing disclosures requiring the Company to determine each class of assets and liabilities based on the nature and risks of the investments rather than by major security type and for each class of assets and liabilities, and to disclose the valuation techniques and inputs used to measure fair value for both Level 2 and Level 3 fair value measurements.  The Company adopted ASU 2010-06 as of January 3, 2010, except for the presentation of purchases, sales, issuances and settlement in the reconciliation of Level 3 fair value measurements, which is effective for the Company on January 2, 2011.  This update will not change the techniques the Company uses to measure fair values and is not expected to have a material impact on the Company’s consolidated financial statements.

In June 2011, the FASB issued ASU No. 2011-05, Presentation of Comprehensive Income. The ASU amends ASC Topic 220, Comprehensive Income.  The new standard eliminates the option to report other comprehensive income and its components in the statement of changes in equity and instead requires entities to present net income and other comprehensive income in either a single continuous statement or in two separate, but consecutive, statements of net income and other comprehensive income. Reclassification adjustments between net income and other comprehensive income must be shown on the face of the statement(s), with no resulting change in net earnings. This update is effective for the Company on January 1, 2012 and must be applied retrospectively. The Company is currently evaluating which presentation alternative to utilize and does not expect the adoption to have a material impact on the Company's consolidated financial statements.

(16)     Guarantor Financial Information

The Company's Notes (see Note 8) are guaranteed on an unsecured basis by the Company's 100% directly and indirectly owned subsidiaries Darling National, Griffin and its subsidiary Craig Protein (collectively, the "Guarantors"). The Guarantors fully and unconditionally guaranteed the Notes on a joint and several basis. The following financial statements present condensed consolidating financial data for (i) Darling, the issuer of the Notes, (ii) the combined Guarantors, (iii) the combined other subsidiaries of the Company that did not guarantee the Notes (the "Non-guarantors"), and (iv) eliminations necessary to arrive at the Company's consolidated financial statements, which include condensed consolidated balance sheets as of July 2, 2011 and January 1, 2011, and the condensed consolidating statements of operations for the three and six months ended July 2, 2011 and July 3, 2010 and the condensed consolidating statements of cash flows for the six months ended July 2, 2011 and July 3, 2010.






19



Condensed Consolidating Balance Sheet
As of July 2, 2011
(in thousands)

 
Issuer
Guarantors
Non-guarantors
Eliminations
Consolidated
ASSETS
 
 
 
 
 
Total current assets
$
95,852

$
310,077

$
3,344

$
(196,967
)
$
212,306

Investment in subsidiaries
1,211,650



(1,211,650
)

Property, plant and equipment, net
118,733

277,271



396,004

Intangible assets, net
19,833

356,744

304


376,881

Goodwill
32,441

345,343

266


378,050

Investment in unconsolidated subsidiary


9,567


9,567

Other assets
27,652

3,362



31,014

 
$
1,506,161

$
1,292,797

$
13,481

$
(1,408,617
)
$
1,403,822

LIABILITIES AND STOCKHOLDERS’ EQUITY
 

 

 
 
 

Total current liabilities
$
265,108

$
80,896

$
2,516

$
(196,967
)
$
151,553

Long-term debt, net of current portion
329,848

25



329,873

Other noncurrent liabilities
35,321

11,004

187


46,512

Deferred income taxes
15,154




15,154

Total liabilities
645,431

91,925

2,703

(196,967
)
543,092

Stockholders’ equity:
 

 

 
 
 

Common stock, additional paid-in capital and treasury stock
583,212

1,022,544

15,412

(1,037,956
)
583,212

Retained earnings and accumulated other comprehensive loss
277,518

178,328

(4,634
)
(173,694
)
277,518

Total stockholders’ equity
860,730

1,200,872

10,778

(1,211,650
)
860,730

 
$
1,506,161

$
1,292,797

$
13,481

$
(1,408,617
)
$
1,403,822




20



Condensed Consolidating Balance Sheet
As of January 1, 2011
(in thousands)

 
Issuer
Guarantors
Non-guarantors
Eliminations
Consolidated
ASSETS
 
 
 
 
 
Total current assets
$
95,679

$
196,383

$
4,669

$
(111,145
)
$
185,586

Investment in subsidiaries
1,118,467



(1,118,467
)

Property, plant and equipment, net
119,511

273,909



393,420

Intangible assets, net
21,569

369,385



390,954

Goodwill
32,441

343,822



376,263

Other assets
31,136

3,321

1,578


36,035

 
$
1,418,803

$
1,186,820

$
6,247

$
(1,229,612
)
$
1,382,258

LIABILITIES AND STOCKHOLDERS’ EQUITY
 

 

 
 
 

Total current liabilities
$
202,705

$
59,343

$
3,927

$
(111,145
)
$
154,830

Long-term debt, net of current portion
707,000

30



707,030

Other noncurrent liabilities
39,460

11,004

296


50,760

Deferred income taxes
5,342




5,342

Total liabilities
954,507

70,377

4,223

(111,145
)
917,962

Stockholders’ equity:
 

 

 
 
 

Common stock, additional paid-in capital and treasury stock
286,696

1,022,544

6,224

(1,028,768
)
286,696

Retained earnings and accumulated other comprehensive loss
177,600

93,899

(4,200
)
(89,699
)
177,600

Total stockholders’ equity
464,296

1,116,443

2,024

(1,118,467
)
464,296

 
$
1,418,803

$
1,186,820

$
6,247

$
(1,229,612
)
$
1,382,258





Condensed Consolidated Statements of Operations
For the three months ended July 2, 2011
(in thousands)

 
Issuer
Guarantors
Non-guarantors
Eliminations
Consolidated
Net sales
$
183,604

$
327,243

$
4,683

$
(44,920
)
$
470,610

Cost and expenses:
 
 
 
 
 
Cost of sales and operating expenses
135,325

230,335

4,489

(44,921
)
325,228

Selling, general and administrative expenses
17,524

16,527

41


34,092

Depreciation and amortization
5,571

13,473

11


19,055

Total costs and expenses
158,420

260,335

4,541

(44,921
)
378,375

Operating income
25,184

66,908

142

1

92,235

 
 

 

 
 
 

Interest expense
(7,745
)



(7,745
)
Other, net
(648
)
(283
)
102

(1
)
(830
)
Equity in net loss of unconsolidated subsidiary


(1,174
)

(1,174
)
Earnings in investments in subsidiaries
41,588



(41,588
)

Income from operations before taxes
58,379

66,625

(930
)
(41,588
)
82,486

Income taxes
6,152

24,448

(341
)

30,259

Net income
$
52,227

$
42,177

$
(589
)
$
(41,588
)
$
52,227



21



Condensed Consolidated Statements of Operations
For the six months ended July 2, 2011
(in thousands)

 
Issuer
Guarantors
Non-guarantors
Eliminations
Consolidated
Net sales
$
358,259

$
634,357

$
11,232

$
(93,340
)
$
910,508

Cost and expenses:
 
 
 
 
 
Cost of sales and operating expenses
267,379

441,834

10,746

(93,340
)
626,619

Selling, general and administrative expenses
32,711

31,993

81


64,785

Depreciation and amortization
11,755

26,970

11


38,736

Total costs and expenses
311,845

500,797

10,838

(93,340
)
730,140

Operating income
46,414

133,560

394


180,368

 
 

 

 
 
 

Interest expense
(21,972
)
(1
)


(21,973
)
Other, net
(1,106
)
(385
)
95


(1,396
)
Equity in net loss of unconsolidated subsidiary


(1,174
)

(1,174
)
Earnings in investments in subsidiaries
83,995



(83,995
)

Income from operations before taxes
107,331

133,174

(685
)
(83,995
)
155,825

Income taxes
8,542

48,745

(251
)

57,036

Net income
$
98,789

$
84,429

$
(434
)
$
(83,995
)
$
98,789




Condensed Consolidated Statements of Operations
For the three months ended July 3, 2010
(in thousands)
 
 
Issuer
Guarantors
Non-guarantors
Eliminations
Consolidated
Net sales
$
132,470

$
64,650

$

$
(30,910
)
$
166,210

Cost and expenses:
 
 
 
 
 
Cost of sales and operating expenses
99,717

55,046


(30,910
)
123,853

Selling, general and administrative expenses
14,873

1,364



16,237

Depreciation and amortization
5,336

1,870



7,206

Total costs and expenses
119,926

58,280


(30,910
)
147,296

Operating income
12,544

6,370



18,914

 
 

 

 
 
 

Interest expense
(888
)
(1
)


(889
)
Other, net
(120
)
6

(334
)

(448
)
Earnings in investments in subsidiaries
3,930



(3,930
)

Income from operations before taxes
15,466

6,375

(334
)
(3,930
)
17,577

Income taxes (benefit)
4,095

2,229

(118
)

6,206

Net income
$
11,371

$
4,146

$
(216
)
$
(3,930
)
$
11,371





22



Condensed Consolidated Statements of Operations
For the six months ended July 3, 2010
(in thousands)
 
 
Issuer
Guarantors
Non-guarantors
Eliminations
Consolidated
Net sales
$
257,385

$
135,512

$

$
(63,905
)
$
328,992

Cost and expenses:
 
 
 
 
 
Cost of sales and operating expenses
195,358

112,810


(63,905
)
244,263

Selling, general and administrative expenses
29,264

2,738



32,002

Depreciation and amortization
10,458

3,772



14,230

Total costs and expenses
235,080

119,320


(63,905
)
290,495

Operating income
22,305

16,192



38,497

 
 

 

 
 
 

Interest expense
(1,797
)
(2
)


(1,799
)
Other, net
(313
)
8

(677
)

(982
)
Earnings in investments in subsidiaries
9,929



(9,929
)

Income from operations before taxes
30,124

16,198

(677
)
(9,929
)
35,716

Income taxes (benefit)
7,275

5,836

(244
)

12,867

Net income
$
22,849

$
10,362

$
(433
)
$
(9,929
)
$
22,849



Condensed Consolidated Statements of Cash Flows
For the six months ended July 2, 2011
(in thousands)

 
Issuer
Guarantors
Non-guarantors
Eliminations
Consolidated
Cash flows from operating activities:
 
 
 
 
 
Net income
$
98,789

$
84,429

$
(434
)
$
(83,995
)
$
98,789

Earnings in investments in subsidiaries
(83,995
)


83,995


Other operating cash flows
79,603

(70,755
)
10,867


19,715

Net cash provided by operating activities
94,397

13,674

10,433


118,504

 
 
 
 
 
 
Cash flows from investng activities:
 
 
 
 
 
Capital expenditures
(10,770
)
(17,100
)


(27,870
)
Acquisitions
(164
)



(164
)
Investment in unconsolidated subsidiary


(10,741
)

(10,741
)
Gross proceeds from sale of property, plant and equipment and other assets
457

208



665

Net cash used in investing activities
(10,477
)
(16,892
)
(10,741
)

(38,110
)
 
 
 
 
 
 
Cash flows from financing activities:
 
 
 
 
 
Payments on long-term debt
(240,000
)
(5
)


(240,005
)
Net payments on revolver
(140,000
)



(140,000
)
Deferred loan costs
(267
)



(267
)
Issuances of common stock
293,189




293,189

Minimum withholding taxes paid on stock awards
(1,205
)



(1,205
)
Excess tax benefits from stock-based compensation
1,136




1,136

Net cash used in financing activities
(87,147
)
(5
)


(87,152
)
 
 
 
 
 
 
Net decrease in cash and cash equivalents
(3,227
)
(3,223
)
(308
)

(6,758
)
Cash and cash equivalents at beginning of year
13,108

5,480

614


19,202

Cash and cash equivalents at end of year
$
9,881

$
2,257

$
306

$

$
12,444



23



Condensed Consolidated Statements of Cash Flows
For the six months ended July 3, 2010
(in thousands)

 
Issuer
Guarantors
Non-guarantors
Eliminations
Consolidated
Cash flows from operating activities:
 
 
 
 
 
Net income
$
22,849

$
10,362

$
(433
)
$
(9,929
)
$
22,849

Earnings in investments in subsidiaries
(9,929
)


9,929


Other operating cash flows
11,882

(8,574
)
433


3,741

Net cash provided by operating activities
24,802

1,788



26,590

 
 
 
 
 
 
Cash flows from investng activities:
 
 
 
 
 
Capital expenditures
(7,593
)
(1,807
)


(9,400
)
Acquisitions
(15,284
)



(15,284
)
Gross proceeds from sale of property, plant and equipment and other assets
135

9



144

Payments related to routes and other intangibles
(991
)



(991
)
Net cash used in investing activities
(23,733
)
(1,798
)


(25,531
)
 
 
 
 
 
 
Cash flows from financing activities:
 
 
 
 
 
Payments on long-term debt
(2,500
)
(4
)


(2,504
)
Issuances of common stock
7




7

Minimum withholding taxes paid on stock awards
(442
)



(442
)
Excess tax benefits from stock-based compensation
184




184

Net cash used in financing activities
(2,751
)
(4
)


(2,755
)
 
 
 
 
 
 
Net decrease in cash and cash equivalents
(1,682
)
(14
)


(1,696
)
Cash and cash equivalents at beginning of year
68,126

56



68,182

Cash and cash equivalents at end of year
$
66,444

$
42

$

$

$
66,486


24




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

The following Management's Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements that involve risks and uncertainties. The Company's actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors, including those set forth below under the heading “Forward Looking Statements” and elsewhere in this report, and under the heading “Risk Factors” in the Company's Annual Report on Form 10-K for the year ended January 1, 2011, and in the Company's other public filings with the SEC.

The following discussion should be read in conjunction with the historical consolidated financial statements and notes thereto.

Overview

The Company is a leading provider of rendering, cooking oil and bakery waste recycling and recovery solutions to the nation's food industry. The Company collects and recycles animal by-products, bakery waste and used cooking oil from poultry and meat processors, commercial bakeries, grocery stores, butcher shops, and food service establishments and provides grease trap cleaning services to many of the same establishments. On December 17, 2010, Darling completed its acquisition of Griffin Industries, Inc. (which was subsequently converted to a limited liability company) and its subsidiaries (“Griffin”) pursuant to the Agreement and Plan of Merger, dated as of November 9, 2010 (the “Merger Agreement”), by and among Darling, DG Acquisition Corp., a wholly-owned subsidiary of Darling (“Merger Sub”), Griffin and Robert A. Griffin, as the Griffin shareholders' representative. Merger Sub was merged with and into Griffin (the “Merger”), and Griffin survived the Merger as a wholly-owned subsidiary of Darling. The Company operates over 125 processing and transfer facilities located throughout the United States to process raw materials into finished products such as protein (primarily meat and bone meal (“MBM”) and poultry meal (“PM”)), hides, fats (primarily bleachable fancy tallow (“BFT”), poultry grease (“PG”) and yellow grease (“YG”)), and bakery by-product (“BBP”) as well as a range of branded and value-added products. Effective January 2, 2011, as a result of the acquisition of Griffin, the Company's business operations were reorganized into two new segments, Rendering and Bakery, in order to better align its business with the underlying markets and customers that the Company serves. All historical periods have been restated for the changes to the segment reporting structure. Comparative segment revenues and related financial information are discussed herein and are presented in Note 6 to the consolidated financial statements. The Company sells these products nationally and internationally, primarily to producers of animal feed, pet food, fertilizer, bio-fuels and other consumer and industrial ingredients, including oleo-chemicals, soaps and leather goods for use as ingredients in their products or for further processing. All of the Company's finished products are commodities and are priced relative to competing commodities, primarily corn, soybean oil and soybean meal. Finished product prices will track as to nutritional and industry value to the ultimate customer's use of the product. As a result of the Merger, the Company's first six months of fiscal 2011 results include a full six months of contribution of Griffin, as compared to no contribution from the Griffin assets in the first six months of fiscal 2010. The accompanying consolidated financial statements should be read in conjunction with the audited consolidated financial statements contained in the Company's Form 10-K for the fiscal year ended January 1, 2011, as amended by Form 8-K filed on June 15, 2011.

During the second quarter of fiscal 2011 the Company's operating performance significantly improved relative to the second quarter of fiscal 2010. Rendering volumes were slightly lower overall while overall bakery waste inputs remained unchanged in the second quarter of fiscal 2011 as compared to the first quarter of fiscal 2011. Results were positively influenced by strong finished product prices for proteins and fats, which were reflected in strong prices for MBM, PM, BFT, PG and YG, and strong finished product prices for BBP as the Company continues the integration of Griffin. Finished product prices for fats were significantly higher in the second quarter of fiscal 2011 as compared to the second quarter of fiscal 2010 while feed grade protein prices were modestly higher. Pet grade specialty ingredients rose modestly during the quarter before declining near the end. Energy prices remained fairly consistent.
The bakery business segment made a solid contribution during the second quarter of fiscal 2011. Input volumes were consistent with the first quarter of fiscal 2011 and began seasonally increasing towards the end of the quarter as commercial bakeries operated longer hours. Cookie Meal® prices improved significantly over the first quarter of fiscal 2011 consistent with the rising price of corn, which ultimately drove bakery segment earnings.
Operating income increased by $73.3 million in the second quarter of fiscal 2011 compared to the second quarter of fiscal 2010 driven significantly by contributions from Griffin. The challenges faced by the Company indicate there can be no assurance that operating results achieved by the Company in the second quarter of fiscal 2011 are indicative of future operating performance of the Company.

25




Summary of Critical Issues Faced by the Company during the Second Quarter of 2011

The acquisition of Griffin has contributed a significant amount to the Company's operations during the current quarter. The financial impact of the acquisition of Griffin is summarized below in Results of Operations.
Significantly higher finished product prices for fats and proteins as compared to second quarter of fiscal 2010 are a sign of improving U.S. and world economies, increased global demand for BFT and YG for use in bio-fuels, tightening global grain supplies and increased Asian demand for protein. Finished product prices were favorable to the Company's sales revenue, but this favorable result was partially offset by the negative impact on raw material cost, due to the Company's formula pricing arrangements with raw material suppliers, which index raw material cost to the prices of finished product derived from the raw material. The financial impact of finished goods prices on sales revenue and raw material cost is summarized below in Results of Operations. Comparative sales price information from the Jacobsen index, an established trading exchange publisher used by management, is provided below in Summary of Key Indicators.
Higher raw material volumes were collected from suppliers during the second quarter of fiscal 2011 as compared to the second quarter of fiscal 2010. Management believes the positive effect of the integration of prior year acquisition activity, excluding the effects of the acquisition of Griffin, and improving conditions in the U.S. economy contributed to the increase in raw material volumes collected by the Company during the second quarter of fiscal 2011 as compared to fiscal 2010. The financial impact of higher raw material volumes is summarized below in Results of Operations.

Summary of Critical Issues and Known Trends Faced by the Company in 2011 and Thereafter

Critical Issues and Challenges:

The acquisition of Griffin is the largest and most significant acquisition Darling has undertaken. Although Darling expects that Griffin's business will operate to a significant extent on an independent basis and that it will not require significant integration going forward for the Company to continue the operations of Griffin's business, this may not prove to be the case. The Company's management will continue to be required to devote a significant amount of time and attention to the process of integrating the operations of Darling's business and the business of Griffin.
Finished product prices for MBM, PM (both feed grade and pet food grade), BFT, PG, YG and BBP commodities have increased during the second quarter of fiscal 2011 as compared to the same period of fiscal 2010.  No assurance can be given that this increase in commodity prices for various proteins, fats and bakery products will continue in the future, as commodity prices are volatile by their nature.  A future decrease in commodity prices could have a significant impact on the Company’s earnings for the remainder of fiscal 2011 and into future periods.
The Company's overall raw material volumes increased during the first six months of fiscal 2011 as compared to the same period in fiscal 2010 as beef volumes were higher. However, poultry volumes were down in the Southeast as higher corn ingredient costs impacted poultry processing rates. No assurance can be given that beef volumes will continue to increase and there is no assurance that poultry volumes will not decrease further in the future.  A future decrease in beef volumes or further decreases in poultry volumes could have a significant impact on the Company's earnings for the remainder of fiscal 2011 and into future periods.
The Company consumes significant volumes of natural gas to operate boilers in its plants, which generate steam to heat raw material.  Natural gas prices represent a significant cost of factory operation included in cost of sales.  The Company also consumes significant volumes of diesel fuel to operate its fleet of tractors and trucks used to collect raw material.  Diesel fuel prices represent a significant component of cost of collection expenses included in cost of sales.  Lower natural gas prices were offset by higher diesel fuel prices during the first six months of fiscal 2011 as compared to the same period of fiscal 2010.  These prices can be volatile and there can be no assurance that these prices will not increase in the near future, thereby representing an ongoing challenge to the Company’s operating results for future periods.  A material increase in energy prices for natural gas and/or diesel fuel over a sustained period of time could materially adversely affect the Company’s business, financial condition and results of operations.

Worldwide Government Policies

Pursuant to the requirements established by the Energy Independence and Security Act of 2007, on February 3, 2010 the EPA finalized regulations for the National Renewable Fuel Standard Program (“RFS2”).  The regulation mandates the domestic use of biomass-based diesel (biodiesel or renewable diesel) of 0.8 billion gallons in 2011 and 1.0 billion

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gallons in 2012.  Beyond 2012 the regulation requires a minimum of 1.0 billion gallons of biomass-based diesel for each year through 2022, which amount is subject to increase by the EPA Administrator.  On June 20, 2011, the EPA issued a proposed rule which would require 1.0 billion gallons of biomass-based diesel for the calendar year 2012 and 1.28 billion gallons for the calendar year 2013. Biomass-based diesel also qualifies to fulfill the non-specified portion of the advanced bio-fuel requirement.  In order to qualify as a “renewable fuel” each type of fuel from each type of feedstock is required to lower greenhouse gas emissions (“GHG”) by levels specified in the regulation.  The EPA has determined that bio-fuels (either biodiesel or renewable diesel) produced from waste oils, fats and greases result in an 86% reduction in GHG emissions exceeding the 50% requirement established by the regulation.  Prices for the Company’s finished products may be impacted by worldwide government policies relating to renewable fuels and greenhouse gas emissions.  Programs like RFS2 and tax credits for bio-fuels both in the U.S. and abroad may positively impact the demand for the Company’s finished products.  Accordingly, changes to, a failure to enforce or discontinuing of these programs could have a negative impact on the Company’s business and results of operations.
The Company’s exports are subject to the imposition of tariffs, quotas, trade barriers and other trade protection measures imposed by foreign countries regarding the import of the Company’s MBM, BFT and YG.  General economic and political conditions as well as the closing of borders by foreign countries to the import of the Company’s products due to animal disease or other perceived health or safety issues impact the Company.  As a result trade policies by foreign countries could have a negative impact on the Company’s business and results of operations.
Other Food Safety and Regulatory Issues

Effective August 1997, the FDA promulgated a rule prohibiting the use of mammalian proteins, with some exceptions, in feeds for cattle, sheep and other ruminant animals (referred to herein as the “BSE Feed Rule”) to prevent further spread of BSE, commonly referred to as “mad cow disease.” Detection of the first case of BSE in the United States in December 2003 resulted in additional U.S. government regulations, finished product export restrictions by foreign governments, market price fluctuations for the Company's finished products and reduced demand for beef and beef products by consumers. Even though the export markets for U.S. beef have rebounded and 2011 export volumes may exceed pre-BSE levels, most export markets remain closed to MBM derived from U.S. beef. Continued concern about BSE in the United States may result in additional regulatory and market related challenges that may affect the Company's operations or increase the Company's operating costs.
With respect to BSE in the United States, on October 26, 2009, the FDA began enforcing new regulations intended to further reduce the risk of spreading BSE (“Enhanced BSE Rule”). These new regulations included amending the BSE Feed Rule to prohibit the use of tallow having more than 0.15% insoluble impurities in feed for cattle or other ruminant animals. In addition, the FDA implemented rules that prohibit the use of brain and spinal cord material from cattle aged 30 months and older or the carcasses of such cattle, if the brain and spinal cord are not removed, in the feed or food for all animals (“Prohibited Cattle Materials”). Tallow derived from Prohibited Cattle Materials that also contains more than 0.15% insoluble impurities cannot be fed to any animal. The Company has followed the Enhanced BSE Rule since it was first published in 2008 and has made capital expenditures and implemented new processes and procedures to be compliant with the Enhanced BSE Rule at all of the Company's operations. Based on the foregoing, while the Company acknowledges that unanticipated issues may arise as the FDA continues to implement the Enhanced BSE Rule and conducts compliance inspections, the Company does not currently anticipate that the Enhanced BSE Rule will have a significant impact on the Company operations or financial performance. Notwithstanding the foregoing, the Company can provide no assurance that unanticipated costs and/or reductions in raw material volumes related to the Company's implementation of and compliance with the Enhanced BSE Rule will not negatively impact the Company's operations and financial performance.
With respect to human food, pet food and animal feed safety, the Food and Drug Administration Amendments Act of 2007 (the “Act”) was signed into law on September 27, 2007 as a result of Congressional concern for pet and livestock food safety, following the discovery in March 2007 of pet and livestock food that contained adulterated imported ingredients. The Act directs the Secretary of Health and Human Services and the FDA to promulgate significant new requirements for the pet food and animal feed industries. As a prerequisite to new requirements specified by the Act, the FDA was directed to establish a Reportable Food Registry, which was implemented on September 8, 2009. On June 11, 2009, the FDA issued “Guidance for Industry: Questions and Answers Regarding the Reportable Food Registry as Established by the Food and Drug Administration Amendments Act of 2007: Draft Guidance.” Stakeholder comments and questions about the Reportable Food Registry that were submitted to the docket or during public meetings were incorporated into a second draft guidance (“RFR Draft Guidance”), which was published on September 8, 2009. In the RFR Draft Guidance, the FDA defined a reportable food, which the manufacturer or distributor would be required to report in the Reportable Food Registry, to include materials used as ingredients in animal feeds and pet foods, if there is reasonable probability that the use of such materials will cause serious adverse health consequences or death to humans or animals. The FDA issued a second version of its

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RFR Draft Guidance in May 2010 without finalizing it. On July 27, 2010, the FDA released “Compliance Policy guide Sec. 690.800, Salmonella in Animal Feed, Draft Guidance” (“Draft CPG”), which describes differing criteria to determine whether pet food and farmed animal feeds that are contaminated with salmonella will be considered to be adulterated under section 402(a)(1) of the Food Drug and Cosmetic Act. According to the Draft CPG, any finished pet food contaminated with any species of salmonella will be considered adulterated because such feeds have direct human contact. Finished animal feeds intended for pigs, poultry and other farmed animals, however, will be considered to be adulterated only if the feed is contaminated with a species of salmonella that is considered to be pathogenic for the animal species that the feed is intended for. The impact of the Act and implementation of the Reportable Food Registry on the Company, if any, will not be clear until the FDA finalizes its RFR Draft Guidance and the Draft CPG, neither of which were finalized as of the date of this report. The Company believes that it has adequate procedures in place to assure that its finished products are safe to use in animal feed and pet food and the Company does not currently anticipate that the Act will have a significant impact on the Company's operations or financial performance. Any pathogen, such as salmonella, that is correctly or incorrectly associated with the Company's finished products could have a negative impact on the demand for the Company's finished products.
In addition, on January 4, 2011, President Barack Obama signed the Food Safety Modernization Act (“FSMA”) into law. As enacted, the FSMA gave the FDA new authorities, which became effective immediately. Included among these is mandatory recall authority for adulterated foods that are likely to cause serious adverse health consequences or death to humans or animals, if the responsible party fails to cease distribution and recall such adulterated foods voluntarily. The FSMA further instructed the FDA to amend existing regulations that define its administrative detention authority so that the criteria needed for detaining human or animal food are lowered. Prior to the FSMA becoming law, FDA had authority to order that an article of food be detained only if there was credible evidence or information indicating that the article of food presented a threat of serious adverse health consequences or death to humans or animals. On May 5, 2011, FDA issued an interim final rule amending its administrative detention authority and lowering both the level of proof and the degree of risk required for detaining an article of food. This interim final rule, which became effective on July 3, 2011, gives the FDA authority to detain an article of food if there is reason to believe the food is adulterated or misbranded. In addition to amending existing regulations, the FSMA requires the FDA to develop new regulations that, among other provisions, places additional registration requirements on food and feed producing firms; requires registered facilities to perform hazard analysis and to implement preventive plans to control those hazards identified to be reasonably likely to occur; increases the length of time that records are required to be retained; and regulates the sanitary transportation of food. Such new food safety provisions will require new FDA rule making. The Company has followed the FSMA throughout its legislative history and implemented hazard prevention controls and other procedures that the Company believes will be needed to comply with the FSMA. Such rule-making could, among other things, require the Company to amend certain of the Company's other operational policies and procedures. While unforeseen issues and requirements may arise as the FDA promulgates the new regulations provided for by the FSMA, the Company does not anticipate that the costs of compliance with the FSMA will materially impact the Company's business or operations.
The emergence of diseases such as 2009 H1N1 flu (initially know as “Swine Flu”) and H5N1 avian influenza (“Bird Flu”) that are in or associated with animals and have the potential to also threaten humans has created concern that such diseases could spread and cause a global pandemic. Even though such a pandemic has not occurred, governments may be pressured to address these concerns and prohibit imports of animals, meat and animal by-products from countries or regions where the disease is detected. The occurrence of Swine Flu, Bird Flu or any other disease in the United States that is correctly or incorrectly linked to animals and has a negative impact on meat or poultry consumption or animal production could have a material negative impact on the volume of raw materials available to the Company or the demand for the Company's finished products.

Results of Operations

Three Months Ended July 2, 2011 Compared to Three Months Ended July 3, 2010

Summary of Key Factors Impacting Second Quarter 2011 Results:
 
Principal factors that contributed to a $73.3 million increase in operating income, which are discussed in greater detail in the following section, were:

13 weeks of contribution from the acquisition of Griffin,
Changes in finished product prices, and
Increase in raw material volume.